For businesses that consider or choose to take on debt to implement growth initiatives, achieving the right balance between that debt and equity is important. Maximizing a company’s return on equity requires a certain amount of debt. Oak Street appreciates the need for clients’ capital management strategies to align with their long term growth plans while minimizing potential cash flow vulnerabilities and works cooperatively with its clients to achieve these goals.

Equity or debt financing?

When you decide to secure financing for your insurance business, you have to determine whether equity or debt financing is the best fit. Equity is the value of a piece of property after any debts that remain to be paid for it have been subtracted. Equity Financing is the business exchange of leveraging a portion of existing equity (ownership/shares) for capital. Debt Financing is defined as an amount of money owed to a person, bank, company; the state of owing money to someone or something (Merriam Webster Dictionary).

The biggest differences between equity and debt financing are ownership and control. With equity financing, you typically give another entity or person an ownership stake in your business. What’s more, this may allow an outsider to significantly influence the daily operations of your business. On the other hand, debt financing allows you retain your current ownership structure and control of your operations, but will reduce your income as a result of debt cuts. The main change resulting from debt financing is the need to budget and ensure adequate cash flow to cover the repayment of a loan.

Can my business qualify for financing?

There are financing options for insurance businesses. While banks are often the first lender owners consider, banks are often hesitant to lend capital to insurance agencies and insurance agency buyers. An insurance agency’s primary asset is its future commissions and banks normally base lending on balance sheet financials and hard collateral such as real estate and inventory. As a result, insurance businesses frequently find it difficult to obtain bank financing, especially without providing personal assets as collateral.

An insurance lender, however, will allow future commissions to serve as collateral for financing and take into account carrier ratings, contract rights, retention rates, loss ratios and other factors. In determining if a business is credit worthy, an insurance lender typically considers agency value, eligible commissions, historical and projected cash flow from commissions and the agency’s ability to repay the debt while reasonably continuing operations with its amount of available working capital.

Cash flow. EBITDA stands for Earnings Before Interest Taxes Depreciation & Amortization. Most traditional banks/lenders are comfortable lending one to three times a company’s EBITDA. This is an easy way to determine the core cash flow a business is generating. If comfortable with the type of risk, some banks/lenders may get more aggressive and lend a multiple of up to three to five times EBITDA. Higher multiples typically result in greater loan and loan payment amounts, which make for a tighter cash flow. Consequently, higher interest rates may be charged with higher leverage.

Agency value. This represents the value of the agency or property, similar to an appraisal of a residential property or home. Lenders will use a third-party valuation to ensure they don’t lend an amount of money that may exceed the value of the agency in the event it is sold. An agency that needs a valuation should consider utilizing an insurance industry expert that understands the value and nuances that occur in this space (carrier contracts, contingency bonuses, standard vs. non- standard business, etc.).

Commissions. With commission-based financing, the historic retention/persistency ratios of agencies has a significant impact on the amount of money available to borrow. The higher the retention ratios, the larger the loan amounts and longer the repayment terms tend to be. Agencies writing tougher classes of business with lower retention ratios may qualify for a lower leverage due greater uncertainty of policies renewing.