With so many agency acquisitions taking place these days, its important to understand the different types of agency lenders if you hope to have a chance at buying an agency. Most acquisitions of property and casualty insurance agencies today involve 80% or more payable to the owner at closing of the sale. To be competitive in the agency acquisition realm requires capital. So before jumping into the game, you must ask yourself “Where am I going to get the money?”.
Luckily for you, there are more options for financing the purchase of an independent insurance agency than just about any other type of business. I have categorized them based on how I see the differences, and these are not in any particular order of favoritism. The list is not comprehensive but represents a majority of finance sources. Obviously you can also borrow money from family and friends, but I would discourage it. Note that my comments below are based on typical or average terms and conditions, as variance will occur on a case-by-case basis. Financing options include:
- Commercial bank loans
- Commission-based loans (Oak Street Funding)
- SBA 7(a) loans
- Private equity capital
We work with select commercial banks around the country that loan money for the purchase of an insurance agency. The borrower will need to have, or be required to maintain, a business banking relationship. The financing terms are 4-6 years on repayment of the loan, which can create a tight cash flow after debt service. The borrower will need 10-20% of the purchase price for the down payment with seller financing terms varying case-by-case. Most likely the bank will want the loan collateralized with real property, or guaranteed by someone with a high net worth. The interest rates can be cheaper than other financing sources (currently 5-6%), but the conditions are tough to meet for the average borrower.
Oak Street Funding is likely the largest lender for insurance agents in the country. Their model is to loan based on the renewal commissions of various carriers. They factor in the book of business being acquired and that of the acquirer to determine the amount that can be loaned for an acquisition. It is a unique lending model that allows individuals to borrow more than they might otherwise be able to, but only if the make-up of the books of business supports the loan amount. The financing terms range from 5-10 years depending on the products, which can yield a nice cash flow after debt service. The borrower will need 5-20% of the purchase price for the down payment (more likely the higher-end for the first acquisition) with a minimum of 15% seller financing. As with other private lenders, the interest rates are a few points higher than a commercial loan because the money is being borrowed from a bank. One great benefit of working with Oak Street Funding is that a successful borrower can continue to use them for financing acquisitions and the terms typically get better after the first few transactions. In comparison, most lenders are a one-time financing source or have aggregate loan caps for a borrower. Oak Street can also work an earn-out into the terms if the cash flow supports it, which most other lenders will not.
The Small Business Administration (SBA) has a loan program for the purchase of a business (called a 7(a) loan) similar to that of the FHA’s loan program for buying a house. If the loan fits within a box of parameters, then the government will guarantee 75-85% of the loan for a commercial lender. Because of that, most SBA-lenders require a 25% or more “equity participation” by the buyer and/or seller of the business; thereby, eliminating the lender’s risk and making the loan easily sellable on the secondary loan market. It creates a big incentive for commercial lenders to issue SBA loans. The catch is that the guidelines are fairly strict. The seller’s business tax returns will need to reflect a clean and true cash flow of the business (the government is not too fond of hidden earnings), so a pro forma projection carries less weight than historic profitability. For transactions having more than $350k in Goodwill value (generally = sale price – tangible assets), the sale price will need to be supported by a fair market valuation from a certified business appraiser. This can cause a problem because the standard of “fair market” value assumes a generic, non-strategic buyer. Most agency buyers are in fact strategic buyers so the real market value is often 10-20% higher than an appraiser’s calculated fair market value. Why am I stating this? Because the appraised value might be less than what the business is truly worth OR what has been agreed to between the buyer and seller – a potential issue to closing a transaction.
The SBA 7(a) loan program has a loan cap of $5M, but most SBA-lenders will not finance more than $1.2M for the purchase of an insurance agency because of the lack of collateral in the business. The SBA does not require collateral to support the loan, but many lenders do on a case-by-case basis to further protect themselves. The SBA loan will require that the borrower put down 25% of the purchase price, or the seller will need to carry the balance of the equity participation in a stand-by note for 2 years to the full term of the loan – meaning they will not be able to collect principle on the note during the stand-by period. With all that said, the benefits of using an SBA loan are strong because the interest rates are in line with commercial bank loans and the repayment period is from 7-10 years, yielding a strong cash flow after debt service.
I am not going to get into much detail about private equity capital in this discussion because it is a subject unto its own. Anyone watching the market place will see announcements of private equity-backed acquisitions on a regular basis these days. On a smaller scale, many high net worth individuals often have an interest in investing in insurance agencies for the same reasons as everyone else. All types of private equity money are based on relationships and who you know, so if you do not have the connections then do not consider it an option. PE sources also want equity (no surprise there) so the cost of the money is ownership.
General Statements about Loan Terms
Every lender charges a loan origination fee that can be bundled into the financing, and most charge a flat commitment fee as well before they will begin underwriting the loan to cover their time should the transaction fail to be completed. They may also charge a pre-payment penalty should you pay the loan off faster than anticipated. The debt service coverage (cash flow/annual loan payments) for most lenders needs to be greater than 130%, so there will need to be a “cash flow cushion” on any transaction. The borrower, including majority shareholders, will usually need to sign personal guarantees on the loans. The seller financed portion will also always be subordinate to the lender. The loan process for most professional lenders is 45-60 days. It should go without saying (but needs to be said) that a lender cannot underwrite the loan unless they receive everything that they need. Trying to withhold or avoid providing requested information will only cause delays in the funding.
Questions to Ask
It is very important to understand the lender’s criteria before submitting an offer to the seller. Some questions that will help you are:
- How many similar transactions have they financed in the last 12 months?
- How does the transaction need to be structured in regards to your down payment and the terms of any seller financing?
- How do they underwrite the loan?
- What requirements will be placed on you after the sale in regards to cash flow management and accounting?
- What requirements will be placed on the seller in regards to their note and subordination?
- Will they loan you more money for future acquisitions – if that’s in your game plan?
One thing to make sure of is that you are not dealing with a loan broker that is presenting themselves as a direct lender. If you are working with a loan broker, have them provide references to you and ask many of the same questions above to test their knowledge. Loan officers and loan brokers are sales people (just like the rest of us) so do some due diligence before entering into a commitment with them.
Posted by: Michael Mensch, CBI, M&AMI and Managing Partner