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Understanding key man risk

See all articlesUnderstanding key man risk
Selling a business
By
Sean O'Neill
Sean O'Neill
Managing Director
December 5, 2019
6
minute read

Minimising the risk of staff affecting your business valuation

In the majority of businesses, upper-level management is comprised of relatively few employees. In such circumstances, it is not unusual for a company’s future success and viability to hinge on the continued health, success and contributions of an owner, founder, or upper-level management team.

Key man risk is the phenomenon of placing knowledge, skills, and important relationships in the hands of one or a few staff members. If this key man is to leave the business, they take their knowledge with them, leaving the business open for risk.

Nash Advisory manages business sales from start to finish, and can help your business identify and manage key man risk when the time comes.

Identifying key man risk

Identifying key man risk

As a financial advisory business, Nash Advisory is all too familiar with key man risk. It is a common element in sales of businesses of any size, but in particular, family or privately-owned ventures.

Mitigating key man risk begins when a business takes stock of their key individuals.

  • Who are in positions of power?
  • What roles do they execute that cannot be done by anyone else?
  • Is the knowledge of these employees being managed effectively?
  • Where is the risk to the company if these people are to leave?

We find it useful to evaluate the following key business areas to determine whether key man risk is present.

1. Management and Leadership Skill

Management and leadership skill

Do key people in the organisation have important skills or experience to motivate or direct through changing industry circumstances?

Key management and people with key leadership skills add immeasurable value to your business, and are an appealing prospect to potential buyers, especially those of a private equity nature.

Management and leadership skills are hard to disseminate around the business and it does pay to keep these individuals on board throughout a sale.

2. Suppliers

Are relationships with suppliers largely dependent on key people in the organisation?

Maintaining supplier relationships is critical for ongoing operations. It pays to retain these relationships after a sale, as rebuilding them from scratch can take years.

To mitigate this risk, start spreading the role of dealing with suppliers among several individuals with different levels of responsibility.

3. Customers and clients

Are relationships with customers largely dependent on key people in the organisation?

The profitability of a business comes from client relationships. Managing and maintaining these during and after a business sale is imperative to retaining a solid cashflow in the future.

A good way to dissolve client-facing key man risk is to ensure that the customer or client has multiple touch points within the business who they can feel comfortable dealing with.

4. Innovation

Do key people in the organisation have a unique ability to innovate products?

Innovation through knowledge of a business and its industry are huge selling points. One person should not hold the keys to a company's innovation.

Training is a great way to get other employees thinking critically about innovation. By introducing them to new ideas, they will feel comfortable innovating on their own.

5. Obtain debt or equity

Do key people in the organisation have the ability to obtain or provide debt or equity?

Obtaining or raising equity is an inherent skill that often subsists within a few key people in a business. This is a significant risk factor for businesses looking to sell, as they stand to lose their access to equity in the future.

Consider finding other avenues of obtaining equity before a business sale. The more options available, the less risk the business faces.

6. Employee loyalty

Employee loyalty

Are employees who are important to the business’s operations loyal to key people in the organisation?

Loyalty is difficult to quantify and equally difficult to mitigate against. Nevertheless, alliances need to be considered, especially when a business is facing a sale.

There is no way to break up loyalty. However, a business can take note of alliances and plan for any eventualities following a business sale.

How key man risk affects valuation

If a prospective buyer identified that key man risk does exist and the identified key man will leave the business, then it is common practice for the buyer to:

  1. Value the business as if there were no key man risk,
  2. Then, apply a key man risk discount factor.

Key man risk directly impacts on valuation, and it is therefore imperative to set in place systems, management, contracts, and processes to ensure key man risk is limited.

[feature_link]To get the best possible result when selling your business, it pays to understand how to value a business for sale.[/feature_link]

How to mitigate key man risk

There are two general steps that employees can take to reinforce their business against key man risk when preparing for a sale.

  1. Adequately train employees to effectively assume the duties and responsibilities of the key personnel.
  2. Diversified revenue, suppliers and distribution sources so that do not depend on the key personnel.

Contact Nash

If you’re considering selling your business, it is crucial to ensure that the business is in a position to be sustainably transitioned to the new owner.

Nash Advisory have extensive experience working with businesses looking to sell. We develop an action plan of items that the business can implement to limit key man risk, and ultimately realise increased value for the business upon sale.

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