(Editors note: This is the second in a three-part series. Augusts Insider newsletter included a story that addressed mergers vs. acquisitions. In October, we will finish the series with a look from the sell side.)

There are two sides to the Merger & Acquisition (M&A) transaction; the buy-side and the sell-side. The respective processes are very different and will be explored separately, as the driving forces behind being a buyer vs. a seller are generally at opposite ends of the spectrum. We will first review the M&A transaction from the buyers perspective, followed by the sellers perspective.

All businesses have two primary means of growth; organic growth generated through new customers and new employees vs. mergers or acquisitions. There are a number of pros and cons to each form of growth as listed in the tables below, which is why many firms pursue both strategies.

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Neither choice is risk free or guaranteed, nor is either choice right or wrong, but there are certain aspects of the M&A process that buyers should consider to mitigate the risk of completing a bad deal.

M&A Buy-side Transactions

Acquiring another business is a significant operational and financial stepping stone to growth. There are a number of distinct phases to the M&A process, as illustrated below:

Phase 1 Defining the parameters of what to acquire

Phase 2 Develop and implement an on-going acquisition marketing plan

Phase 3 Assessment of Risk and Value of prospective acquisition candidate

Phase 4 Establish the structure and form of the acquisition transaction

Phase 5 Preparation of Offer Letter, Due Diligence and Transaction Closing

Phase 6 Post acquisition integration

Each of these separate phases will be briefly discussed below, but please recognize this is not an all-inclusive set of instructions. For anyone other than the most experienced M&A buyers, it may be worth your time and other resources to consider engaging an industry expert to help navigate the M&A process.

Phase 1 Defining the parameters of what to acquire

As an interested buyer of another agency, there are a number of factors to be considered when starting to look for something to acquire. Its not recommended to pursue anything that lives and breathes, so the buyer should ask themselves a series of questions to help narrow the field:

1. What kind of firm do we want to acquire? Do we want to expand our product mix, or add on to what we currently offer?

a. P&C vs. Benefits

b. Personal vs. Commercial

c. Large account focus vs. smaller accounts

d. Niche focus vs. generalists

2. Do we want to expand our sales territory, or become a bigger player in our current market?

3. Do we want to create a short-term exit for a seller, or a long-term growth opportunity (i.e. a firm owned by someone 55-65 yrs old, or 40-50 yrs old)?

4. How large of an agency do we want to acquire, in terms of revenue, # owners, # producers?

5. What is the appetite for risk and debt start small or go big?

The first step is to establish a matrix or scoring mechanism for the preferred type of business the buyer wants to acquire, and then not stray outside the box spending time, energy and resources pursuing extraneous deals. The next step is for the buyer to create marketing and communication plans to get the word out, and be able to explain and illustrate why they would be the best buyer candidate for sellers to consider.

Phase 2 Develop and implement an on-going acquisition marketing plan

Identifying M&A prospects can be a time consuming process since it generally involves face to face time with a number of individuals, trying to determine if they fit the profile you are looking for, and then forging a relationship with them. The M&A process seldom leads to a fast transaction and instead often involves a long-term relationship building process. Sellers as a rule are not willing to consider a sale until theyre ready to sell, something buyers have little influence over. The goal is to make sure a variety of potential sellers are aware of the buyers interest, and think enough of the buyer, their relationship, and their organization to contact them when they are ready to do something.

Phase 3 — Assessment of Risk and Value of prospective acquisition candidate

Fast forward to when a likely seller candidate has been identified, courted, and is ready to sell; its time to determine what the business is worth and how it should be paid for. Many buyers believe this is the time for an independent consultant to provide their assessment of Fair Market Value for the selling agency. Unfortunately, this is often the wrong use of the valuation process for two reasons:

A Fair Market Appraisal of Value is intended to provide an unbiased assessment of the value of the subject firm to a hypothetical third party buyer as it stands without any external influences (e.g. buyer synergies and other operational changes)

Every buyer is different, and the value of a seller to each particular buyer will be different (i.e. value is in the eye of the beholder).

Instead of a valuation, the key financial considerations in the acquisition of another agency are generally the projection of cash flows and return on investment (ROI) measurements, although ROI can be somewhat artificially influenced by how the transaction is being financed. Nevertheless, it is critically important for the buyer to develop a set of financial projections in order to track revenue, expenses, cash flow, and debt service (unless paid entirely with existing cash balances) under a variety of performance scenarios to evaluate the risk and margin of error. If the buyers organization does not possess the skill sets or experience to be able to develop this type of financial model, they would be well served to engage an industry expert for their assistance.

The value the selling agency has to the buyer is determined based on how much it can afford to pay under a normal set of assumptions for growth and expense management. If there are a variety of synergies that can arise in the transaction, such as eliminating duplicate positions, better utilization of office space, or ability to create more efficient operations due to increased scale, these can all be incorporated into the purchase price consideration. A word of caution, however; while its not unusual to provide the seller with some degree of the synergy value in this kind of analysis, keep in mind that it really isnt the seller delivering this value, but rather the buyer taking advantage of their own situation.

In addition to the pure financial modeling, the buyer should engage in a risk assessment of the sellers firm, primarily focused on the book of business. Risk attributes to consider include any unusual concentration of business in limited accounts, insurance companies, product niches, client tenure, etc. Additionally, buyers should evaluate the restrictive language in all employment contracts, producer ownership or vesting in books of business, the technical training, professionalism and experience levels of the staff and producers, the agencys office location, client locations, sales management, status of information technology utilization, and other matters depending on the situation. All things being equal, a seller deemed to have less risk in the business will drive a higher purchase price multiple.

Phase 4 — Establish the structure and form of the acquisition transaction

No two transactions are identical, and there are countless ways to structure an acquisition transaction. Generally speaking, buyers prefer to pay only for the revenue or profit actually recorded; in effect a 100% retention transaction. Sellers on the other hand will almost always prefer 100% cash both illustrations of a no-risk scenario. Unfortunately, these are mutually independent, so both parties must concede something to the other side and be willing to accept a certain amount of risk in the transaction. The key is to determine how much risk each side is willing to accept, then structure and price the transaction accordingly.

There are a variety of options when it comes to structuring an acquisition:

Stock purchase vs. Asset purchase

All cash vs. all debt vs. something in between

Seller financing vs. 3rd party lenders

Fixed price vs. performance based incentive

Revenue vs. Profit based performance incentives

On-going compensation or consulting arrangements vs. seller exit

An issue buyers must address at the onset of any discussion is whether to purchase a firms assets or the stock of the company. Assets can be amortized for tax purposes over 15 years under current tax law, thus reducing the effective cost of the acquisition (or allowing the buyer to pay a little more). Buying assets also limits the buyers liability exposure since they are not acquiring the actual legal entity. If the seller is a C-Corp (or an S-Corp that converted from a C-Corp within a certain period of time), selling the assets of the firm can be very expensive from a tax liability perspective, often referred to as the double-tax effect. For sellers other than C-Corp entities, asset sales will generally provide them with the preferred lower capital gains treatment on the proceeds. Both buyer and seller should always have their tax advisor review the transaction terms and structure for any adverse tax or other regulatory ramifications before making any firm commitments on price and terms.

Phase 5 Preparation of Offer Letter, Due Diligence and Transaction Closing

Once terms have been negotiated and agreed upon in a Letter of Intent or Term Sheet, there remains one critical step the buyer needs to address verification of all the information provided by the seller, or Due Diligence. Throughout the M&A process and the exchange of information between parties, the information is generally accepted as accurate. The purpose of Due Diligence, as President Reagan referred to the Soviet Union during the 1980s, is Trust but Verify, and its critical the buyer take the time to perform some level of verification of the financial information provided by the seller.

In an asset purchase, the primary focus of the Diligence review is generally verification of selected revenue information, certain expense items, and the billing/collection/cash processing, but other areas may also need to be covered depending on the degree of integration of the two firms post-acquisition. In a stock purchase transaction, since the buyer is acquiring the whole company, a much more in-depth review of the assets and liabilities of the seller needs to be considered to protect the interests of the buyer. Similar to the financial modeling process, if the buyer does not have the internal resources or skill sets to adequately perform these reviews, they should consider engaging an outside party with familiarity with this type of service.

The final stage of a buy-side engagement involves legal advisors taking much that has come from the above steps and putting it into legal documents in preparation for the closing. An attorney with buy-side transactional experience is preferred to the family attorney that drafts wills, estate plans and real estate transactions, and one with an insurance background is preferred to one who is unfamiliar with the nuances of insurance. It is common practice for the buyers attorney to prepare the initial drafts of the purchase documents and any employment contracts, and to represent the buyers interest in any subsequent negotiation of terms.

Phase 6 Post acquisition integration

Once the transaction has closed, buyer and seller need to have an integration plan to meld the two organizations into one cohesive unit. Too many acquisitions fail to achieve their intended level of synergies, revenue and profits because the parties did not spend the time thinking about and implementing an integration policy. To help everyone reach the maximum potential benefits of the transaction, there needs to be consideration of all aspects of the sellers organization and how clients, processes, and individuals will be impacted by the change.

Summary Comments

The purchase of an insurance agency is a significant event in the life of the business. Buyers want to acquire at the least expensive price possible, while sellers want to extract the maximum amount of money from the buyer as possible. Buyers need to be conscious of not letting their M&A emotions carry them away to inflated values just to do a deal.

Executing the purchase of a business from start to finish is an exhausting and distracting process. It may take several years for a buyer to find the right agency to purchase, and 6-12 months to complete a transaction. There are many stages to the transaction, the most significant of which have been identified above, but each transaction will have its own peculiarities, trials, and tribulations for all parties involved. Maintaining an objective perspective in times of adversity, and staying focused on achieving the big picture goals will help to keep the respective process moving forward.

Daniel P. Menzer, CPA, CM&AA is a principal with OPTIS Partners, LLC (www.optisins.com ), a Chicago and Minneapolis based investment banking and financial consulting firm providing M&A, valuation and strategic consulting services to firms in the insurance distribution sector. Mr. Menzer can be reached at 630-520-0490 or via email at menzer@optisins.com.