This article originally appeared in Independent Agent magazine.
For many agency owners, exit strategies aren’t strategies at all.
If you believe perpetuation is an event you’ll make happen when you’re ready to retire, that critique applies to you. Perpetuation is a process that requires a long-term plan and diligent execution, and that means your best chance for successful perpetuation lies in careful planning over the years—not months—leading up to your retirement.
When agency principals build a plan around the four critical components of agency perpetuation, they’re far more likely to succeed. Here’s what you need to remember.
1) People. The people to whom you will sell your business are the most important aspects of any ownership perpetuation process. These professionals must be able to:
- Take responsibility for leading your agency into the future.
- Manage day-to-day operations as well as strategic goals and accomplishments.
- Maintain your existing client base and generate new business.
Finding the right people to perpetuate your agency—whether they’re family members, long-term employees or new recruits—is one of the most difficult tasks for any agency principal. Not everyone has the necessary level of skills, drive, motivation or talent.
And don’t be blinded by family or long-term employee allegiances. At family-owned firms in particular, prospective employees who have a different last name may feel they face a glass ceiling when it comes time for a leadership transition. Always place the most qualified people in key roles and let these employees know they have a future in the agency’s leadership. Then groom them for years to expose them to the realities of agency management.
2) Agency value. Make sure you’re realistic about the value of the agency. The value of your business is based on its future profits, not revenue.
When determining yours, look to an independent industry adviser to perform a risk assessment and analyze projected profitability. Depending on the type of transaction—asset or stock sale?—you may also need to evaluate your firm’s balance sheet. Sellers who set an unrealistically high price for their agency will very likely price themselves out of a perpetuation.
Remember that an internal buyer can only afford to pay what the business can generate, plus cash reserves. Outside buyers will almost always pay more. Agency principals who want to pursue an internal perpetuation must accept that they will be “leaving money on the table” compared to a third-party sale.
If you end up with purchase prices that cannot be supported by projected cash flow over seven to nine years, you’ve set your agency’s value too high. Stretching payments over a longer period of time would ease the cash burden, but using the same logic, would you pay for a car over eight years or a house for 50?
3) Capital. Many perpetuation plans that involve buying out a significant owner require more cash than the agency can generate through normal operations in the early years after a transaction. Management should build up enough cash to cover these shortfalls.
As a general rule, agency perpetuations are not tax efficient. In a stock redemption, the buyer of agency stock makes the purchase with after-tax dollars from retained earnings. In a transaction between shareholders, the buyer generally requires excess bonus compensation funding from the company to generate the cash necessary to meet the payment obligations of the purchase price. Regardless, the Internal Revenue Service is a party.
The only way owners can increase their agency’s capital base for supporting a future ownership transition is to retain some of the firm’s earnings over time. Doing so will negatively impact your agency’s tax burden or current cash position of agency owners, but building a rainy-day fund is always prudent, regardless of perpetuation plans.
4) Time. No matter what your perpetuation plan, its success requires plenty of time. From recruiting and grooming potential candidates to building a capital base for supporting the ownership transition, agency principals need to recognize that perpetuation is a long-term process—not a decision you can reach in a single strategy planning session.
Starting from scratch, you need a minimum of five years to set up and implement a workable plan—assuming that everything goes smoothly. If perpetuation candidates leave, the agency’s value slumps or capital is redirected, you may need as long as 10 years to complete your plan.