By Michael Torney, J.D., CFP®, LL.M., CEPA
Many business owners assume their business is more valuable than it actually is. One of the biggest reasons? Key man risk.
Key man risk is the concept that a business is highly dependent on the contributions of one (or a few) person(s). Think of Berkshire Hathaway without Warren Buffett, or Tesla without Elon Musk.
You may think the company will be fine and the key employees will stay, but a buyer will likely not share in your confidence. The buyer has no relationship with those key employees. Or perhaps worse, one of those key employees is the seller!
Let’s look at both concerns.
- There is one (or more) key employees: With the original owner no longer running the company, how can a buyer be assured the key employees will stick around? Were they aware that the seller was looking to sell the company? Do they feel hurt they did not get an opportunity to purchase the company? If they are being asked to take on additional responsibilities, are they adequately prepared to do so? What will keep them incentivized to work after the original owner is gone?
- The Seller is one of the key employees: this can be even more problematic. The business owner is presumably selling their company to retire or start another venture. If they are responsible for a significant portion of the company’s ongoing success, what is the buyer purchasing?
One of the best ways to reduce key man risk is to start years ahead of a sale. Begin a process of identifying where the key man risk lies in a company. Then you can figure out the best way to cross-train employees or hire a “replacement” that you will train for a number of years to reduce the reliance on the key employee.
Another tactic: incentivize the key employees to stay with the company. This can be accomplished with deferred compensation packages or even with equity in the company.
Finally, an owner should look to be building the next generation of employees who can run the company. If a company can survive the unexpected loss of a key man without significant detriment in revenue or projected growth, that’s a very valuable company to purchase.
Key man risk is one of a few areas that impact the wealth planning of our business owner clients. If you would like to discuss this topic, please reach out at DuffTorneyteam@monetagroup.com. We’re happy to walk through this important topic together.
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