Abstract:   In divorce, when a marital estate includes a closely held business interest, its value can have a significant impact on the division of assets, as well as the determination of support payments. A key person discount may apply when valuing a business that relies disproportionately on one person for its success. This article discusses what this discount is, how business valuation experts apply it and when it’s relevant in a divorce context.

How to unlock “key person” risk in divorce cases

In divorce, when a marital estate includes a closely held business interest, its value can have a significant impact on the division of assets, as well as in the determination of support payments. If the owner-spouse 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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