While many businesses often possess intangible value such as goodwill, small and medium size businesses in particular can possess what can be described as “personal goodwill”. We have all heard this story before; an owner-operated small business is sold, and profits sharply drop thereafter, pushing the business to the brink of bankruptcy. “It hasn’t been the same since he or she left” is often heard from customers.
While some goodwill is commercial in nature (brand name, customer lists, an established workforce, know-how, etc.) and transferable to new owners, personal goodwill is the value that stems from the efforts or reputation of a person and quite often, it is a founder of the business in question. The business’ reputation and profitability are tightly linked to this person’s talents, skills, expertise, personal aura and resourcefulness.
A common example of this can be seen in the legal world – highly-skilled and well-known lawyers’ phones ring more often. These individuals source these direct calls solely because of their track record and skills, regardless of the firm they work for. Consider now customers calling the firm, dealing with the firm for a consult? That’s commercial goodwill – and due to the strength of the brand. The difference between both is that commercial goodwill is saleable. Personal goodwill is not.
Be it the sale of an enterprise, estate planning transaction, income tax transaction, or in a litigation context, this concentrated dependence on one individual may be warranted in calculating the enterprise value, as it’s not commercially transferable. It represents a significant risk element that should be taken into account by either i) increasing the required rate of return on equity, or ii) by discounting the calculated enterprise value via a key person discount. Regardless of approach, it must be properly supported. A superficial analysis applying an arbitrary key person discount to the business’ enterprise value is rarely defendable against a good cross-examination in a litigation context.
While every case is specific, common factors assessed in quantifying a key person discount are:
- The involvement (duties, responsibilities and skills) of the key person in the business. It is not uncommon to observe that a key person, should they be replaced, may need 2-3 or more hires to perform the same tasks in the capacity of the key person.
- The concentrated dependence on the key person (which may be quantified using a before-after scenario analysis).
- The level of relationship management, knowledge and friendship of the key person with strategic accounts, customers and suppliers. Often customers enjoy dealing with one individual because of this relationship and are fiercely loyal. Upon the key person’s exit, the customer may start doing business with another vendor or service provider – as the relationship was with the key person, not the business itself.
- The identity and association of the business with the key person – The tighter the association, the higher the key person risk. Such identity and reputation may be the result of decades of hard work, which simply cannot be replaced nor substituted following the exit of the key person.
- The size of the business (generally, the larger the business, the less an impact a key person has on the value of the business – as exemplified by the oft-described “one-man show”).
- Evidence of succession planning, key person insurance and risk mitigation.
Often-times key person discounts are very significant in nature and constitute a vital component in valuing a business enterprise. In the unfortunate examples of sudden death of the key person, some businesses are permanently affected and in some circumstances, are liquidated since they cannot operate profitably. Properly understanding and assessing such a key person discount is paramount in valuing any owner-managed business dependent on one or few individuals.
Our expert in business valuation can help you demystify this matter!