The Cost of Losing a Key Person: Understanding the Impact of Key Person Discount on Business Value

"A key person discount is not just a numerical adjustment in business valuation, it represents the potential loss of a critical asset that can impact the future success of the company," says Tamir Levy, Ph.D., Equitest’s Founder-CEO.

What defines individuals as "key people"?

Individuals who hold significant responsibilities in an organization or business and contribute significantly to its success are referred to as "key people". The absences or departures of such individuals can have far-reaching impacts on the company's operations, revenue, and overall success. Key people may manage key accounts, oversee vital projects or even develop and implement the company's strategic vision. Their departure can result in loss of customers, declining revenue, and even business collapse. Hence, it is essential for companies to identify and manage the risks associated with their key personnel.

The definition of key persons varies based on the size, type, and structure of the business. Listed below are a few examples:

1. Founder or CEO: In small startups or family-owned businesses, the founder or CEO plays an essential role in driving the company's growth and success.

2. Sales Manager: A sales manager who manages important customer relationships and maximizes revenue for the company can be considered as a key person.
3. Head of Research and Development: In technology companies, the head of research and development in charge of developing new products and technologies can be a key figure.
4. Chief Marketing Officer: A marketing manager who leads the company’s marketing and advertising strategies and helps build the brand image can also be considered a key figure.

1. Lead Engineer: In engineering firms, the lead engineer who oversees critical projects and has unique technical expertise could be a key person.
2. Chief Financial Officer: A chief financial officer who manages the company's finances, investments, and budgets and ensures financial stability could also be considered a key person.

Understanding the Risks of Key Person Dependency in Business

Understanding the Business Risks Associated with Key Person Dependency
Losing a key employee can be risky for a company because their departure could significantly affect operations, revenue, and overall success. Here are some possible risks:

1. Operations disruption: When a key employee leaves, it can cause delays, mistakes, and lower productivity in the company's daily operations and workflow.
2. Loss of Key Relationships: Key individuals frequently have crucial connections with customers, suppliers, or partners that are challenging to replace. These relationships could be lost if they leave, which would result in a drop in sales and profits.
3. Skills and Knowledge Gap: Knowledge and Skill Gaps: It's possible that a key person possesses specialized knowledge, abilities, and experience that are hard to replace. Knowledge gaps caused by departures can lower the firm's quality, innovation, and competitiveness.
4. Negative Impact on Morale: The departure of a key person can also have a negative impact on the morale and motivation of other employees, who may feel uncertain about the company's future or their own roles within the organization.
5. Reduction in Business Value: The loss of a key person can reduce the overall value of the business, resulting in a lower selling price if the company is sold or valued for investment purposes.

Therefore, it is crucial for businesses to have contingency plans in place to manage the risk associated with the departure of key persons and ensure business continuity.

what is The Cost of Losing a Key Person?

The cost of losing a key person can be significant for a business, both in the short and long term. Here are some of the potential costs:

1. Recruitment Costs: Finding a suitable replacement for a key person can be time-consuming and costly. The company may need to pay for job postings, recruitment agencies, and background checks, and may also need to offer higher salaries or benefits to attract top candidates.
2. Training Costs: Even after finding a replacement, the company may need to invest time and resources in training the new employee to fill the knowledge and skills gap left by the key person. This can include onboarding, mentorship, and professional development programs.
3. Loss of Revenue: The departure of a key person can lead to a decline in revenue and profits, particularly if the person had critical relationships with clients or was responsible for generating significant business. The company may need to spend time and resources rebuilding these relationships or finding new clients to replace the lost revenue.
4. Reduced Productivity: The departure of a key person can also lead to reduced productivity and efficiency, as other employees may need to take on additional responsibilities or may struggle to work without the guidance and direction of the key person.
5. Negative Impact on Company Culture: The departure of a key person can also have a negative impact on the company culture, as employees may feel uncertain or demotivated about the company's future. This can lead to decreased engagement, increased turnover, and difficulty attracting top talent in the future.
6. Key Person Discount: If the business is being valued for investment purposes, the departure of a key person may result in a lower valuation due to the Key Person Discount applied to reflect the potential loss in value resulting from the actual or potential loss of a key person.

Overall, the cost of losing a key person can be substantial, both in terms of financial and non-financial factors. Therefore, it is crucial for businesses to have contingency plans in place to manage the risk associated with the departure of key persons and ensure business continuity.

How Does it Affect Business Valuation?

The departure of a key person can significantly impact a company's valuation. A key person plays a critical role in the success of a business and contributes to its value through expertise, experience, and leadership. If the key person leaves, it can create uncertainty and risk for the company, which can lead to a decline in its valuation.

When a key person leaves, the company's revenue, profitability, and future prospects may be impacted. Potential investors and buyers may view the loss of a key person as a red flag and may reduce their valuation or offer a lower price for the company. The departure of a key person can also impact the company's reputation, which can further reduce its valuation.

To minimize the impact on the company's valuation, it is essential to have a contingency plan in place to manage the risk associated with the departure of a key person. The plan may include identifying potential successors, providing appropriate training and development, and ensuring that critical knowledge and information are documented and shared within the organization. By having a contingency plan in place, the company can minimize the impact on its valuation and ensure business continuity.

Key Person Discount refers to a reduction in the value of a company that occurs when a key person, who is critical to the organization's success, departs from the company.

Case Study: The Cost of Losing a Key Person

ABC Corporation is a manufacturing company that produces automotive parts for leading automobile manufacturers. Sarah, the vice president of operations, is a key person in the company responsible for managing day-to-day operations, leading the production team, and ensuring quality control. Sarah has been with the company for over a decade and has built a reputation for her expertise, experience, and strong leadership skills.

ABC Corporation is a manufacturer specializing in the production of auto parts for leading automakers. Sarah, Deputy Chief Operating Officer, is a key figure in the company, responsible for day-to-day operations, leading the production team and ensuring quality control. Sarah has been with the company for over a decade and has built a reputation for her strong experience, experience and leadership skills.

One day, however, Sarah announced that she was going to quit her job because of a personal emergency. The company’s management team understands the potential impact of Sarah’s departure on the company’s operations, bottom line, and employee morale. They estimated the cost of losing Sarah to be about $300,000.

The company immediately began looking for a replacement for Sarah. They post job openings on multiple companies and reach out to recruitment agencies to find the right candidates. The company spends $15,000 on recruitment expenses, including job placements, recruitment services and background checks.

After several weeks, the company finally finds a replacement for Sarah, but they realize that the new hire will require significant training and onboarding to get up to speed with the company's operations, quality standards, and team dynamics. The company estimates that it will take at least six months for the new hire to be fully productive, leading to a potential loss of revenue and profits. The estimated loss of revenue during the training period is around $200,000.

In addition, other employees in the manufacturing team feel uncertain and dissatisfied with the future of the company, which reduces productivity and employee morale. Some employees start looking for new jobs, which increases turnover. The cost of increased marketing is estimated at $50,000.

Moreover, the company's reputation in the market is also impacted, as some clients start expressing concerns about the company's ability to deliver quality products without Sarah's expertise and leadership. The estimated loss of revenue due to reputation damage is around $50,000.

Overall, the cost of losing Sarah, the key person, is significant for ABC Corporation. The company incurs recruitment costs of $15,000, training costs of $200,000, loss of revenue of $200,000, increased turnover costs of $50,000, and reputation damage costs of $50,000, resulting in a total cost of $515,000. The company realizes the importance of having a contingency plan in place to manage the risk associated with the departure of key persons and ensure business continuity.

The Change in Value

In our case study, ABC Corporation estimated the cost of losing Sarah, a key person in the company, to be around $515,000. This cost includes recruitment costs, training costs, loss of revenue, increased turnover costs, and reputation damage costs.

Assuming that ABC Corporation's valuation was $10 million before Sarah's departure, the impact on the company's valuation can be calculated as follows:

Valuation before Sarah's departure = $10 million Cost of losing Sarah = $515,000

Valuation after Sarah's departure = Valuation before Sarah's departure - Cost of losing Sarah Valuation after Sarah's departure = $10 million - $515,000 Valuation after Sarah's departure = $9,485,000

Therefore, the departure of Sarah, the key person, can result in a decrease of $515,000 in the company's valuation. This reduction in valuation is called Key Person Discount and it can be significant. It highlights the importance of having a contingency plan in place to manage the risk associated with the departure of key persons and ensure business continuity.

Conclusion

Business valuation software can be a valuable tool in managing the risk associated with the departure of key persons and ensuring accurate company valuation. By having a contingency plan in place and utilizing business valuation software, companies can minimize the impact on their valuation and ensure business continuity.

Are you concerned about the impact of losing a key person on your company's valuation? Take action today and invest in business valuation software to manage the risk and ensure accurate company valuation. Sign up for a free trial.