Anytime we discuss the importance of a KEY PERSON in a business, you should assign a value to that individual. Let’s first expand on the importance of the KEY PERSON. The great entrepreneur Andrew Carnegie once said, “You can tear down my buildings and destroy my machines but leave me my people and I will rebuild my business.” In fact Dun & Bradstreet conducted a survey several years ago. They reviewed reasons for business failures for over 17,000 enterprises. The results? Shockingly over 5O% of business failures were due to MANAGEMENT WEAKNESSES such as incompetence, neglect or unbalanced or no managerial experience. I’m confident everyone can appreciate the value of KEY PEOPLE.
There are many LOSSES or COSTS associated with the loss of a KEY PERSON. There could be a weakening of the company’s credit rating. There would definitely be “COSTS” to find, hire and train a replacement. And not to mention the psychological factors of distraction of other employees, deteriorating morale or even a higher level of personality conflicts. Perhaps the worst COST is a loss of confidence in suppliers and customers.
However, how do we VALUE A KEY PERSON? As we discussed earlier in valueing ones’ business, it is often just as difficult, if not moreso, in valuing a KEY PERSON. There is no really one set way to determine the value of a KEY WORKER but over the years business owners have used THREE DIFFERENT METHODS TO ESTIMATE THE VALUE OF AN EMPLOYEE TO THEIR BUSINESS.
* THE MULTIPLE OF COMPENSATION METHOD
This assumes that the employee’s value is accurately reflected in in his or her TOTAL COMPENSATION PACKAGE. The multiple can be two times the annual earnings or sometimes even higher. It will depend on the type of business and the approximate difficulty in finding a replacement. This is often the easiest way of finding a value.
* COST REPLACEMENT METHOD
Here you would total the direct out-of-pocket costs involved in recruiting, hiring and training a replacement. Factored in this formula is also the loss of opportunity. For example, a business could lose a customer or even miss the opporunity of landing a client without the resources of that KEY INDIVIDUAL.
* CONTRIBUTION OF PROFITS METHOD
This is perhaps the best method. Here we are going to estimate the impact that an employee has on the company’s NET PROFIT. You first find what your “normal” return on profits are. Any profit in excess of that is believed to be the result of a KEY PERSON. You may have several Key Employees so you would then take an estimate of the percentage of EACH EMPLOYEE. This percentage is then multiplied by the TOTAL EXCESS PROFIT OF EACH EMPLOYEE. This sum is then multiplied by the time (number of years) needed to find and train a competent replacement. This may sound difficult but your accountant would be helpful.
Please remember we go through these tasks to help develop YOUR BUSINESS SUCCESSION PLAN. We must also discuss funding your KEY PERSON or what some finance consultants like to call PROFIT INSURANCE. We will examine this when we discuss FUNDING YOUR BUY-SELL AGREEMENT.