I would like you to consider the following situation. You have been given a valuation assignment to perform, and during your research into the subject company you learn that there is a key individual that contributes greatly to the success of the business. The contribution could come in the form of specialized knowledge or skills, key client relationships, key supplier or banking relationships, or a number of other contributions. They could be a salesperson that can sell ice in Alaska or swampland in Florida. The form the contribution takes doesn’t matter, what does matter is that the company couldn’t operate as profitably if they weren’t there. Simply put, this is a “Key Person” necessary to the continued success of the business and their possible loss is a factor to the valuation that should be considered. Internal Revenue Service (IRS) Revenue Ruling 59-60, the authoritative guidance on the valuation of closely held businesses issued by the IRS says “…The loss of a manager of a so-called “one-man” business may have a depressing effect upon the value of the stock of a business particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise…” The IRS recognizes the possible need for a Key Person discount.
I can’t tell you what the impact on value of a Key Person discount should be, as that is dependent on the specific facts and circumstances of the subject company. I can say that potential Key Person discounts should be analyzed to determine if there mitigating factors that work to lessen the risk. If it is given that there is a Key Person discount that should be considered, I want to talk about how you apply the discount, because it can have an impact on the final value. There are three ways in which a Key Person discount can be applied.
First, the discount can be applied in the form of an entity level discount, similar to the application of a discount for lack of control or a discount for lack of marketability. These discounts are applied directly to a preliminary conclusion of value. If a valuator determines that the preliminary value of a company, prior to a Key Person discount (or any other discounts) is $1,000,000 and they believe that a 20% Key Person discount is appropriate, then the resulting value would be $800,000. The challenge with this approach is determining the appropriate discount to apply. What do you base it on? Is there market data available to support a conclusion?
Secondly, a Key Person discount can be applied by including the discount as incremental specific company risk included in the determination of the discount rate. This discount rate and the company’s expected cash flows are used to value the business. However, there is a danger in this approach. As an example, assume that a valuator believes that a 20% Key Person discount is reasonable. Adding this Key Person discount directly to the discount rate is not the same thing as applying the discount to a preliminary estimate of value. Assume that in the first example the $1,000,000 preliminary value was arrived at by dividing expected cash flow of $200,000 by a 20% discount rate. If the Key Person discount of 20% were to be added to the discount rate of 20% to arrive at a new discount rate of 40%, the resulting estimate of value would be $500,000, a 37.5% decrease in final value from the $800,000 in the first example. I have seen this methodology applied in valuations. The impact of adding a Key Person discount percentage to the discount rate can be dramatic, often resulting in unrealistic values if not done properly. If this method is selected the valuator should realize that a Key Person discount percentage applied at the entity level should not be the same percentage that is added to a discount rate to account for the same risk
The third way a Key Person discount can be applied, and the one which makes the most sense to me, is to account for the risk in the expected cash flow of the business. This approach may not be easy, but I believe the due diligence required to develop a new cash flow estimate, accounting for a potential loss of sales revenue, an increase in costs, and other factors, is more easily defended and explained than a Key Person discount percentage that has no observable data support. In this approach the cash flows have the risk built into them. The expected growth of the cash flows could also be impacted by the Key Person risk. When the cash flows have been modeled to reflect the risks surrounding the Key Person no additional discount is required.
When a business has a Key Person that can impact its value if they were to leave, the risk of their departure needs to be considered and accounted for in the valuation process. The treatment of a Key Person discount can be applied in three different ways and care should be given in the application or the ending value might be unrealistic.