Abstract: Businesses of all sizes sometimes rely heavily on one or two key employees. Valuations of such companies may include a key person discount, and courts have allowed them in certain cases. This article discusses what a key person discount is and some of the factors valuators consider in estimating it, including the key person’s responsibilities, the degree of dependence on the key person and the likelihood of losing him or her. The article also notes that it’s important that valuators avoid the pitfall of double dipping when incorporating key person risk into a valuation.
Unlocking the key person discount
Businesses of all sizes — from Fortune 500 giants like Apple to family-owned operations — sometimes rely heavily on one or two key employees. Valuations of such companies may include a key person discount. While such discounts are rare, courts have allowed them in certain cases.
The discount in a nutshell
Key person discounts reflect the reduction in a company’s value resulting from the actual or potential loss of a key person. A key person might generate most of the company’s revenues; possess intricate technical knowledge, intellectual property, charisma or creative ability; or maintain close relationships with critical customers or vendors.
A discount may be warranted if the loss of the key person is likely to result in significant adverse effects, including lost customers, rising costs and stagnant product development. It’s most appropriate when the subject business is continuing (rather than liquidating) and the key person is free to leave the company.
When estimating a key person discount, valuators generally consider:
- The key person’s responsibilities,
- The degree of dependence on the key person,
- The likelihood of losing the key person,
- The depth and quality of other management,
- The availability and likely compensation of a replacement, and
- The risks associated with losing the key person.
The valuator also weighs factors that might offset the loss. Examples include key person life insurance policies and valid noncompete agreements.
The risk of double dipping
Before relying on a valuation that incorporates a key person discount, check that it doesn’t account more than once for the risks of losing that individual. Key person risks can be factored into the valuation equation in three ways: 1) through a separate key person discount, 2) by normalizing the company’s future income stream or 3) by factoring it into the discount or capitalization rate (or the pricing multiple).
For example, if the valuator determines the future income stream will decrease as a result of losing the key person, he or she shouldn’t also increase the discount or capitalization rate to account for the risk of losing that same key person.
A key component
There aren’t many Steve Jobses or Walt Disneys out there. But some lesser-known companies also have owners and employees who play a vital role in their success. Valuators may account for the risks of losing these individuals — whether with a separate key person discount or other adjustments to the relevant methodology.