Virtually every business has centralized management and/or relies on the talents of a few individuals. This risk of centralized management is taken into account for business valuation purposes in the company’s future earnings or rate of return (i.e., discount rate). In some cases, however, one person is the linchpin, and if he or she leaves the organization, it may lead to a decrease in earnings or is considered an additional risk factor in the rate of return.
This “key person” typically has unique skills, technical knowledge, experience or special relationships with customers or suppliers that would be difficult to replace or replicate. An example might be, one partner in an “ad firm” that generates 75% of annual sales. Or an entrepreneurial person who understands a startup’s proprietary formula or manufacturing process.
In such cases, a separate “key person” discount may be appropriate. This discount is applied to the overall value of the company (i.e., reducing value). There is a small body of empirical evidence that supports key person discounts. They typically fall into a range of 5% to 25%. In addition to the aforementioned factors affecting a key person discount, there are others including a person’s age, health, medical history and day-today responsibilities.
Some business appraisers quantify a key person discount by means of the difference between the company’s projected value before and after the loss of a key person. Others estimate the cost to replace the key person, including the cost of recruiting, training, replacement compensation and the temporary decrease in cash flow caused by the key person’s departure.
How can American Business Appraisers Help?
There are several ways to identified a key person by business appraisers. The important issue here is that it is recognized and accounted for in the written valuation report.
Every individual situation is different and not everyone requires our appraisal services and sometimes just talking with one of our appraisers is all that may be necessary. With our initial consultation, there is no cost or obligation to you. We promise you two things; first, to invest a reasonable amount of time to gain an understanding of your specific requirements, and second, our communication will be kept confidential.