When asked about how to value a firm, insurance agency or broker, many will say that it’s based on a multiple of the firm’s revenue, also known as revenue multiple valuation. Purchase price is often expressed as a multiple of revenue for ease of discussion, but this can create misconceptions.
The value of a firm is calculated as a multiple of profitability or cash flow generated. This reality means that firm owners who believe that all $15 million firms command the same value in the open market may have to reassess that assumption.
This is because the sustainable profitability of a firm is vastly different, which contributes to or is the primary cause of the valuation difference. There are many components to the value of a firm, including EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) multiple and influencers like growth rates, location, specialty, leadership talent, and items of strategic value to the buyer. However, in our experience, the difference in value between similar agencies is often driven by the difference in the sustainable profit margin.
For example, a $15 million revenue agency or brokerage with a sustainable EBITDA margin that is double that of another firm with the same revenue would also expect to sell at double the purchase price and double the revenue multiple of the firm with the lower EBITDA margin. It is not uncommon to have similar sized firms operating at profoundly different profit margins.
How to Value a Firm Without Using the Revenue Multiple Valuation
One effective way to influence profit margins and drive operational improvement is to improve your producer compensation strategy. As the industry has changed and firms have added services, capabilities, and a higher level of technical employees, firms can benefit from a more focused approach on refining their compensation plans. There is not a one-size fits all producer compensation plan, but firms should evaluate their cost structure, location, staffing needs, and long-term growth and profitability goals, and then develop an appropriate plan that delivers a sustainable return on investment to the risk takers (the shareholders/partners).
In the current hiring environment, the goal should be focused on retaining the best while managing long-term goals as it relates to client services, necessary staff, and margin expectations. A quality shift in your plan can be critical in driving higher quality talent across the board. Technology, marketing initiatives, cross-sell, role redefinition, tiered sales roles, mentorship and evaluating unique commission schedules are all potential ways to differentiate your compensation model.
In other words, an owner can largely control their value by managing it to an attractive and sustainable profit margin. If the goal is to sell stock internally to perpetuate ownership, then consider making the hard decisions now so you can demonstrate to the next generation that the firm can deliver a strong level of profitability which will help fund the debt service and provide a strong return on investment (to current and future owners).
Don’t Rely on Revenue Multiple Valuation for Your Firm
If you’re looking to sell externally, consider making the tough changes and living your pro forma to demonstrate sustainability so you can potentially reap the rewards of a higher purchase price.
Don’t stand by the side lines, continuing with weak profitability, when you can make changes now to improve your firm’s operations and value. Don’t believe the rule of thumb for valuation that all firms are worth 3x revenue. Some are worth more and others are worth less. In our experience, the outcome is at the control of firm ownership.
If you have questions about Today’s ViewPoint or want to explore driving value for your firm, email or call James Graham, Vice President, at 949.272.0351.
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