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.

Other than these unusual times, what could cause a credit crunch for businesses? Often, available credit is based on personal relationships between an employee and the creditor. The creditor may consider an employee to be responsible for the profits that will enable the business to repay any loans. Although this personal relationship is often with an owner or senior executive, it is sometimes based on others – a star salesperson, an organized and efficient office manager, an inspiring supervisor or foreman, or an employee who is a respected community worker. Various employees may provide that key relationship that reassure the creditors of a business.

When valuing key employees, employers sometimes take the employee’s contribution to business credit for granted. As today’s crisis is teaching everyone the necessity of good and available credit, the value of an employee to business credit lines must be considered. If a key employee suddenly died or became disabled, would the business’s creditors hesitate to continue credit? How much cash would be needed to bridge the difficult time following the employee’s loss to reassure creditors?

One of the first principles of financial planning for both individuals and businesses is to protect your existing assets and newly acquired assets. Credit relationships are a valuable asset. They are difficult to acquire, and when acquired, should be protected. Key person insurance can protect businesses from the loss of a key person. Businesses usually consider the effects of a key person on sales or profits, but often neglect to consider the key person’s loss on the business’s credit availability.

PlanLab has a Key Person module that helps to guide business owners through the process of considering the impact and value of a key person to the business. It helps the business owners consider all aspects of the employee’s effect on the business, including the relationship with creditors. 2008 has been a difficult year for businesses, and everyone needs to learn from the experience. One lesson is the value of available credit and the necessity to protect the business’s credit by considering a key person’s effect on the business’s credit.

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