The due diligence process is a critical stage for either selling or acquiring an insurance agency or brokerage. M&A transaction “due diligence” is the process by which a buyer of a business validates the condition of a business they are acquiring and includes reviewing legal, financial, and operational details of the business. When it comes to the due diligence process, it is imperative for both sides to handle the process efficiently and proficiently. Not handling the process efficiently leads to deal fatigue by the parties. Both the seller and buyer can get tired of a drawn-out back-and-forth dialogue with little progress. Not handling the process proficiently can lead to mistakes. Both the seller and buyer can find themselves in renegotiations, overlook critical details, and/or have the deal terminated by the other party.
M&A transaction due diligence problems typically arise from four areas: (1) inexperience, (2) lack of preparation, (3) misrepresentation, and (4) omission. I have discussed in a previous blog how these can apply to a buyer’s inability to consummate a transaction (click here), which in turn wastes the seller’s time. I will discuss herein how these can apply to the seller’s inability to consummate a transaction.
Diligence Failure Due to Lack of Preparation
Very few insurance agency owners have extensive experience in completing M&A transactions. Very few have also taken steps to prepare their businesses for sale. What often happens is that the owner is either approached by a buyer or makes a relatively quick decision to sell and then begins thinking about the process. The owner likely has not collected and reviewed all of the documentation needed to pass due diligence and complete a transaction before engaging in the process, so they are in a reactive position with a buyer. The buyer asks for something, the seller then collects it, delivers it, and waits to see how the buyer responds.
The reactive position creates long-time delays as the seller often must request documents from third parties, such as carriers or their accountant, who may not put the task on a high priority. An inexperienced or unprepared buyer may also make a series of requests that require the seller to go back to the third party more than one time, adding more delays. Extended delays in a transaction are seldom advantageous to the seller; hence, understanding the due diligence process and preparing for it will greatly increase the probability of the transaction being completed successfully.
Example 1: Poor Financial Record Keeping
I’ll speak in more general terms on this example because we’ve known of a number of transactions that failed due to the owner’s inability to pass the buyer’s due diligence. In all of the failed deals, the buyer and seller were able to come to an agreement on price and structure of a transaction, but the seller was unable to provide sufficient documentation to validate their revenue and earnings. The most common trend is that the agency handles a significant volume of agency billed business and does not maintain accurate and current financials.
What we typically observed was that the owner ran the business based on the cash in their bank accounts and had their accountant figure out the financials once a year to file their tax return. This creates a few issues: (1) While most owners think that their accountant knows their business, most accountants don’t deal with enough insurance agencies to truly understand agency financials, so they do things like record premiums on an income statement because they see the deposits on a bank account statement; (2) The accountant is reacting to an immediate need (i.e. completing a tax return), so he/she never gets the opportunity to work with the owner on a better accounting system; and (3) Deals seldom happen smoothly at the end or beginning of fiscal period, so the seller is scrambling to get their accountant to put together an interim or, worse, a trailing 12-month statement.
The sad fact was that the owners truly wanted to sell, but they gave up because they couldn’t produce the information needed. Agency owners in this situation have two options: (1) get the house in order before initiating a sale, or (2) prepare to sell at a discount, leaving money on the table.
The Implications of Misrepresentation and Omission
Misrepresentation relates to an inaccurate statement of a material fact that would impact the transaction. Omission relates to details that are not disclosed, whether intentional or not, before an offer is negotiated. As is often the case, the owner of an insurance agency contemplating a sale may not want to disclose many details before the buyer submits an offer because they want to flush out the buyer’s position. This is understandable as insurance agency owners get solicited by buyers frequently. Alternatively, they may put a positive spin on the facts to increase the buyer’s perception of value. Withholding or misrepresenting the facts, though, often creates a bigger headache down the road and increases the amount of wasted time. Whatever offer is made is subject to a thorough due diligence wherein the buyer will most likely discover any details that are withheld or misstated. The end result is typically a renegotiation or the deal being called off completely after many weeks or months of work.
Example 2: Misrepresenting Adjusted Earnings
Some years back, we were involved in a transaction in which the seller was represented by their own advisor. We received preliminary information on the agency, including an adjusted income statement showing a pro forma EBITDA. Our client submitted an offer based upon the information provided and a Letter of Intent was negotiated. We moved forward into due diligence and submitted an extensive request list to verify various aspects of the agency. During our due diligence analysis, I recognized that their EBITDA calculation was overstated, and so as we worked through the data I, very tactfully, engaged the other side’s advisor to get them to acknowledge their errors. By about 4-5 weeks post-signing of the Letter of Intent, we had come to a pro forma EBITDA number that was a third less than the originally proposed number. At this point, the buyer’s and seller’s attorneys had already been working on the asset purchase agreement for a few weeks so the seller was financially committed. The discussions with the buyer and time requirement in delivering the diligence data also caused the seller to be emotionally committed to the deal. Needless to say, our client negotiated a price reduction of over $1M. The overstatement of earnings put the seller in a weak negotiating position since it was discovered well into the process.
Example 3: Omitting Critical Details
On another buy-side engagement a few years back, we were many months into a transaction involving a wholesale brokerage before an unknown detail came to light. It turned out that the seller had taken an advanced commission from a carrier for rolling a book and that advanced commission showed up on the income statement on a cash basis. In short, more than half the EBITDA had not been earned, and part of it was an incentive payment for rolling the book. This wasn’t mentioned prior, and the purchase price was made on a multiple of EBITDA. The buyer didn’t even offer to renegotiate the price; they simply walked from the deal. The true EBITDA and the EBITDA margin were too low to even entice them to consider continuing on with the transaction. Both sides (and yours truly) had already invested significant resources into the deal, and it was all for naught. The omission of a crucial detail, whether intentional or not, cost the seller over $10,000 in accounting and legal fees, as well as the time and energy they had invested into the transaction.
Not properly preparing for the due diligence process of an agency sale is an expensive gamble. You can end up investing significant time and money during the transaction and have the deal fall apart completely. Alternatively, you find yourself in a hard renegotiation many months into a deal and are faced with the question of taking a reduced price or starting all over again.
Many of our clients have wondered why we invest so much time in the early stages of an engagement collecting information and asking questions. Experience has taught us that preparation is critical to execution. If you are truly ready to sell your agency or brokerage, then give us a call and let us help you execute a successful transaction.