In the first chapter, we discussed a number of key performance indicators that agency managers can and should use to maximize their productivity and profitability. I'd like to now talk about three of those things which, if you do nothing else, are the most important for agency owners and managers to focus on to assure not only profitability, but also value.
For many years, my agency partners and I have discussed the inevitability of retirement. Despite our best efforts, none of us is going to live forever - someday we will have to perpetuate the agency. All of us know that, and we know that the agency's profitability and growth rate at the time we sell will drive the value we receive.
What has been difficult for us is to come to an agreement on operational changes to magnify that result. In talking with Mergers and Acquisitions practitioners, I've learned that this curious behavior of my partners and myself is fairly common. The problem with it is that, while the M&A folks and the buyer can adjust your financial statements to look like they would post-acquisition - thus increasing your return - they don't have as much incentive to do that, because it’s the agency owner’s job.
This is why agents that don't pay attention to data analytics don't do as well when they sell… and they also don't do as well during their ownership period. If you think about the returns you as an owner receive from taking the risk to own an insurance agency and for doing the extra work to manage it over decades, you know you will be paid back for those risks and efforts based on the profits you make every year and your sales price.
Now, I’m not talking about complicated predictive analytics or predictive modeling requiring artificial intelligence. Your own intelligence is more than enough to analyze your data and understand where tweaks are needed to increase your competitive advantage and the value of your agency.
The three key analytics that maximize both profits and sale value are Spread, EBITDA, and Year-over-year Growth Rate.
Spread gives you great information about productivity, gross profitability, and how your compensation compares to the marketplace. Spread is the ratio between your revenues per person and your compensation per person - it is a direct measure of gross profitability.
In a service business, payroll is like “cost of goods sold” to a manufacturer. All other expenses come out of gross profit and what remains is net. Compensation is clearly the most expensive item in any insurance business, especially one as customer-centric as ours, where the customized experience and personal relationship are what add value.
If spread is less than it should be, the first thing that you must consider is whether or not your compensation is appropriate. If spread is low, and you discover that your compensation is high relative to the marketplace, this means several things:
- The first thing is that you have room to grow. If you're aggressively growing, that's a good thing: it may be exactly what you want to accomplish from a management perspective.
- On the other hand, it may just indicate that you weren't being as careful as you could be with compensation for your insurance agents.
Aren’t data-driven decisions amazing? Look at all this information you already had at hand, without a digital transformation or data management. Now that you know your spread and have interpreted it, there are two places to look to see whether improvements could be made.
Do you have too many people?
You can determine that through analysis of your data sources, by looking at your revenue per CSR to make sure that each customer service person is managing an appropriate sized book of business compared to generally accepted agency standards in the insurance industry.
Is compensation too high?
Check current compensation studies to determine whether or not CSR’s or producers are being paid more than is typical in the industry. If your customer service people are servicing too small books of business, it may be that you make an informed decision and take an opportunity to not replace the next person who leaves.
If you determined that your spread is too low because your compensation is too high, you can allow that to balance itself over time - in the case of service people - or you may need to take action with respect to producer compensation.
While spread is primarily a measure of gross profitability, it is most valuable in directing you at what expenses to reduce, as opposed to what revenues to increase. As business models go, reducing expenses first is always a good call.
The second KPI that deserves analysis is EBITDA (earnings before interest, taxes, depreciation, and amortization). This tells you how much you're delivering to the bottom line, given your financial structure.
Every agency is different in how it is structured:
- Some borrow money and have interest expenses, others do not.
- Some have acquired books of business as a part of their growth strategy and have amortization of goodwill.
- Others have no acquisitions and no goodwill expense.
- Some agencies choose to depreciate assets that they purchase over a long period of time, and others take accelerated depreciation.
EBITDA equalizes all of those things so that you can compare yourself to other agencies more easily.
If your EBITDA lags behind the typical agency, you are clearly making less money than you should. Since agency value is primarily determined as a multiple of EBITDA, agency value is also affected.
"The two things that you seek to derive as benefits from owning and operating an insurance agency - profits and value - are both impacted if EBITDA is low or high."
If EBITDA is low, the first place to look for solutions is on the expense side of your profit and loss statement. Outside of payroll, which typically runs as much as 50% of an agency's overall expenses, it becomes difficult to move the needle from a cost perspective, but you should consider that even small tweaks can add up to significant amounts of money over time. Take a very hard look at all items of expense in real-time: can you save money in the claims process, for example? Can any subscriptions or luxuries be cancelled or reduced?
Obviously, payroll is the biggest needle that you can move on the expense side of the ledger, and we've already discussed that.
After looking at expenses, turn your attention to income. The first question to ask yourself is:
How much can you grow your revenue without growing your expenses?
If potential revenue growth, without expense increases, is significant, then holding the line on expenses over a couple of years will solve your problem. If it doesn't, you may need to think about becoming more aggressive on marketing and sales in order to bring EBITDA into balance, making efforts to cross-sell to your existing customers (life insurance is great for account rounding), and using social media to prospect and get more potential customers to visit your site.
Another frequently overlooked area for improving EBITDA is the owner’s compensation. Agency owners are typically compensated through commissions on their book of business.
Many agency owners pay themselves a higher than industry average commission rate, primarily to manage cash flow. They find it's simply easier to take money out of the business in commissions on a monthly basis than it is to take distributions or profits. While this is convenient, it has a very negative impact on EBITDA, obviously.
I recently had a friend who sold his agency at one of the highest multiples of EBITDA ever received by anyone in the industry. What really drove the sale value up was that owners paid themselves a salary and did not take commission, which meant that the EBITDA itself was much higher than average. The difference between their EBITDA percentage in the typical EBITDA percentage was a factor that drove the higher multiple.
So, as you can see, both the percentage and the raw number have a compounding effect on each other.
When I asked him about his structure, he told me that they had built their agency to sell it. So they operated it as they knew any buyer would from the beginning, to maximize not only the dollars in EBITDA, but the percentage.
You can clearly see that the result was worth it.
If your EBITDA falls below industry averages, take a look at owner compensation as well. If you're planning on selling your agency in the next five years, maximizing EBITDA should be your number one priority.
Interest, depreciation, and amortization
One last thought about EBITDA: do not take interest, depreciation, and amortization for granted. While they do vary from agency to agency, they also represent expenses, which are controllable and have an impact on bottom-line profitability in value.
Obviously, interest expense is something you have to write a check for, and if you can control it, it also improves cash flow. But decisions about depreciation and amortization are a little less simple.
Most agency owners take as much depreciation and amortization as they're legally allowed to every year. While this makes general sense from a cash flow and tax reduction strategy point of view, it may not be the best management system or strategy if you're within the five-year window of selling your business: it may make more sense to increase EBITDA by deferring, or by spreading out depreciation and amortization.
You may find that you make more money from the increased value of your agency than you save in taxes. As you approach the potential date of a sale, this is something well worth considering.
The final point about interest depreciation and amortization is that they may become profit stealers if you ignore them. If those items are high, you should ask yourself if you’re buying more things than you need. You may not be, but it's worth asking the question.
The other thing that could indicate is that you face lower productivity in the future due to a lack of investment.
If you have little interest, depreciation, or amortization in your income statement, it may be that you haven't been investing enough money. So, those expenses are great prompts for helping you think through how you want to manage the business in the coming 5- and 10-year period.
Year-over-year growth rate
The last analytic that I want to discuss is the year-over-year growth rate.
I've never met an independent insurance agency owner that wasn't interested in growing. In fact, I think almost all of us think of our businesses as being growth-oriented. So having a general sense of how fast we're growing is something we're all used to. But knowing exactly what our growth rate is, this year, last year and since we've been in business is a fundamental metric that we should know exactly, based on existing data.
Focus on growth
The first reason is that it will sharpen our focus in terms of how we operate the agency for growth: there's an enormous difference in the ultimate size and value of an agency that grows at 10% a year compared to one that grows at 8% a year. Those very small differences in growth rate, spread out over 10, 20, or 30 years, make a gigantic difference in the ultimate return an agency owner experiences. Knowing matters.
The next reason why the growth rate matters is that it's a key metric that insurance companies consider in deciding whether to not to appoint an agency, and also how they want to work with and reward that agency.
Agencies with consistent growth rates in the double digits will find that they get more production incentives, bonuses, and opportunities from carriers along with their best underwriters and other benefits; agencies that grow at a slower rate don’t. Knowing your growth rate and sharing it with insurance carriers can help to supercharge your business over time.
We typically think about agency value as being a multiple of EBITDA, and as I pointed out earlier, the higher the EBITDA percentage over a longer period of time, impacts the buyer’s willingness to increase the multiple, which drives a higher valuation.
Year over year growth rate is also important in determining what multiple a buyer will pay for your agency, because it factors into the quality of your earnings: an agency that's growing at 5% per year is going to get a higher multiple than one that isn't growing at all, and an agency growing at 15% per year is going to see an even higher multiple of whatever its EBITDA is.
One of the issues that cause agency sellers to leave money on the table, because they often aren't aware of it, is the growth rate.
As agency owners grow older and less concerned with growing their personal books of business, the overall growth rate in agencies tends to slow down. It would be worth looking at your year over year growth rate in the last 12 months vs. in the last 10 years.
If the growth rate over the last 10 or 12 months is lower than in the last 10 years, and you are thinking of selling in the next 5 or 10 years, you have time to overcome that declining growth rate by investing in sales and marketing activities.
Those sales and marketing activities are likely to drive down your EBITDA in the short term, but if you have enough time, then five years is enough time to drive the total amount of EBITDA up, and as you see a return on those investments you will drive the multiple up. Those two things in combination will make an enormous difference in the sale value of your agency when it is time to transact.
Always keen on helping others make their dreams come true, Tony and his team have helped independent agents grow into more than 250 independent agencies. This has made OAA the number one ranked Strategic Master Agency of SIAA for the last 5 years, and one of Oklahoma's 25 Best Companies to Work for.
Tony loves to share his knowledge, insight and wisdom through his bestselling books as well as in free mediums including podcasts and blogs.
Tony and his family are members of Crossings Community Church, and he is very active in community initiatives: he’s chairman of It’s My Community Initiative, Inc., a nonprofit working with disadvantaged people in Oklahoma City; and chairman of the Oklahoma Board of Juvenile Affairs., and he has served through many other organizations including the Salvation Army, Last Frontier Council of the Boy Scouts of America, and the Rotary Club.
In his spare time, Tony enjoys time with his family. He’s also an active outdoorsman and instrument-rated commercial pilot.