When buying a broker there are many pitfalls which could, at a later stage, prove disastrous. Sarah Sherlock highlights five important areas to consider before purchase

The forthcoming changes in broker regulation look set to increase the costs of compliance for brokers. This, added to other pressures on small brokers, together with the upward trend in rates and therefore income, may prompt some brokers to consider selling on their businesses now rather than meeting the challenges of Financial Services Authority (FSA) regulation.

Although this may look like a heaven-sent opportunity for other brokers to expand locally and nationally by acquiring existing concerns, anyone looking to buy a broker should undertake a thorough due diligence exercise and be aware of the potential pitfalls which await the buyer.

Here are five key areas to consider before any acquisition.

The method used to value a broker will depend a great deal on external factors including its clients, its pricing and its location. A broker dealing with commercial clients can owe its success to any of the above, or to the value the broker provides to the business client through other services besides broking.

The value of a firm can be calculated on premium income or on commission income, as agreed between the parties involved. The valuation would usually be in the region of 75% to 150% of the firm's annual commission or premiums. But again, this depends on the circumstances involved, including the broker's existing debts and liabilities (especially long-term liabilities you won't require post-completion).

The value of a broker often boils down to the value of its client list, and goodwill will be a large part of the valuation, but often, and especially in firms dealing with personal insurance, a broker is only as good as his last deal. Even for brokers with a predominantly commercial client base, client loyalty is not assured.

To avoid goodwill evaporating, consider requiring restrictive covenants, or earn-out provisions tied to non-competition requirements, which will allow you to consolidate your hold on new clients. A broker may appear to be looking for a lump sum for retirement purposes and a quiet life, but could just as easily decide to start up another firm in the same area and take up where he left off, including persuading established clients to change firms. This is an issue which largely depends on your assessment of the individuals involved.

Taking on another firm's work includes taking on its liability, and you should take care that you are covered both for D&O and E&O liabilities. The seller should provide appropriate cover for its period of control and, given the possibility of latent claims, three years' cover is not sufficient. Ideally the cover should last for 15 years into the future (the long-stop period for professional negligence claims under the Latent Damage Act [1986], unless any fact relating to the claim has been deliberately concealed by the allegedly negligent party).

You should review the broker's records and claims history to take a view on your possible liability. Even with suitable cover in place, investigating and resolving claims will be costly in terms of employee time alone. Think carefully about the warranties and indemnities you want the broker to provide before purchase.

If you are planning to stop providing particular services when you buy the broker, you should consider how you are going to manage the remaining work of this type (for example, are you going to continue to run it in-house or look to a professional run-off entity) and the costs involved in the route you choose (such as specialist employees or training).

The standard due diligence undertaken when buying a business should help you get an idea of the broker's complaints history, but you will also want to check that the firm has in place appropriate training, monitoring and recording procedures to comply with regulatory requirements.

Be aware of the cost of any additional training that the firm may require. Further expense may be incurred if you have to bring the new firm up to speed on its regulatory requirements, as well as the cost of training the new firm to comply with your existing internal procedures.

General Insurance Standards Council (GISC) members are likely to be more attractive to prospective purchasers than non-GISC intermediaries. As a general rule the GISC rules provide a common-sense checklist of the good business practice that you should be looking for in a broker, whether it is a GISC member or otherwise.

Remember that the business you buy may not be compliant with FSA standards when they are introduced. The FSA may seek to impose standards on business conducted by the firm pre-acquisition in relation to a complaint arising after the FSA has assumed regulation of your business.

Are you planning to keep all of the employees on when you purchase the broker? The various Transfer of Undertakings (Protection of Employment) Regulations may apply, and employment law advice is vital should you wish to make any employees redundant (do factor in the cost of any redundancy package).

In addition, wholesale redundancies are risky without having a clear idea of what business of the broker you wish to continue following purchase. You may end up without enough qualified people to deal with a particular area of business, and that will cost you, both in terms of extra training and in terms of employee time spent on areas of business with which they are less familiar. The potential for negligence claims is increased (and thus possibly your E&O premium), and you could risk non-compliance with regulatory requirements concerning the competency of your staff.

When purchasing the broker you will also become responsible for any pension scheme it manages for its employees. This expense should be taken into account. You should also note that if you want to make any changes to a pension scheme which will affect the accrued entitlement of any member there are several legal hurdles to overcome, such as obtaining the consent of all members of the scheme or ensuring that the changes do not breach any existing employment contract. The cost of ensuring that the correct procedures are followed should be weighed against any savings you plan to make in this area.

Are you planning to use the same premises for the business? If so you will need to check that any tenancy agreement continues despite a change of control of the broker, and that you are aware of potential problems with the premises, including any expenses that will

be incurred in renovating the property or transferring staff to those premises. Should you wish to keep the business but move it to different premises, consider whether any lease can be terminated and how the change will affect the broker's business - how much of its work is due to its location?

Check that any IT agreements do not terminate upon a change of control of the broker, and that the licences for any software will not be affected by the purchase. The latter point applies to all licensed software (for example, Microsoft products), but is particularly important in relation to any bespoke systems that the broker has commissioned, or systems on which its staff are trained and on which it relies for its day-to-day business.

Can the broker's IT systems be integrated with your own? If so, at what price?

A broker won't necessarily have a great deal of intellectual property (IP), but you should make sure that any IP rights you will want to use, such as trademarks and internet domain names, are transferred to you during the purchase.

This is not an exhaustive list of points to be considered when buying a broker. Given each broker's unique combination of size, location, business, history and so forth, particular factors will be more important in particular circumstances.

However, the above points give you some idea of the wide range of issues of which any prospective purchaser should be aware.

Sarah Sherlock is in the corporate department of solicitor Reynolds Porter Chamberlain

A year of consolidation - who bought whom
The Folgate Partnership acquired Duncan Pocock and Smithson Mason: the Duncan Pocock brand will be retained and it will become a regional hub for its operations in the south east. Smithson Mason will be the hub broker for the Yorkshire and north-east

Swinton acquired Colonnade and Safeguard: the £27m acquisition from Provident makes Swinton the biggest high street broker in Britain. Safeguard is a specialist caravan broker.

Hill House Hammond acquired Cheam Insurance Brokers, ML Bender, G Whitfield Insurance Services, EG Reece & Co, Tividale Insurance Services, Derek Eastwood Insurance Brokers and Lloyd & Whyte: motor specialist Cheam will work with HHH's Croydon-based high value motor unit. HHH has also acquired over 3000 personal lines policies from Avondale Fitzgerald.

The Primary Group acquired Wensum Agency Insurance Brokers: the telebroker specialises in private car insurance and has an annual premium income of more than £5m. Wensum will become part of Primary's Altrincham call centre.

Thompson Heath & Bond (THB) acquired TL Clowes: THB increased its brokerage to £19m through the acquisition.

The Primary Group acquired Health for Industry (HFI): HFI is one of the UK's biggest independent healthcare consultancies and adds new services to the group's international medical insurance provider Goodhealth Worldwide. Christopher Claridge-Ware and Steve Morley-Ham set up HFI, which has a £50m gross annual turnover, in in 1990.

Bruce Stevenson has acquired Coates Insurance: no redundancies has been made as Coates staff followed director Gordon Banks to the new company, which now has 42 staff.

Argyll Insurance Group acquired Pharon Insurance brokers: Pharon will continue to operate from its Kent office, its base for nearly 40 years, with an unchanged team working under Ron Woodwood.

Smart & Cook acquired Lewis Wotherspoon: Lewis Wotherspoon, which specialises in the motor, construction and retail trades, will be added to Smart & Cook Group's Scottish subsidiary, Smart & Cook Scotland.

Giles Insurance Brokers acquired Cottle: Giles, Scotland's largest independent brokers, said Halesowen-based Cottle had a turnover of £6m and 25 staff.