A key person can add or detract from the value of an organization, but having a structured framework it may effects may yield interesting implications

The Difference Makers Key Person(s) Valuation

Can one person make a difference in the value of a business?

Absolutely. In small businesses, especially those built around personal services, it is part of the valuation process, where the key person is valued or at least priced and incorporated into the valuation.

Who is a key person?

They are individuals at various levels of the organization that have been identified as key value drivers, but the key people in an organization can be at every level, with differing value effects.

It starts of course with founders who create organizations and lead them through their early years, Staying at the top and CEOs for companies.

Further to estimate the value of the Key person there may be three general approaches: -

Key person (s) Value Effect

1. Key person valuation:

To calculate, twice the value company, once with the key persons included, with all that they bring to its cash flows and value, and then again, without those key persons, reflecting the changes that will occur to value inputs:

Value of key person(s) = Value of business with a key person - Value of business without a key person

2. Replacement Cost:

In certain instances, the value of a key person can be computed by estimating the cost of replacing that person. Thus, key people with specific and replicable skills, such as skilled scientists, may be easier to value than key people, with fuzzier skill sets, such as strong connections and people skills. However, finding replacements for people with unique or blended skills can be more difficult, since they may not exist.

3. Insurance cost:

There are some key people in an organization who can be insured, where insurance companies, in return for premium payments, will pay out an amount to compensate for the losses of these key people. For companies that buy insurance, the key person's value then becomes monetized as a cost, reducing the value of these companies when the key person is present while increasing its value when it loses that person. The key person valuation approach, while general, can not only yield different values for key people but also generate a value effect that is negative for a key person whose influence has become malignant.? The value of a key person can evolve over time, from a significant positive at one stage of an organization to neutral later or even a large negative, explaining why some key people get pushed out of organizations, including those that they may have founded.

Further, as per Section 37(1) of Income Tax 1961, there is a policy on key Persons known as Keyman insurance which can be claimed as a deduction for the premium paid by the company as allowance and considered as an expense for a company.

Key Person(s): Pricing effects

It is true that markets are pricing mechanisms, not instruments for reflecting value, at least in the short term, and it should come as no surprise then that the effects of a key person are captured in pricing premiums or discounts, sometimes arbitrary, and sometimes based upon data.

In appraisal practice, where your business price comes first, based upon its existing financials, and then reduce that pricing by 15%, to 20%. valuing private companies, suggested a key person discount of between 10%-25%, though he left the number almost entirely to the appraiser's discretion.

In public companies, the market also reacts to the loss of key personnel can be an indication of how much investors priced the presence of those personnel. Empirically, the research in this area is deepest on CEO departures, with the market reaction to those departures broken down by cause into Acts of God (death), firing, or retirement.

Managing Key Person Value

A business that has significant positive value exposure to a key person can try to mitigate that risk, albeit with limits. The actions taken can vary depending on the key person involved, with more effective protections against losses that are easily identifiable.

Insurance, No-compete clauses, overlapping tenure, Team building, and Succession planning

Determinants of Key Person Value

If key person value varies across businesses and across time, it is worth examining the forces that determine that value effect, looking for both management and investment lessons. In particular, key people will tend to matter more at smaller enterprises than at larger ones, more at younger firms than at mature businesses, and more at businesses that are driven by micro factors than ones driven by macro forces.

Company size

In general, the value of a key person or persons should decrease as an organization increases in size, but at the largest companies, with hundreds or even thousands of employees, and multiple products and clients, it becomes more and more difficult for a single person or even a group of people to make a significant difference.

Stage in Corporate Life Cycle

In the early life cycle, where the corporate narrative drives value, a single person, usually a founder, can make or break the business, with his or her capacity to set a narrative and inspire loyalty (from employees and investors). As a business age, CEOs matter less, as the business takes form, and scales up, and less of its value comes from future growth. At mature companies, CEOs often are custodians of value in assets in place, playing defense against competitors, and while they have value, their potential for value-added becomes smaller.? At a company facing a decline, the value of a key person at the top ticks up again, partly in the hope that this person can resurrect the company and partly because a CEO for a declining company who doubles down on bad growth choices can destroy value over short periods.

Micro vs. Macro Factors

There are some companies where value comes more from company-specific decisions on products/services to offer, markets to enter, and pricing decisions, and others, where the value comes more from macro variables. A media company, like Disney, where movie or television offerings constantly have to adjust to reflect changing demand and in response to competition, whereas an oil company, where it is the oil price that is the key determinant of revenues and earnings. We may find key people, who can add or take away from value at the former (micro companies) than at the latter (macro companies).

Business Moats

Business moats refer to competitive advantages that companies have over their competitors that allow them to not just grow and be profitable, but to create value by earning well above their cost of capital (Kc). Moats can range the spectrum, both in terms of sources (cheap raw material, brand names, patents) as well as sustainability (some last for decades and others are transitory).

In conclusion

There are many canards about intrinsic valuation that are in wide circulation, and one is that intrinsic valuations do not reflect the value of people in a company. That is not true, since intrinsic valuations, done right, should incorporate the value of a key person or people in a business, reflecting that value in cash flows, growth, or risk inputs. That said, intrinsic value is built, not on nostalgia or emotion, but on the cold realities that key people can sometimes destroy value, that a key person in a company can go from being a value creator to a value destroyer over time, and that key people, in particular, and human capital, in general, will matter less in some companies than in other companies.