Generally, the next most important step in Due Diligence consideration should be a thorough review of the premiums receivable and payable, assuming they are included in the net assets being purchased. Most agencies are careful about managing their receivables so they can pay their carriers on time. Thus, the information is generally available and easy to verify. Customer receivables are based on the aged receivable report, and should include the reconciliation to the financial statement balance. Buyers should also understand how customer credit balances are processed and reported within the receivable aging report and whether the credit balances are being addressed in a timely fashion. Finally, inquiries should be made regarding collection procedures and problems, any bad debt experience, and related producer responsibilities.
Unlike accounts receivable, the visibility and often the information available for review for aged premiums payable is less than ideal. Premiums payable can be an area rife with problems if the seller hasn’t exercised proper financial controls and procedures. Undesirable situations, such as stale payable items, debit-balance items or company balances that don’t reconcile with insurance company records and financial statement balances, are all indications of problems that a buyer needs to investigate. Careful due diligence in this area should identify these problems prior to the closure of any transaction.
If a complete list of all personnel, salary levels and other information including employee benefits has not been provided as part of the preliminary information received from the seller, this information needs to be compiled during the Due Diligence process. Ideally, the buyer should also prepare a reconciliation of salary and incentive compensation expense by person through the Due Diligence date to the expense on the income statement to confirm its accuracy. Finally, the buyer should verify that all payroll filings and tax payments are current and properly reflected in the agency’s financial statements.
Buyers should also review selected expense categories to identify any significant non-recurring items, missing items or unusual disbursements (or receipts) to make sure the Pro Forma expense levels will be attainable going forward. Expenses such as outside consultants, technology-related purchases or upgrades, marketing campaigns, bulk-supply purchases and others can combine to create expense levels that may not be repeatable going forward. We find one of the best ways to initiate this review is to have monthly revenue and expense information, in a meaningful level of detail, assembled in a spreadsheet for at least the past 12 months so that unusual levels of activity can be more easily identified.
There is generally a separate allocation of the purchase price to the fixed assets of the business. In most transactions, the value of the operational fixed assets is considered imbedded in the overall value of the intangible assets and not separately additive to value. However, the buyer should obtain the summary and supporting schedules of fixed assets, consider confirming the existence of any individually material items, and review the reconciliation of the balances to the financial statements. Depreciation methods and balances should be reviewed for consistency. While not usually material to the entire purchase price, the fixed assets are generally depreciated for tax purposes over 3-5 years whereas the intangible assets are amortized over 15 years. Consequently, there is a small tax advantage to the buyer to designate a portion of the purchase price to the tangible assets of the firm, usually assigned at book value.
Insurance-agency sellers should be prepared to provide a comprehensive status report on their overall technology environment. The report should include:
- A detailed list of all equipment, software versions and required software licenses used in the office for normal desktop applications as well as agency management systems and overall network applications. For software products with maintenance contracts, include a description of the coverage and annual costs.
- A copy of all security policies and procedures, including back-up and disaster-recovery plans.
- Description of remote access capabilities, website client and/or employee portals and any other internet based applications, including pending updates or changes in process.
- Anticipated capital expenditures for technology, and any other pertinent information.
Buyers ultimately need to assess the costs and benefits of consolidating multiple operations on the same platforms, but the starting point is always the inventory of what’s currently in use.
If other asset or liability accounts are included in the purchase transaction, they should also be reviewed for propriety and supporting documentation during the Due Diligence period. Items for review may include direct-bill receivables, prepaid insurance, operating-accounts payable, and various expense accruals.
In a stock-purchase transaction, the analyses discussed in this article should be conducted on all balance sheet accounts not specifically identified by the seller as ones they will remove prior to the sale. In addition, as mentioned earlier, a much more extensive review of legal, contractual, regulatory and other potential, unrecorded liability exposures is strongly recommended.
Many transactions will include an escrow held back by the buyer to protect them from any potential misrepresentations or differences in realized values of the net assets acquired, in particular from the receivables and payables. Buyers generally require sellers to leave a certain amount of working capital in the company at the time of closing, usually 30-60 days of operating expenses. This allows the buyer to continue the normal operations of the business until the receivables can be collected. To the extent the actual working capital balance at closing differs from what was requested by the buyer, an upward or downward adjustment to the purchase price may be necessary. While sellers often see this as a direct reduction in the sales price of their business, the reality is that without this working capital requirement, the buyer would end up having to infuse capital immediately in order to meet the normal day-to-day operating expense of the business, resulting in a higher purchase price than anticipated.
Due Diligence from the Seller’s Perspective
For the seller, the Diligence process is much like the home inspection when trying to sell a house. The price and terms have been agreed upon, and everyone is anxious to move forward, but someone needs to come in and verify everything that’s been said about the business, and it can be a rather nerve-racking period. While nothing can eliminate all the angst associated with the diligence process, there are a number of steps that can be taken to minimize it. The most prepared sellers don’t wait until they’re actually selling the business to start getting ready:
- Establish a history of sound financial processes and controls well in advance of considering a sale of the business. In addition, consider an independent review or audit of your financial records, depending on the size of your business.
- Take steps to eliminate unnecessary assets and liabilities so the business doesn’t look or feel like an extension of your personal checkbook
- Review your internal processes within the finance and insurance operations of the business to ensure they correspond to any written or verbal descriptions to make sure what’s supposed to be happening is in fact what’s really going on. If written documentation does not exist, consider putting this on the “To do” list.
Conclusion
Both buyer and seller will be best served by preparing for the Due Diligence review, with the buyer knowing what to ask for and review in each particular situation, and the seller being aware of what to expect and being able to deliver it. Buyers require an extensive (some call it mind-numbing) set of documents the seller needs to make available for Due Diligence review. Yet, the best way for sellers to prepare for Due Diligence is to have a strong foundation of financial and operational internal controls, policies and procedures within their agency developed over a period of years. Then, when the time comes for outsiders to review, quantify and critique all of this information, surprises should be minimal—and results favorable—to both sides of the transaction.
OPTIS Partners, LLC (www.optisins.com) is a Chicago based investment banking and financial consulting firm to businesses in the insurance distribution sector, providing M&A, valuation and strategic consulting services. The authors, Dan Menzer and Tim Cunningham can be reached at 630-520-0490 or menzer@optisins.com and 312-235-0081 or cunningham@optisins.com, respectively.
The views, opinions, positions or strategies expressed by the authors and those providing comments are theirs alone, and do not necessarily reflect the views, opinions, positions or strategies of AgencyEquity.com.
