A business that is highly dependent on an individual for continued success may be exposed to what is known as key person risk. For owner-managed or family-owned businesses, this risk may reside within themselves, which creates a double whammy effect when it comes to the value of the business.
It is not uncommon for an owner to be the best salesperson, provide expansive industry knowledge, or simply be a great leader and motivator. Each of these attributions are excellent for any organization, but if you look at the business from an outside investor’s point of view, it can be construed as a significant risk to the business.
If we break down valuation into its most simplistic form, it is earnings divided by risk. The greater the risk, the lower the valuation. A particular business may have been extremely profitable over the years, which helps the earnings side of the equation. However, it may not get a favorable valuation multiple if a buyer cannot get comfortable with the key person risk associated with the very same person they are purchasing the business from. The departure of a key person from the business can very well disrupt operations; alarm customers, suppliers, and lenders; and create opportunities for competitors.
Unfortunately, in many cases, this issue is typically not addressed until it is staring the owner directly in the face, which could be right as she or he receives an offer to buy the business or is looking to retire. At this point, it may be too difficult to mitigate the risk and it can lead to an owner having to take a haircut on their valuation or continue working for a few more years. As a result, it is ideal to stay ahead of this risk and look for ways to reduce it or even eliminate it altogether.
Succession planning can play a key role in achieving personal and business goals by creating a structured plan to transition to a successor leadership team. Some businesses will utilize training or mentoring programs as a way to encourage others to learn a key person’s responsibilities and can even provide opportunity for growth in their own skill sets and abilities.
With proper succession planning, it is only natural that a strong management team will develop, which is also incredibly beneficial in the event of a sudden departure from the business due to illness, disability, or death. It also goes that without saying that a strong management team will not only reduce the risk associated with an owner, but also drive increased profitability. Increased earnings along with reduced risks creates a double win according to the valuation formula previously described.
With all this in mind, as any business owner’s sun sets into the latter part of their career, they should be looking well ahead at their management team and replacement. This will help ensure they can ease out of the business while also capitalizing on the value they created over the years. If you would like to learn more about succession planning and risks associated with valuations, please contact us.