A GPS for Your Sale

Use M&A expertise to avoid deal-breaker potholes.

If you follow agency mergers and acquisitions, this edition of Leader’s Edge has a lot for you to ponder. When you read our annual Merger & Acquisition Review in this issue, you might be struck by the amount of activity. If that spurs you to think about selling your brokerage—or buying one—consider this: A successful arrival at your destination may depend on expert navigation by a professional M&A advisor.

We called 2010 “The Year of Clarity” in agency M&A because the trends have come into focus, allowing us some certainty in our outlook for 2011 and beyond. As you know if you’ve read our report, 2010 was quite a rebound year. We saw 258 announced transactions, a 40% increase from 2009 and the fourth most active on record.

I am involved in and observe many transactions. I am constantly amazed by the things I see and hear from buyers and sellers. What often is most surprising is how naive many potential sellers and buyers are when it comes to deciding if they should hire an advisor to guide them through the M&A process.

It may sound self-serving, but the decision to hire an advisor may be the most important one a seller or a buyer will make. But how can you be sure it is a wise decision, and how do you know you’ve signed with the right advisor?

The Role of an Advisor

Although I’ve been handling M&A transactions for decades, I am still mystified by sellers or buyers who think they can navigate this world without an advisor. I acknowledge anybody can get a deal done, but how do you ever know if it was truly successful? A successful M&A transaction can be defined by finding the right partner, the right price or the right deal structure—or by many other financial and non-financial attributes of the deal.

Insurance professionals tend to think of themselves as the best salespeople, so naturally many believe they are expertly qualified to sell their own business. They’re not. They treat the sale of their business as if they were selling an insurance policy. They use anecdotal information regarding multiples to convince themselves they are experts in putting a deal together. But when I ask them about things like working capital, baseline purchase price versus total purchase price, earn-outs, taxes, non-competes, escrow, indemnification, baskets and deductibles, and other critical issues, they act like price is all that matters. The reality is that price is just the beginning. The devil, as they say, is in the details.

If you want to learn more about the value of an advisor, and how to choose one, look to one of the great industry tag lines: “trusted advisor.” Insurance people use the term all the time. We believe in that term. But what does it mean?

Those of you who have heard me speak know that I define a trusted advisor as a person who is strategically important to help you achieve your business goals and objectives and is hard to replace. So if you believe in your role as a trusted advisor to your clients, why would you not want a trusted advisor when selling your most valuable asset?

When I speak with prospective clients, I tell them it is a huge mistake not to hire an advisor. Whether helping the client prepare the company for sale, negotiating the deal points or managing the rough spots that inevitably surface during a six- to nine-month process, an advisor who specializes in the insurance industry boosts your chances of a successful outcome. While most prospects understand the role and the value, the next question always is: “Is it worth the fee?”

An Advisor’s Fees

Hiring an experienced advisor is not cheap, but just as with a football team that spends big money to get a highly rated quarterback, the return on investment can be huge. Many people don’t like to get into details on fees, so let’s lay that approach on the table.

An advisor typically charges a non-refundable retainer and a success fee. The retainer can range from $5,000 to $50,000 for a typical middle-market transaction. Let’s narrow this range and make it $10,000 to $25,000.

Beyond the retainer, an advisor gets paid solely on a success fee basis, which means the advisor gets further payment only if a deal is closed. M&A transaction advising is a high-risk, high-reward business. The typical success fee is generally a percentage of the purchase price. Once again, the range can vary, from 2% to 7%, depending on the size and complexity of a deal. Let’s use 3% to 4% as the norm. So if the transaction involves a $5 million revenue firm that sells for $7.5 million and the advisor’s fee is 4%, then the advisor will be paid $300,000.

I have several additional thoughts on this fee example:

1. What do you pay a real estate agent on the sale of your house? Often it’s 5% to 6%. An advisor’s fee is a bargain compared to that.
2. Assuming you have a pro forma EBITDA margin of 25%, that sale price translates to $1.25 million and a multiple of six times EBITDA. Sounds reasonable, right? Well, if the advisor can increase the multiple by just .25 times, you recoup your fee.
3. Let’s consider working capital. Do you know how much working capital is required? It could be 15 days, 30 days or even 60 days. I have been involved in deals where we negotiated a lower working capital amount that exceeded our fee.
4. What percent is normal to be paid upfront? It could be 70% to 80%. Once again, advisors can recoup their fee just from negotiating the amount paid upfront.
5. How do you know what a reasonable earn-out looks like? An advisor’s experience can help you make a fair arrangement.

I could discuss many more deal points that show how an advisor fee can lead to an enormous return on investment. The reality is that the multitude of steps in any transaction is a huge distraction for agency owners who also need to manage their business. Those competing priorities require owners to have a trusted advisor on their side.

Choosing an Advisor

If you are still reading, you might be thinking, “Yes, an advisor makes sense. But how do I choose one?” Consider the following:

1. What is the advisor’s experience? Your advisor needs to have the relevant experience in executing M&A deals in the insurance industry. A generalist will never get you the best deal.
2. Does the advisor have experience in your specialty? If you are an employee benefits firm, you don’t want to work with an advisor who primarily works with p-c firms. Many advisors say they are experts, but make sure you ask questions to confirm that they really understand your business. What comparable transactions have they worked on? How big were those deals, and who were the buyers?
3. What additional support will the advisor provide? In other words, who else will work on your engagement besides the advisor? Is someone else available when questions arise? A one-person advisory firm is not enough. Understand the roles of the people on the advisor’s team, and don’t be tricked into a bait-and-switch tactic that some advisors use.
4. What are the advisor’s references? While this might seem basic, ask for references and call them. Just like top grading, ask the references specific questions about the process: How did the advisor bring value? Was the advisor always available for calls? Did the advisor help throughout the process? You know you have found a good advisor when the references talk not just about how much more money they made, but about the intangible value the advisor brought for things that you never even considered.
5. What are the advisor’s skill sets? Having M&A experience does not necessarily mean the advisor comes with the specific skills that enhance job performance. Is the advisor a CPA? Where did the advisor work before? What is the advisor’s experience with legal agreements? All these factors help differentiate between a good advisor and a great one.
6. What were some of their broken deals? The last question to ask your potential advisor concerns deals that did not close and, more important, why they didn’t close. Ask how many failed transactions they’ve been involved in. See if you can get a reference from a former client whose transaction did not close. This kind of information could tell you a lot about your advisor.

The Engagement Agreement

Once you hire an advisor, the next step is the engagement agreement. The following are key items you should expect in your agreement.

1. Description of services. Make sure your agreement clearly explains the scope of services to be performed. Key items generally include: preparing a confidential memorandum, performing a valuation, identifying potential buyers, negotiating the transaction, assisting with due diligence and performing some role related to legal agreements.
2. Fee arrangement. As discussed previously, the fee arrangement should cover such points as the retainer (how much and how it is paid—all at once, monthly, etc.); success fee; how the fee is handled on earn-out dollars; and other items, such as escrow, stock in lieu of cash, seller notes, etc.
3. Term of the engagement. How long will the engagement last? Typically it is nine to 12 months, and then month-to-month after that. The agreement also should state how the engagement is terminated (30 days’ written notice, etc.).
4. Exclusivity. Given the high risk/reward equation for an advisor, all advisors will require an exclusive arrangement. An advisor will spend hundreds of hours on your engagement, and the retainer will not come close to covering the costs. While it may seem risky to you to put all your eggs in one basket, if you have done your homework properly, exclusivity should not be a problem.
5. Tail provision. All agreements will have a tail provision that states that, for a time period of time after the engagement is terminated, the advisor will be paid if you complete a transaction with a party that was introduced by the advisor. Typically the tail provision is 12 months.
6. Confidentiality. Your agreement must include language regarding confidentiality. The language should explain, for example, how your advisor will protect your confidential information. It should also stipulate that your approval is required before potential purchasers are contacted.
7. Indemnification. The agreement will include legal language regarding indemnification. Typically, you are indemnifying the advisor against legal action unless the advisor has acted with gross negligence or willful misconduct.
8. Reimbursable expenses. Your advisor will incur out-of-pocket expenses related to travel and other miscellaneous expenses. Your agreement should state either the maximum amount of reimbursable expenses or provide you control over such expenses.

Buying or selling an agency is not easy, and research shows most transactions ultimately fail. While an advisor cannot guarantee success after closing, a qualified, experienced advisor will do so much more than get you the best price.

The transaction process is like a rollercoaster. The bumps and rough spots and challenges will make you wonder whether you will ever get the deal done. However, like a high-quality GPS in an unfamiliar city, the right advisor can quickly become your top M&A asset—and your best investment to ensure a successful deal.

Finally, though you enter the process thinking you have hired a qualified advisor to assist in a complex transaction, you may find that you have hired a lifelong friend who will be your trusted advisor long after the deal is done.