May 6, 2014

Try to imagine your business without its key employee. That person might be the owner, the managing partner or the top rainmaker.

What would be the cost to your organization if that key person died today?

To protect yourself against a loss like this, you must at a minimum cover the economic loss caused by the death of the key person – and the cost of replacing that person.

There are standard ways to insulate against the risk of loss of a key person:

• Insurance against the death of the key person
• A succession plan
• A buy-sell agreement for an orderly disposition in case of the key person’s retirement or departure for other reasons

But to take these measures, it’s necessary to know the key person’s value to the organization.

Here are three of the methods appraisers use to arrive at a number.

1. The simplest and most straightforward method is the salary approach. Determine the portion of the key person’s salary that represents routine duties someone else in the organization could do right now.

For example, if the key person is paid \$400,000 per year and someone could perform that person’s routine duties for \$100,000, the key person’s unique value is \$300,000.

Multiply that number by the time it would take to train a replacement. The resulting number is the amount of key person insurance the company needs. Thus, if it would take two years to train a replacement, the key person’s value is \$600,000. This method works best where salary adequately reflects the key person’s contribution.

2. Next simplest is what we might call the “lifetime contribution” method. Multiply the key person’s expected remaining years of service by the annual economic loss the company expects it would incur if that person were to depart.

Then, discount that figure to present value on some reasonable interest rate. The result is the amount of insurance the company needs to buy now to protect itself against loss of the key person during expected years of service. This method works best when there is a reasonable basis for projecting the key person’s continued value during uncertain future years.

3. A third method tries to measure the key person’s contribution to company earnings more directly. Take the average book value of the company over some period, say five years. Multiply that number by a factor that represents a fair return if the money had been invested elsewhere (for instance, in a mutual fund).

Subtract the result from the company’s average net income over the chosen period. The difference is the key person’s contribution to earnings. Multiply it by the time required to replace the key person (for instance, two if it will take two years) to arrive at the amount of insurance needed.

This method works best when the company’s added value over an index fund is wholly attributable to the key person – such as when the key person is the visionary who is almost wholly responsible for the company’s success. Think Steve Jobs.

Mitigating the risk of loss of a key person is an essential part of business planning. Don’t overlook this important step.