you own a small business, have you looked
closely at the depth of your management team?
Do you have a management succession plan in
place? If the answer is no, you are not alone.
Most small business owners look at one thing
– the company’s management ability. It may
be worth your time to look at both.
most major corporations with diverse management
responsibilities, the success of many small
businesses is largely dependent on a single,
key person. This key person could be the CEO,
who makes strategic decisions based on his
business experience, or a salesperson, who
has established great relationships with the
company’s largest customers. No matter which
scenario, this person has shown great success
when it comes to growing the business, and
as a result, stores a vast amount of intellectual
capital. The loss of such a person, for any
reason, could have a devastating effect on
the ongoing cash flow potential of the business.
This loss is also likely to reduce the company’s
value in the eyes of investors or potential
investors. As a result, most business appraisers
or valuation professionals apply what is called
a key person discount when placing a going-concern
value on such a business for investment, taxation
and/or other purposes.
person discounts may have an extremely negative
effect on the value of any business. Valuation
professionals often apply hefty discounts
based on experience factors with little or
no other supporting documentation. The Tax
Court allowed a twenty-five percent (25%)
key person discount in the settlement of one
estate tax case. Recent studies indicate
a range of discounts between 5% and 10%.
to Revenue Ruling 59-60, the loss of a key
person “may have a depressing effect on the
value of the [company’s] stock.” In addition,
this ruling instructs valuators to consider
what effect losing a key person would have
on “the future expectancy of the business,”
and “the absence of management-succession
potentialities.” Key person discounts may
or may not apply to small and midsized businesses
depending on a number of factors, including:
factors which may reduce or eliminate the
need for the key person discount in valuing
a business include:
Composition: Discounts become less
likely as management becomes more diversified
in that both strategic and tactical decision
making authority is spread to additional
persons. Comprehensive management succession
plans coupled with appropriate training
programs can also reduce the key person
or Operational Complexity: Some businesses
may require a professional designation
to conduct business while others may necessitate
a great deal of technical know-how to
operate efficiently. If a single person
possesses such expertise, a key person
discount may be applicable if a suitable
replacement is unavailable.
to Change: Businesses in cyclical
and highly competitive industries have
historically been more sensitive to operational
changes and more likely to incur financial
declines with the loss of a key person.
A business that has a high degree of sensitivity
to change requires a higher key person
your small business prepared to handle the
unexpected? Are you thinking of stepping
aside and relinquishing control to someone
else? Are you contemplating the sale of your
business? In any case, watch out for the
consequences of the key person discount.
A lack of planning on this important issue
may result in severe consequences not only
for you, but for your investors, or worst
of all, your heirs.
Proceeds from a company-owned life
or disability policy on the key person
could serve to offset any projected decrease
in future cash flows resulting from the
loss of the key person.
Cost Savings: As a general rule of
thumb, the key person’s compensation and
benefits are commensurate with his/her
value and tenure with the business. In
all likelihood, any replacement would
require less compensation.
Agreements: This type of agreement
is designed to protect the small business
in the event that the key person submits
his/her resignation. By implementing
a non-compete agreement, the key person
may not go into direct competition with
the business he or she left.
can help you avoid this issue. You can make
intelligent decisions, which make your company
systems dependent rather than people dependent.
Give us a call today to talk about your unique