Key Man Discount: Valuation Issues and Strategies to Mitigate Risk

Posted on 06.29.16

Key Man Discount: Valuation Issues and Strategies to Mitigate Risk

By Greg P. Saunders, Associate, Valuation and Forensic Services

How equipped is your business to handle the departure of a key person?

As discussed in IRS Revenue Ruling 59-60, “The loss of the manager of a so-called “one-man” business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence of management-succession potentialities are pertinent factors to be taken into consideration.”[1]

Key man discounts result from the risk of either an actual or potential loss of a key person in a business enterprise.  However, through succession planning and implementation of certain business strategies, the potential discount for losing key management can be significantly reduced.  Revenue Ruling 59-60 supports this notion, “On the other hand, there may be factors which offset, in whole or in part, the loss of the manager's services…. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager's services in valuing the stock of the enterprise.”[2]

Attributes that lead to a company’s dependence on an individual include strong relationships between the key person and suppliers or customers, unique product innovation capability and marketing vision, extraordinary management and leadership skill, financial strength of key person (e.g. personal guarantees of loans), and experience. In addition, disruptions in business operations under new management are heightened if employee loyalty to the key individual is widespread.  The key man discount may be magnified if the probability of his/her departure is high.

While vastly important, a key person does not have to be the be-all and end-all of an enterprise.  Potential offsets to the risk of a key individual’s departure can be utilized to alleviate the threat.


Examples of strategies to mitigate risk include:

  • Succession Planning 
    Preparing and formalizing a succession plan for the business is crucial to the firm’s capability to smoothly transition after the loss or departure of a key person.  Consideration should be given to the availability and adequacy of potential replacements, both within the firm and externally.
  • Life or Disability Insurance
    Insurance policies for the loss of life or disability of key personnel mitigates the risk of losing those individuals by providing funds to the company in case of such an event.
  • Employment or Non-Compete Agreements
    In the event that a key person leaves the firm, employment and non-compete agreements can reduce the individual’s ability to compete in the same line of business.  These agreements usually set a time period and geographic region for which the individual is restricted from competing.
  • Compensation Savings
    In circumstances where the key person’s compensation is higher than the cost it would take to replace the individual, these cost savings are seen as a decrease in the risk of losing the key man.

Although the risk of a key man’s departure can never be completely eliminated, strategies such as those discussed above provide an opportunity for business owners to reduce the adverse impact in their company’s value. The key to mitigating such risk is to take a proactive approach.

Questions on this topic? Contact our Valuation and Forensic Services team or 804.747.0000 | Email.

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Greg Saunders | Valuation and Forensic Services | Keiter | Richmond, VA

Greg is an associate in Keiter’s Valuation and Forensic Services Group. He performs business valuation services for purposes of mergers and acquisitions; estate, gift, and income taxes; litigation and shareholder disputes; employee stock ownership plans; reorganizations; marital dissolution; business planning; buy/sell agreements; and financial reporting.  In addition, he performs litigation consulting services including damages and lost profits calculations.  Greg also performs forensic accounting services, including financial investigations and litigation consulting services.  Read more of the Valuation and Forensic Services Group’s insights on our blog.

 

Sources:

[1] Internal Revenue Service Ruling 59-60, 1959-1, CB 237, Sec. 4.02(b).

[2] Internal Revenue Service Ruling 59-60, 1959-1, CB 237, Sec. 4.02(b).