The Impact of Mismanagement on Agency Value
Business valuations, including agency valuations, are completed based on various appraisal standards (indeed, standards do exist although not all appraisers follow them).
These standards vary depending on the purpose of the valuation, the use of the appraisal, and the appraiser's professional standards. Different standards apply based upon the appraiser's professional designations and memberships. For example, the standards for valuing gems is different from the standards for valuing dental practices. The standards applicable to a CPA are different from those applicable to a certified appraiser who is not a CPA. All valuations are supposed to be based on an upfront, agreed upon definition of value before the appraisal begins. As with insurance policies, different definitions of value also exist. In insurance you have replacement cost value, actual cash value, market value, and so on and so forth.
When appraising a business, many definitions of value exist. Typically the two most common definitions are Fair Value and Fair Market Value. It is unfortunate the terms are so similar in name because the definitions and resulting values are often significantly, not only materially, different. Both require the assumption of what a prudent buyer would do upon acquisition, including an adjustment to the ex-owners' compensation to some semblance of the IRS's "Reasonable Compensation" standard.
What happens then when someone wants a valuation of their business/agency that violates all these standards, definitions, and requirements, when the client wants to know the value of imprudent management that violates the Reasonable Compensation rules, among other poor management practices?
The first thing that comes to mind is the need to watch the Mel Brooks' comedy, "The Producers."
What is the motivation and what are the potential issues involved when considering committed mismanagement? Often this request is associated with some form of fraud. The idea is that someone buys into a business at a deep discount with the intention to flip the business using common market standards that they think they understand, but do not. All kinds of laws and tax regulations prohibit this activity (See ESOP and estate tax rules that have been specifically designed to prevent this from occurring).
Sometimes though, the request is associated with an honest endeavor based on a seller's unwillingness to run the business or attempt to run the business well. Nonetheless, the seller wants an honest valuation that accepts that the management incompetency will be maintained post sale. This violates almost all of the business valuation standards of which I am aware, so a formal valuation is most likely impossible. It would be an outright violation of the standards if an ESOP, estate, third-party shareholders, or bank loans are involved. Assuming the appraiser and client can come to an agreement, including a complete and total release of liability of the appraiser from all applicable standards and liabilities, it could be an interesting exercise.
To some extent, the process is much like making the EBITDA adjustments in a regular valuation, but the adjustments are not the same. For example, typically if a phantom mistress is on the payroll, their compensation is excluded in a standard valuation. With bad management, assuming all partners are in agreement regarding including the paramour, her compensation stays. Using a more common example (the mistress example is not a creative invention on my part), the owners take credit for accounts they do not service, maybe never even sold, but they are credited with those accounts. As a result they are paid as if they are servicing those accounts.
Now, let us assume the above example equals ten percentage points of unnecessary expense, not an unusual amount in agencies. Let us further assume an EBITDA multiple of 7 and a based EBITDA of 25% on $1,000,000 in revenue. In a standard valuation, the ten percentage points would be added back making the EBITDA 35% and the value would increase by $700,000 (ten percentage points on $1,000,000 equals $100,000 and multiply that by 7).
But wait! There is more. Less profitable agencies command lower EBITDA multiples, at least usually. Maybe the value goes to 6.5 x $250,000 (25% times $1 million) which equals $1,630,000 instead of 7 times $350,000, which would equal $2,450,000. The difference then is about $825,000. Incompetency is expensive.
Given a choice between competent management and standard valuation parameters or accepting incompetency as a fact, but with a willingness to accept a lower value, the former is the better choice about 99% of the time for most people, but not all. If the incompetency is intransigent, in other words, no hope exists of fixing it and no possibility exists of the buyers refusing to do the deal, then at least acknowledge the issue so the deal is affordable. When the seller insists on maintaining incompetency but also insists on a price based on competency, nothing good can result.
The best example of this situation is when the seller insists on the higher value but simultaneously insists on continuing to be paid far more than they are worth. Even if the loan payments cash flow, not enough cash will remain to enable investment in new producers, new technology, higher staff wages, and so on. The agency will come to a standstill. The new owners will go home nightly deeply frustrated.
Unfortunately, this scenario is common and frankly, it is one reason I really like the IRS's Reasonable Compensation Rules because those regulations allow me to explain to the seller that their goals are not acceptable to the IRS which is far easier than having to tell them they are being too greedy.
To each their own. When you own a business, it is your choice whether you choose competency or incompetency. It is a choice. Sometimes the choice is deliberate and sometimes it is subconscious. The owner will make a choice. Whether they make a commitment might be a different matter. Clarity is mentally beneficial regardless of the choice. No matter what some people telling you what you want to hear, incompetency has a steep price, and that price is evident when agency owners choose to run their businesses incompetently. But maybe, like with some people I know, the price is worth it to you.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand Insurance Education, Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.