How to Value a Key Person

Among the many methods a business can use to value key employees, 4 of the more common ones are detailed below. A business might select one or several methods, then take a weighted or unweighted average of them.

1. Multiple of Salary

Using this method, the value of the key person is based on a multiple of his or her earnings. A business can determine whether to use base salary or a multiple that includes bonuses or commissions.

2. Loss of Value to the Business

The key person contributes to the success of your clients business. With this method, you assign a percentage of the businesss value to those contributions.

In other words, if the key person were to leave the business, you believe the business would decline in value by that percentage or amount.

3. Cost to Replace Profits from Sales

If the key person were no longer part of the business, his or her contributions to profits would be lost. This method examines those lost profits.

Then, it estimates what profits might be generated by a replacement over time. The difference, the lost profits, is present-valued in determining the value of the key employee.

A business might select the number of years (from 1-10) needed for a replacement to reach a point at which the lost profits would be recovered.

4. Cost to Replace Contribution to the Business

A key person might contribute much more than profits to the business. This method looks at sales generated by the key person after compensation.

Then, it matches those sales to estimates of sales that a replacement would generate. The difference (the lost sales) is present-valued in determining the value of the key employee.

A business can target the time it might take (from 1-10 years) for a replacement to reach a point at which lost sales would be recovered. This often results in a higher valuation than the replacing-lost-profits method because a large portion of the valuation is tied to replacing gross sales and not, strictly, net profits.

Also factored into the calculation are the costs of searching for a replacement, hiring, relocation and training.

These 4 methods can produce widely varying results. Consider the following hypothetical situation:

–Key person salary: \$100,000

–Value as a multiple of salary: 8

–Costs to search, hire, relocate and train a replacement: \$75,000

–Years required for a replacement to “mature:” 7

–Current business value: \$12 million

–Current annual sales: \$5 million

–Percentage the key person contributes to annual sales: 25%

–Annual sales and profit growth: 10%

–Present value discount rate used in the calculations: 3%

Based on these variables, each of the 4 methods produces very different results:

\$800,000 (Multiple of salary);

\$2,400,000 (Loss of value to the business);

\$4,437,256 (Cost to replace key persons profits from sales);

\$1,337,614 (Cost to replace key persons contribution to the business).

The average of these methods is \$2,243,718. So, depending on the business, any one of these valuations might be appropriate. A business must therefore determine which method best suits its needs, take an average of all methods or default to the largest valuation method under a “worst case” approach.

It is critical that you work with your clients to determine which method is appropriate.

Mark A. Teitelbaum

Reproduced from National Underwriter Edition, September 9, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.