If I had to do all over again I would have placed an empty pickle jar besides my desk and throw in a dollar every time a business owner proclaimed his/her business would be nothing without them. At times, I feel the same way. But, my education and experience tells me otherwise. That being said, if the business owner or another individual disproportionately accounts for the business’s success, it’s important to consider whether the risk of losing such a “key person” warrants an adjustment to the company’s value.
What’s a key person discount?
A key person discount may be appropriate if a single owner or employee who would be difficult to replace is responsible for much of the company’s profitability and continued viability, especially when none of the company’s management team members are qualified to assume the key person’s responsibilities. The discount — usually a specific dollar amount or percentage — is taken to reflect the actual or potential departure of a key person.
Instead of taking a separate, discrete discount at the entity level, some experts incorporate a key person discount into their valuation methodology. For example, under the income approach, a valuation expert might adjust the discount rate, capitalization rate or projected cash flows to reflect key person risks. Alternatively, an expert who uses the market approach might adjust the pricing multiples to reflect this risk.
When are key person risks relevant?
Owning a small business isn’t enough to justify a key person discount. These adjustments are typically reserved for situations in which an individual has:
• Management or leadership skills that can’t be replaced at a comparable cost,
• Close relationships with stakeholders (such as suppliers, customers, investors and lenders) that allow the company to get more favorable deals than it otherwise would,
• Rare technical knowledge or skills that help the company stay at the forefront of the industry, or
• Unusual employee loyalty such that his or her departure could trigger a mass exodus of important staff.
Though key person discounts are typically associated with professional practices, they have also been applied to manufacturing and retail companies. Also note that courts appear most likely to accept a key person discount for going-concern businesses where the key person is free to leave and compete with the company. So, the existence of valid employment or noncompete agreements may offset the key person discount.
A common pitfall
Dependence on a key person can be a costly gamble if he or she unexpectedly leaves. Valuation professionals and attorneys must take care, though, to ensure that the risk isn’t double counted. If the discount has already been incorporated in the expert’s methodology, a separate key person discount at the entity level shouldn’t also be applied.
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ATTORNEY’S THAT HAVE READ THIS POST HAVE ALSO READ THE FOLLOWING WHITEPAPER
“Understanding Risk In Business Valuations”