Acquisition and Due Diligence Mini-Series, Part 2: 4 Keys to a Successful Due Diligence Process

This is the second of five episodes focused on helping agency owners understand what's involved in acquiring a new agency in order to build their existing business. 

In this episode, Peter and Doug discuss due diligence - a critical step in considering any  acquisition. In due diligence, a prospective agency buyer enters into a formal process with the owner of an agency he/she is considering purchasing. The process allows for an investigation of the agency's financials, operations, and legal details so that the prospective buyer can understand the agency business, assess it against competitors, and look for any signs that might suggest problems at the agency. 

Peter discusses the 4 keys he has found helpful in ensuring success in due diligence. 

Transcript

Acquisition and Due Diligence Mini Series, Part 2: 4 Keys to a Successful Due Diligence Process

Doug  00:15

Welcome to Insurance Agency Insights, where we're committed to helping small and medium sized agencies achieve their business goals. We're your hosts, Doug Burke, an investment banker to the industry and with me is 

Peter  00:27

Peter Friedman, CEO and president of AgileCap, a specialty lender focused exclusively on the insurance agency industry. At AgileCap, we believe agency owners can only take control of the course of their business when they have a thorough understanding of the financial aspects of their agency. Over the last 20 years, through ups and downs of the US economy, AgileCap has advised agencies on borrowing money, acquiring new businesses, and investing in their future. We'll bring you insights on how finance and capital can and will impact your agency's future.

Doug  01:00

So Peter, this week, we're continuing our mini series on Agency Acquisitions and Due Diligence. In our last episode, we talked about getting financially ready for an acquisition. Once you've done that, and you've identified an agency that fits your business growth strategy - which we'll cover in a future episode - you'll begin the due diligence process. 

Peter  01:21

And the due diligence process is just it's a critical aspect of what you're going to be doing. It's the steps you're going to take, when you look at an agency, to understand the assets and liabilities of that agency, and consider whether or not you're going to buy it. It's evaluating the future, and whether or not it's a good strategic fit with your agency. It's one of the key aspects of the acquisition process. 

Doug  01:46

So, to be clear, Peter, due diligence happens after you've identified an agency you want to buy - one that you think is going to fit your growth goals - and you've dug around and investigated it, to whatever degree you can using your networks and the internet, and you've decided that it represents a good opportunity for you. Then the next step is to enter into a more formal investigation of the agency's financials, operational, legal details, so you can understand it better, assess it against competitors, and watch for any signs that might alert you to problems at that agency. That's basically what due diligence is, and you suggest there are four keys to a successful due diligence process. What are they? 

Peter  02:32

Absolutely. And there's a lot of individual activities in this process, but I would say there are four key things you want to think about. 

Peter  02:39

One is go in prepared. So, be prepared as to what you're looking for, have resources available. 

Peter  02:47

The second piece of that is make sure you have the right people, so your team is assemble. And so that would be lawyers or accountants or professionals who know the insurance agency, sometimes it's real estate agents if real estate as part of this process. 

Peter  03:01

So, it's about knowing what you're getting into when you go into it, having the right team, keeping communication - not only with your team members, but it's pretty important that you have a defined communication strategy with your home office - these are the people who currently work for you. And that's just going to depend on what you've got going on, whether that's a complete open strategy, and you go and talk to the team and say, "Hey, this is what we were going to do", or you want to keep it confidential until you're fairly certain that it's going to happen. You just have to have a strategy around communication. 

Peter  03:32

With the last piece of your due diligence - and this kind of flows into that next phase - when you're looking at contracts and purchase agreements and stuff - is making sure everyone's aware that you're going to have a noncompete clause. It's a critical piece in the insurance agency world, as it really protects the asset that you're buying. Without one, the agent who you bought the agency from could go off and essentially take your current customers - something that you paid money for - they could just take away, and that's a critical piece. 

Doug  04:02

So I think of the four steps as "Prepared, People, Communicate, Noncompete". So let's go through them in that order. What does an agency owner need to do in order to be prepared to accomplish that first due diligence step in the acquisition process? 

Peter  04:21

So, step one is obviously you got to find an agency. We'll talk about that, but there's lots of ways that you can do that: internet, networks, brokers, things of that nature. But that's obviously you have to find something for sale. But let's assume, in this conversation, that you have identified a target and they're a willing seller, you're a willing buyer. So the next step in the conversation is you have to get information. You really have to pull together - have a complete understanding - of what it is that you're  going to be buying. And the critical piece of that process is a confidentiality agreement. So you want to make sure the seller and yourself agree that this information that you're sharing - and it mostly protects the seller, to be honest - stays between the two of you, or your representatives, and it's not used - assuming the acquisition doesn't move forward - to poach clients or poach processes, or things of that nature. So that's a critical piece of it. 

Peter  05:18

Once you have that - and that should be done first - you want to start to compile a lot of information: tax returns, financials, book of business, relationships with carriers, if there's real estate involved, what is the terms, whether it's lease or purchase? The employees...What's their history?, What are they looking for in salary? All sorts of expenses. You want to complete understanding, and you want that understanding to the best of your ability to be verified from a third party. So, tax returns are considered a third party, or 1099's. Self-produced P&Ls are really important, but they ARE self-produced, so you want to confirm that with the carriers and the policies enforced and things like that. Or you want to report directly out of an agency management system that maybe ties directly into the carrier. So you're trying to collect as much information as possible when you are doing your due diligence process. 

Doug  06:15

So one of the ways that people are accomplishing this is on what's called a virtual data room. But you can also have a physical data room. But I think it often is important for the employees of the acquisition candidate to not per se be alerted that a deal might be happening. So they might not like what might happen in an acquisition. And so this information that's being shared can be shared either in a Dropbox box, Google Drive, other virtual data room setting, or sometimes put into a lawyer's conference room - with physical papers that you can go through. Have you seen those types of scenarios, Peter, as a way of managing the data flows? Or is it just done by email? 

Peter  06:59

So, historically, you're right, there was an actual data room. And I'd say in the last 10 years, it's transitioned to mostly virtual data rooms, where things are putting in a Dropbox in order to keep them secure - whether that's Google Drive, or Dropbox, or OneDrive, or the myriad of different ways. The pandemic has accelerated, that, to be honest. We've seen, over the last 12 months, zero actual data rooms and swapping of paper. Everything has been done virtually. What many people say about the pandemic is it just accelerated all the trends that were happening before. And I think that's exactly the case that you can set up a dedicated virtual data room, that you can share information in a secure way, because this information has tax returns as social security numbers, has lots of information that you don't want shared outside of the two parties. Absolutely. 

Doug  07:48

Let's talk about exclusivity, Peter. I mean, this is important, right? For the buyer. 

Peter  07:53

Absolutely. What you don't want to happen is you don't want the seller to be trying to sell the agency to you and to someone else at the same time. And so one of the key pieces of the next step, which would be a letter of intent is an exclusivity period. So you create a legal document that would indicate things of the nature of price, structure, timeline, and these types of things. And they're relatively basic - they're a page or two -but they'll also denote, to your point, exclusivity, which says, "Hey, you can only negotiate - you can only share information - with ME, the potential buyer, for a period of time...let's say 60 to 90 days, with potential extensions, things of that nature". And that's critically important because you don't want to be competing against someone else when you're doing your diligence. You want to have a pretty open communication with the seller, and you want to feel comfortable that you're not taking a risk that sharing information between the two of you is actually sharing it with potentially several buyers. And that's a critical part of the process. 

Doug  08:55

So all that goes into the letter intent. What are the important elements of a letter of intent? 

Peter  09:00

So, I would say price is critical, structure - which is how are you going to get paid - whether that is cash, a seller note, earn out, a variety of different things. As a buyer, how are you going to pay? That's a critical piece. Are there any implications when it relates to tax and timing of payments, as well as timing of doing the transaction? When are we closing? When are we signing? If there are aspects related to real estate. An employment contract is another one between the buyer and the seller...the buyer may want the seller to stay on for a certain period of time and get paid a certain amount. Any consulting services? And as we talked about before, one of the key pieces is that's when you start to highlight a noncompete clause and make it very clear in that letter of intent, then a noncompete clause is going to be part of this process, and you - as a buyer - want it for 2, 3, 4 or 5 years, things of that nature. 

Doug  09:56

And so, if you're going to put out a letter of intent, do you want it just hanging out there forever or should you put a timeline on it? And if so, what is sort of standard for timelines? 

Peter  10:06

You don't want it out there forever, without a doubt, you're right. It's very dependent. I've seen them as long as 60 days, that's pretty rare. And as short as 24 hours, that's also rare. Generally speaking, you give the other party several weeks to kind of decide whether or not they're going to sell. They've gone through getting you documents and lots of information. Now, they should be fairly committed and should be able to make a decision. But one to two weeks is fairly common to say, "Hey, I'm ready to buy, here's the terms. Are you comfortable with this? Go think about it. If so, sign it and return it to me, and we'll move forward". 

Doug  10:43

So once you enter into a letter of intent that has an exclusivity period, how much time would you normally see for that next phase of due diligence, generally speaking? 

Peter  10:55

The next phase of diligence is anywhere from 30 to 90 days. And that's where you're going to, as a buyer, incur costs to bring your accountant in to review the books, or your lawyer to start to draft the contract. You're where you're going to confirm many of the things that you maybe got in the virtual data room. We're calling carriers and outside people, and you need a certain amount of time to do that. It's also a time that you're going to line up your financing, generally speaking. If you're concerned about financing, you might want to start your conversation with your financing provider before you enter into a letter of intent and exclusivity. But if you're a very solid credit, you have plenty of cash, things of that nature, the acquisition is a great strategic fit, you can start the conversation then and that can take 30 plus days in that scenario. So you really want to give yourself 30 to 90 days. It always tends to be that there are hurdles that you weren't expecting, holidays that come in, that cause people to go on vacation, things of that nature. And you want it to be a time where you move quickly, but not panicked, I would say. 

Doug  12:03

Peter, is there a checklist for all these things? 

Peter  12:07

There are! We post one on our blog, agilecap.com. It's one of probably the most important things you can do is follow a checklist. You can look at ours and take a look at it www.agilecap.com. But it's critical to make sure you don't miss a step. You don't want to go through this process having missed a key component: a lease, an obligation somewhere, a contract to pay a producer a certain amount that's not viable for your business model going forward. So going through that due diligence checklist is a real critical piece. 

Doug  12:38

So, what is the objective of a due diligence process? What is the key to define what a successful due diligence process would be? What are you trying to accomplish in that process? Is it just a bunch of reading of papers and talking to people? What's the objective and the goal? 

Peter  12:56

I would put it in two buckets: one objective and goal, and that's exactly the way I think about it. One is risk: What risk is there that I can't see? And that's a critical thing. Whether it's contracts, employees, declining book, things of that nature, so you're trying to uncover as much risk and unpaid debts or liens or taxes...there's a myriad of risks out there. So that's the first thing. The second piece, which is equally critical, which is value: Where do you see value? How strong is the book? What are the carriers like? What's the relationship like? Can I grow it? How does it fit strategically? Are the employees leaving? - that's the risk side - or are they committed and very excited about working there - that's the value side of things. What are the customers like? Are they canceling their contracts? So are there opportunities? Can you cross sell? So you have 1000 clients that only have auto, and you know you can cross sell 20% penetration in auto and home. So your diligence has a dual goal of assessing risk and assessing value. And as you go into this process with those two things, kind of giant blinkers in your head and use a set of checklists, use professionals when necessary, I think you'll be in a really good position. 

Doug  14:10

So Peter, you've signed a letter of intent with an acquisition target, and you are about to enter the due diligence phase. This is where you get to go behind the curtain, if you will, to see highly proprietary information on the target. Talk to me about that. 

Peter  14:28

Well, sometimes a seller will do diligence on a buyer. The primary reason is that there's 'seller financing'; so the seller is taking risk by lending money for you to buy their agency. And so the relationship between the seller and the buyer will continue for a period of years, while the seller financing is out there. So due diligence can go both ways. It's not unusual that a seller in a smaller business has an emotional tie to the town, the customers, the employees, the building, or maybe a physical connection: they own the building where the office is. And so there are times that due diligence can go both ways and that the seller is due diligencing the buyer and saying "Is this the right fit?" 

Doug  15:11

Okay? Obviously, there's a lot of specialized knowledge when you're considering a big move, like buying another agency. The second key in your four keys is the people. You say, get your acquisition team assembled. Who should you have in your corner, on your team, once you've decided you've got the right target? 

Peter  15:31

Absolutely. So I think there are two key individuals, and then a third, I would say. The first is you need to have an accountant lined up. Sometimes it's a relatively quick review of the books, and it's a low cost solution to be done, but you want someone - a professional, who understands the finances - to quickly review. Your accountant can usually do it; pretty straightforward. Second one is a lawyer. There's risk and value in the legal contract, and so that's a critical piece. The other two individuals - and I should have said four instead of three - and one is, if you're going into a market segment that you don't know that well, there are consultants and advisors who maybe can help you if you're buying a certain type of specialty book to expand your markets, who can assess the agency book and say its value or its risk. The fourth is someone like ourselves at AgileCap. If you're doing financing, you want to involve your finance - your lender - earlier in the process, as they see this market every single day and can give you advice and insight. They can maybe have requirements like "Hey, you want to pay $100 but, in reality, it's not going to cash flow on their analysis, so you really should bid $80." So I would say those are the four key individuals that you want to involve in this process. 

Doug  16:52

What are the things that you at AgileCap, as a lender, have uncovered in the due diligence process that, you know, the buyers were grateful and thankful that you brought it to their attention, they hadn't thought of? 

Peter  17:02

What's the most common one is the perception on the size of the agency that people combine? They perceive - this is a broad generalization - they can buy larger agencies than they can. And they don't understand the impacts of cash flow as well. I would say that lots of buyers don't account for some expenses, for some risks, things of that nature. So we focus, as one of our key things when lending...the three keys are: cash - as we talked about - collateral, what is the value of the asset, and character. And what we've found is that lots of potential buyers don't analyze the cash flow as closely as they should. We also get lots of stories of people haven't caught liens that are out there; fraud, where someone has padded a book...if it's out there, we've seen it. But we're focused, as a lender on the three C's: cash, collateral and character. And, to some extent, you doing diligence should be the same way. Which means does it cash flow: can you pay your bills? And collateral: are you growing the value? And finally the character: what are you buying and what is the character of the individual who's selling? 

Doug  18:07

Okay, Peter, so the third key of a successful due diligence process is keeping communications open with the home team. What do you mean by that? 

Peter  18:16

So you have employees in your business, and they're going to quickly notice that you're not around, that you're having meetings that you maybe weren't having before. Yes, Doug, as you said, going behind the curtain gives you an opportunity to say, Hey, we're gonna keep this confidential, just with myself and my lawyer, my accountant, or my, maybe my top manager, whatever the case may be, until it's much more certain. But you need to have a communication strategy. And that's important, you got to know from the beginning, I'm a believer in being pretty open with your team and saying, Hey, this is what it means here are the implications being very honest. And that openness, and the communication is with the accountant and the lawyer with your people and your staff, your partner in life, maybe your family and such. And so I'm a big advocate of making sure you're talking to everyone. And that can only help this process has been my experience. 

Doug  19:04

So the final key, in the four keys, is the importance of a noncompete clause. You have your letter of intent, which opens the due diligence process, and the last and fourth key is how do you bring up and negotiate a noncompete clause and what should be in that? 

Peter  19:22

Yeah, absolutely. It is really a critical thing that I think many buyers underestimate. And we see it in a transaction we're working on right now. There was a noncompete clause, which was great, but it was only two years long. And it turns out that two years go pretty quickly. And in the 25th month, the individual - who abided by her contract, she did the right things - can essentially poach clients. And two years isn't that long to have someone call you up and say, "Hey, I haven't spoken with you a couple of years, but I'm at this new agency and I'm doing a great job, and you worked with us for 10 years...you should continue to work with us" and that is a risk, but it directly removes value from the equation. And so the noncompete clause is really a value protection clause. And I would strongly advise you make it as long as possible. And there's noncompete, nonpoaching...your lawyer would be the one who can advise you because there are state-specific limitations as to what you can do and can't do, and it's critical to have that. But it is a key piece of value protection. You assess the risk, you assess the value, and you can't let that value disappear on day one...and that's critically important. 

Doug  20:34

So to recap: Preparation, People, Communication, and Noncompete. Those are our four key steps. 

Peter  20:42

And in that, make sure you use a due diligence checklist because you got to keep it organized, and make sure you're checking things off the box and doing it the right way. I would agree. 

Doug  20:53

So in our first episode, we talked about identifying targets and acquisition opportunities and whether that was appropriate for you. In this episode, we've dug into due diligence. What are we going to talk about in the upcoming episodes? 

Peter  21:08

We're going to cover a lot of the aspects.

Peter  21:11

What an agency once you've done the acquisition, maybe we'll talk on some of the finer details as you get across the line. But ultimately, you Congratulations, you bought it. And it's not as simple as taking a car off the lot. And just driving off, there is a lot of complexity in dealing with people in new systems and processes. And how do you mitigate the risk and increase the value long term? Well, as an investment banker, I'm hopeful we're going to talk about how to finance these deals. 

Doug  21:41

And so Peter, I have to thank you for coming on the show with me. And where can people find out more about agile cat? 

Peter  21:48

Thanks, Doug. I appreciate the time, the best way to reach us is on our website, agile cap. com. Feel free to find us on Facebook and Twitter, LinkedIn, or out there happy to talk to you at any point in time, you can very easily reach out and set up a 30 minute consultation with us online at your convenience on your calendar. And we're happy to talk through anything we've talked about today or any part of this series.  

Doug  22:09

So Peter, is there a phone number where people can call agile cap? 

Peter  22:13

Absolutely, we're available. The best way to reach us is our toll free number 855-514-1189. Or even better, feel free to email us at sales at agile cap. com. We'll get back to you very next day. And feel free to ask us any question on either way. Thank you very much. Thanks