Appraisers assess company risk with key-person discounts
The big cheese. The head honcho. The rainmaker. Whatever you want to call him or her, one person can sometimes drive the success of a company. Often, it’s the owner who founded the business with a certain vision that no one else can quite duplicate. In other cases, a dynamic sales manager or innovative technology expert is the superstar.
The great thing about these key people is that they’re, well, great. The bad thing: Their company would likely start to struggle almost immediately upon their departure or sudden demise. Appraisers not only recognize this danger but have a way of calculating its effect on business value. It’s called the key-person discount.
Nuts and Bolts
Sometimes valuators factor key-person discounts in their marketability discount or capitalization rates. At other times, they apply a separate key-person discount to their preliminary value conclusion, with the application at the discretion of the valuator.
A key-person discount doesn’t apply to every small or midsize company. Moreover, this discount type is generally much lower than marketability or minority discounts. Still, when applicable, a key-person discount can notably affect the value of the business.
So, when is it applicable? In accordance with Revenue Ruling 59-60 (RR 59-60), valuators consider two main factors when calculating a key-person discount: 1) the effect that losing a key person would have on the company’s future, and 2) the absence of viable management successors.
There are, of course, other contributing factors. Appraisers consider “business expectancy” by looking at the company and its industry. Among the most important expectancy characteristic that may support a key-person discount is management structure. When one person, for instance, exclusively manages a company, the risks associated with losing that individual are greater.
In addition, the more vulnerable that business operations have been to changes, the more likely the company is to incur substantial financial declines with the loss of a key person. For example, if one individual possesses the knowledge needed to keep the business operational in a complex environment, a key-person discount should be applied. This is typically referred to as “operational complexity.”
A reliance on government contracts could be a factor, too. Some government contracts are awarded to companies because at least 51% of their owners are certified by the Small Business Administration to be “socially and economically disadvantaged.” If the loss of a key-person would cause a company to lose government work, a key-person discount may apply.
Naturally, appraisers look carefully at owners and managers when considering whether to apply a key-person discount. Doing so includes determining how closely each individual is involved in strategic decisions.
Appraisers also assess each owner’s or manager’s unique professional experience or industry expertise, as well as his or her reputation within that industry and the local community. Particularly strong relationships with customers or suppliers are carefully noted, too.
In addition, appraisers check for personal guarantees key people have made for business loans. The loss of those people might force the company to pay higher interest to maintain its loan or, alternatively, the bank might refuse to extend credit.
On the opposite side of the coin, certain factors reduce or eliminate use of a key-person discount. For example, life or disability insurance proceeds can protect a company should a key person die or become disabled. The existence of noncompete agreements similarly protects a business from a key person who might leave and then compete against it.
Appraisers may further estimate a key-person discount in part by quantifying the cost to replace the employee in question. But the key person’s salary should offset this replacement cost, net of any continuing obligations, because the company won’t incur that cost in the future. In some cases, the business may even be able to hire someone with comparable credentials and skills.
Make no mistake: Key-person discounts are far from automatic. But, in a business world where many small companies are led by a single or select few innovators, this valuation tool is fast becoming a rising star itself.
TheKFORDgroup litigation team is made up of experts with the knowledge and experience in expert witness engagements, forensic accounting, and business valuations. Our experts are trained and experienced in business valuations and can calculate and testify about key-person and other discounts. For more information, please call us at 210-340-8351.
Additional information included in this report was provided by PDI Global / Thomson Reuters © 2013