Today we see many businesses with economic problems. They can be placed in two groups: those we think will make it, and those we don’t. Do these groups have any common denominators? I think the group that may not make it, seems to have valued its things above everything else – its products, its markets, its equipment, its sales, and its profits. The ones that appear to be able to survive these hard economic times are the ones who seem to value its people above everything else. If the businesses have confidence in its people, you seem to have confidence that somehow, those people will lead the businesses through these difficult times.
The fact that businesses are built on people, has been recognized throughout America’s history.
Andrew Carnegie, who in the late 1800s was considered one of the richest industrialists in the world and creator of the first business valued over $1 billion, once said: “Take away my factories, my plants; take away my railroads, my ships, my transportation; take away my money; strip me of all of these, but leave me my people, and in two or three years I will have them all back again.” He knew that it is not the things that a business has that counted; it is its people that count.
A successful business often has many key people. Although the owners of a business are usually key individuals, many non-owners may also be a key person. Exactly who is a key person?
The business owner can usually identify a key person by considering a few questions. If an employee was suddenly lost due to death or disability, would there be a hard adjustment period? Would sales be disrupted significantly? Would creditors have less confidence in the business? Would productivity be adversely affected? When the names of employees come to the owner’s mind when asked these questions, those employees are the key people.
Identifying a key person is only part of the problem: the tough problem is determining the dollar value that would be lost if the key person were lost. When an economic value can be placed on the loss of a key person, then insurance and other arrangements can be made to protect the business.
Unlike a machine, people have unique qualities and abilities that make valuing their services difficult. The only right way to value a key person is to consider all areas where the employee affects the business.
Twelve Factors for Considering the Impact of a Key Person
1. Impact on Profits
Impact on profits is very subjective, but when a key person would have a significant impact on profits, the employer knows it. It’s easy to see that a person is responsible for half or three-quarters of the profit; it is very difficult to see that someone is responsible for 5% or 10% of profits.
2. Impact on Sales
The percent of total sales is usually known when the key person is directly involved in sales. When considering the impact on sales, the indirect effects must be considered. Often the key person’s role in the community and relationship with customers impact sales. Non-sales personnel may have a major impact on sales.
3. Unique Qualities
How difficult would it be to find another person with the unique qualities of the key person being considered? How important are those qualities to the success of the business? Answering these two questions helps to determine the impact of the key person.
4. Relationship with Other Employees
Some employees are responsible for the morale of the entire staff. Would the loss of the key person affect morale of the other employees to the extent of lost productivity? This is an often overlooked trait in measuring the impact of a key person.
5. Impact on Company Credit
A key person often is responsible for obtaining credit for the company. The more dependent the business is on its credit lines, the more valuable this relationship. The key person may not be the direct contact with creditors. If creditors see the key person as being essential to continued profits, then the key person could have a major impact on credit.
6. Impact on Future Business Plans
Is the key person being counted on for the continuation of the business when an existing owner retires? Is he or she part of a business succession plan? What is the impact of this key person on the future plans of the business and of the owners of the business?
7. What Is Owed the Key Person
If the business has any accrued payments or debts owed the key person, that amount will probably be due at the key person’s death. The impact of any type of deferred compensation, incentives, bonuses, or debts must be considered when measuring the key person’s impact.
8. Training of Key Person’s Replacement
How long would it take to train the key person’s replacement? When considering the training, you must be sure to consider the time and loss of productivity of those doing the training. In addition, the loss productivity during the training period must be considered.
9. Documentation of Duties
The better the duties of the key person are documented, the quicker a replacement will be up to speed. Often, a combination of existing staff can divide these documented duties to minimize the loss of productivity. However, usually the more valuable the key person, the less the duties are documented. The lack of knowing how the key person functioned day-to-day should be considered in estimating the effects of losing him or her.
10. Impact of Ownership Succession Plans
When the key person is also an owner, are all business continuation and succession plans in order? If not, additional costs may occur in legal settlements or a succession that is not productive.
11. Expectations of Key Person’s Survivors
Although there may not be a legal obligation to provide for the family of the key person, what are the expectations of the family and other long-term employees? Nothing can affect employee morale any more than what appears to them as the employer’s unconcern for a long-time valued key person.
12. Opinion of Owners
There is no one who has a better idea of intuitive value of the key person than the other owners. Their opinion is invaluable in determining the impact of the key person. It is helpful to review all of these factors with the owners, but the owners’ opinions should always be a major consideration.
After determining the impact of the key person for each of these factors, a value of the key person to the business can be derived. There are several methods for determining a value. Often the best method is a function of which of the twelve factors above are the most significant.
There are six basic methods for determining the key person’s value.
1. Business Value Method
The key person’s value to the business is estimated by applying the percentage that represents the portion of profits for which the key person is responsible times the estimated value of the business.
2. Multiple of Salary Method
One of the most common methods for valuing a key person is to use a multiple of salary. Usually a multiple of 3 to 10 is used.
3. Sales Replacement Method
This method tries to amortize the sales loss due to the key person over the period required for the replacement to duplicate sales. Each year fewer sales are considered lost. The present value of the potential lost sales revenue is a good estimate of the key person’s value.
4. Training Cost Method
This method tries to amortize the lost earnings while the replacement for the key person is being trained. Excess earnings are calculated by the adjusted average annual earnings (earnings plus any excess owner salary) less the fair rate of return on the book value. These excess earnings are amortized over the years to train the replacement, assuming that each year has less impact than the previous. The present value determines the cost of training the replacement.
5. Business Life Value Method
For a very valuable key person, the effects could be over the anticipated working lifetime of the employee. The present value of the excess earnings between now and when the key person would have retired is used to estimate the key person’s loss to the business.
6. Owners’ Estimate Method
The other owners’ have a vested interest in their estimate of the value of the key person.
There are many ways to value a key person, and in many cases, it is a combination of these methods that best represents the total value of the key person.
PlanLab’s Key Person Presentation helps determine the value of each impact factor. By combining those values with the six methods described above, Key Person provides a quantitative approach to valuing a key person.