Michael B. Lehner, CPA/ABV, CFE, ASA
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Key people:Hard acts to follow, hard risks to measure

key people business value

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No one is indispensable. But filling the shoes of a founder, visionary or rainmaker that unexpectedly leaves a business is sometimes challenging. The loss of such a “key person” could disrupt day-to-day operations, alarm customers, lenders and suppliers, and drain working capital reserves.

Consider the stock price fluctuations that Apple has experienced following the death of innovator Steve Jobs in 2011. Apple possesses a well-trained, innovative workforce, a backlog of groundbreaking technology and significant capital to continue to prosper. But other businesses aren’t so lucky. Some small firms take years to fully recover from the sudden loss of a key person.

Factors to consider

Key people provide value in different ways, depending on the roles they play in their businesses. So valuators may inquire about the key person’s duties, training, experience and contribution to annual sales. Other factors valuators consider when evaluating a key person discount include:

  • The nature of the business,
  • Personal guarantees signed by the key person, and
  • Management depth and qualifications.

Generally, companies that sell products are better able to withstand the loss of a key person than are service businesses. On the other hand, a product-based company that relies heavily on technology may be at risk if a key person possesses specialized technical knowledge.

Personal relationships are also a critical factor. If customers and suppliers deal primarily with one key person, they may decide to do business with another company if that person leaves the company. On the other hand, it’s easier for a business to retain customer relationships when they’re spread among several people within the company.

Replacement candidates

One of the valuator’s most important tasks is to evaluate the ability of others inside the company to take over a key person’s responsibilities and relationships in case of death or a departure from the business. Does existing management have the knowledge, skills and business acumen needed to fulfill the key person’s duties? Does the company have a solid succession plan in place to smooth the transition?

If no one internally could take over, the valuator also needs to look at the external options. This includes estimating the cost of hiring someone with the same knowledge, skill and business acumen as the key person.

A key person life insurance policy can help the company fund a search for a replacement or weather a business interruption following the loss of a key person. So, companies with key person life insurance typically warrant a lower discount for this risk factor.

Measurement techniques

Valuators generally use one of three methods to incorporate key person discounts into their calculations:

  1. Adjust future earnings to reflect the risk of losing a key person,
  2. Adjust the discount or capitalization rate through the specific company risk adjustment, or
  3. Discount the preliminary value by a certain percentage.

Quantifying the discount is a challenge because, unlike marketability and minority discounts, there’s little empirical support for across-the-board key person discounts in business valuations.

However a valuator chooses to quantify the risk of losing a key person, it’s important not to double-count factors or ignore steps the company has taken to mitigate key person risks. For example, a business might purchase disability and life insurance policies on key people to bridge the temporary cash flow shortage their departures might cause. A business can also minimize key person risks by implementing management training programs, succession plans and long-term contracts with key customers.

Rare but potentially significant

Not every business warrants a key person discount. Most have taken steps to minimize the risks of losing a key person. But sometimes — especially for small businesses with limited operating history and charismatic, innovative leaders — key person discounts are a real, and potentially significant, possibility.

Michael Lehner

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.