January 23, 2013
You undoubtedly have clients that rely on one or more key employees.
A key person’s death or disability could spell disaster for the company, but it’s inevitable somewhere down the line.
You’re not doing the job for your clients if you aren’t helping them hedge against the loss of key people.
A key employee is someone who “makes a significant economic contribution to the company . . . an employee who is responsible for management decisions, has a significant impact on sales or a special rapport with customers and creditors, possesses special skills, or would be difficult to replace.”
A software company might depend on its programming wizard. A CEO might be a visionary leader credited with driving the company to success (think Steve Jobs). A brilliant salesperson may have cultivated the best relations with the most lucrative clients. A CFO’s relationship with the bank may be essential to ensure continued funding.
Ask yourself where your own firm would be without its rainmakers.
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 company.
What is a key person worth?
The fundamental question is what the cost to the company would be if the key person died today. To indemnify itself against such a loss, a company must at least cover the economic loss caused by the death of the key person and the cost of acquiring a replacement. Here are three of the methods appraisers use to arrive at a number.
Simplest and most straightforward 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.
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.
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 (in, say, 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.
Mitigating the risk of loss of a key person is an essential part of business planning. As this very brief survey shows, this task requires a valuation of the enterprise and the key person’s contribution that may be beyond the attorney’s skill set. Reach out to your strategic partner CPA to initiate the process now.
This article was originally posted on January 23, 2013 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.