Helping businesses through worst-case scenarios
Key-person discounts estimate the value of a VIP
If a business depends greatly on just one or two people, a valuation discount may be appropriate to reflect the risk of damage to the business should such a key person die or otherwise leave the company. To determine whether the discount is warranted, a valuator will examine a wide variety of factors.
What is a key person?
Some things that the valuator will look at when evaluating whether to apply a key-person discount include the:
• Company’s relationships with customers and suppliers,
• Nature of the business,
• Key person’s actual duties and activities, and
• Quality and depth of the company’s management team.
After all, key people provide value in different ways, depending on the roles they play in their businesses. For example, a key person may drive the company’s strategic vision or handle day-to-day management responsibilities. He or she may offer technical expertise, an excellent reputation or an extensive network of industry contacts.
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 is gone. On the other hand, it’s easier for a business to retain customer relationships when they’re spread among several people within the company.
A key person may also have a financial impact on the business. In closely held businesses, for instance, a CEO or other key person will often personally guarantee the company’s debts. It’s important to note that having a key person as a large revenue generator would likely materially affect the financial position of the business.
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.
Will other employees measure up?
One of the valuator’s most important tasks is to evaluate the ability of others to fill a key person’s shoes 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? What would be the total cost of hiring someone with the same knowledge, skill and business acumen as the key person? And would it be feasible for the company to take out a life insurance policy on the key person?
The risk may be greater if the company would have to bring in a replacement who’s unfamiliar with the business.
How is the discount determined?
Identifying risks associated with key persons is one thing; estimating the impact of those risks on business value is quite another. 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 calculated value by a certain percentage, similar to a marketability or minority interest discount.
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.
Keep in mind that smaller closely held companies are more likely to depend on one or two key people than are larger closely held companies or public companies — both of which are usually able to replace key management personnel with relative ease and, thus, minimize potential losses.
How much value?
Particularly in a sluggish economy, businesses should be aware that losing a key person can damage the company’s ability to deliver products or services to its customers. In addition, if the company is fishing for a buyer or wanting to acquire another business, the loss of a key person will be a red flag to prospective buyers. Make sure your clients understand how much value a key-person discount can have in these situations.