What to Do When One Employee Holds the Key to Business Value
Author: Ron Soluri Jr.
A company’s earnings and cash flows can suffer significantly when an executive or other critical employee leaves. Small and service-oriented businesses and professional practices are particularly vulnerable to such financial losses.
To account for this risk, professional valuators may apply a key-person discount. These discounts don’t apply to all business appraisals and they’re rarely one-size-fits-all. Thus, a valuator must ask several questions specific to the subject company and its key employees.
Which appraisals are affected?
Choosing when a key-person discount is appropriate can be tricky. Smaller closely held businesses are likely to depend on one or more critical employees, but such risk is often accounted for in a separate “size premium.” Larger closely held companies or public companies usually are able to replace key management personnel and thus minimize potential losses.
In general, businesses that sell products are better able to withstand the loss of a key person than service businesses, which depend to a greater extent on key employees’ knowledge, reputation and relationships. However, a product-based company that relies heavily on technology or intellectual property may be at risk if a key person possesses specialized technical knowledge.
Who are the key people?
Key people provide value in different ways, depending on the roles they play in their companies. For example, a key person might:
- Drive the company’s strategic vision,
- Handle day-to-day management responsibilities,
- Offer technical expertise,
- Lend his or her excellent reputation, or
- Provide access to an extensive network of contacts.
Personal relationships are a critical factor in identifying key employees. If clients, customers and vendors deal primarily with one person, they may decide to do business with another company if that person is gone. On the other hand, it’s easier for a company to retain customer relationships when they’re spread among several people within the company.
A key person may also have a financial impact on the business. It’s not unusual for the CEO or another executive in a closely held business to personally guarantee the company’s debts. Lenders may call in such debts if the key person is no longer with the company.
How deep is the bench?
When determining key-person discounts, valuators must assess the ability of others to fill key employees’ shoes. To survive without a key person, existing management must have the knowledge, skills and business acumen to continue normal operations without interruption.
Another key factor is whether there exists a comprehensive succession plan that formally outlines which individuals assume control after key people leave. In the absence of a plan, the departure of one key person could trigger power struggles or require the company to bring in a replacement who isn’t familiar with the organization.
What’s the impact?
Identifying risks associated with key persons is one thing; estimating the impact of those risks on business value is quite another. Valuators generally use one of three methods to incorporate key-person discounts into their calculations: 1) Adjust future earnings to reflect the risk of losing a key person (typically used when a key person’s departure is imminent), 2) adjust the discount or capitalization rate, or 3) discount calculated value by a certain percentage (similar to a marketability or minority interest discount).
Quantifying the discount can be challenging because little empirical support for across-the-board key-person discounts exists. However, research has shown that, in cases where a discount was appropriate and a departure was reasonably certain, the applicable decrease in value associated with a key person’s loss ranged between 4% and 6%.
Among the many legal contexts in which key-person discounts can arise are marital dissolutions, shareholder disputes, mergers and acquisitions, and tax court challenges. To ensure the best outcome for your client, work with a valuator who has experience estimating such discounts and is capable of defending his or her appraisal methodology in court.
If you have any questions about valuations or any other issue, give us a call at 716.847.2651, or you may contact us here.
Court Confirms the “Gold Standard” of Valuation
Author: Tim McPoland
Business valuation arises in many legal contexts, including damages calculations in commercial litigation. In a recent case we have discussed, Malik v. Falcon Holdings, LLC, Seventh Circuit Court of Appeals Chief Judge Frank Easterbrook turned to what he called the “gold standard of valuation” to help determine damages for plaintiffs.
Aslam Khan held 40% of the common units in Falcon Holdings, a limited liability company that owned and operated 100 fast-food restaurants. Khan allegedly told Falcon’s managers that when he acquired full ownership of the company one day he would reward top managers with 50% of Falcon’s equity.
In 2005, Khan bought out Falcon’s other owners and became the company’s sole equity owner. When he failed to distribute common units to any of the managers, five of them took him to court.
The plaintiffs used the price Khan paid in the buyout to calculate that the company was worth about $48 million. They also determined that because 20 managers qualified for units under the terms of Khan’s offers, each plaintiff lost about $1.2 million ($48 million × 50%/20).
District court’s ruling
In summary judgment the district court found that Khan had promised the plaintiffs an equity stake in Falcon. But it held that the managers hadn’t adequately estimated their damages.
The court reasoned that the other owners didn’t own 100% of Falcon, making it impossible to derive the value of the whole firm from the amount Khan paid for their interests. Also, the amount the other owners were paid depended on how much Khan and Falcon could borrow — not on Falcon’s true value. Therefore, the plaintiffs’ approach was flawed.
Easterbrook questions analysis
On appeal, Judge Easterbrook rejected the district court’s analysis. That court’s two propositions ignore the fact that the “gold standard of valuation” is what a willing buyer will pay a willing seller in an arm’s-length transaction. Easterbrook concluded that the buyout of the other owners involved a willing buyer and a willing seller dealing at arm’s length, so the price they agreed on was the value of the asset.
But the judge also found fault with the plaintiffs’ damages estimate. The interest that plaintiffs valued and the interest Khan owned were different. The plaintiffs valued the entire company — or the sum of Falcon’s debt plus its equity. However, while Khan owned 100% of the equity, the bank held the debt interest. The judge found it unsound to assume that Khan’s equity interest in Falcon was worth 100% of the company’s total value.
Easterbrook also questioned the plaintiffs’ assumption that Khan would give each of the 20 managers 2.5% of Falcon’s equity units without attaching terms or conditions to them. He characterized this proposition as “a disaster not only for the ownership structure of a closely held firm but also from a tax perspective.”
Plaintiffs hold out hope
Easterbrook vacated the district court judgment and remanded the case for proceedings consistent with his opinion. The plaintiffs are still expected to receive something if they calculate damages according to the “gold standard,” but that amount will likely be less than the $1.2 million each manager had hoped for.
If you have any questions about the “gold standard” of valuation or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.