When someone wants to buy a business they assess the various risks and decide if the asking price justifies the risks, given the returns they are expected to receive. In most cases a buyer can manage or reduce most risks, given they are aware of them.
However there is one risk that is difficult to deal with and can mean the impending death of any business post-acquisition – that is key person risk.
It may come as a surprise that most buyers of a business are not solely focused on its price. They also want to know:
- What is the likelihood that the expected cash flows will be different to the past?
- What is likely to go wrong?
- Can I manage the business?
The price they are prepared to pay will be a function of:
- The returns the owner is expected to make.
- The risk that the returns will not occur.
So the buyer must assess all the risks of the business and decide how they can be managed and dealt with and if those risks are serious enough to impact the future cash flows and therefore influence the price of the business.
Key person risk tends to kill a deal because it is so hard for a buyer to divorce the owner from the business without impacting the business in the process.
What are the key types of risk in a business?
In business, risk is defined as the uncertainty associated with future cash flows. In essence it is any issue or event that is likely to change the expected cash flow in the near or long term future. It is also an integral component of the value of a business – the higher the risk the lower the value.
The main types of risk in a business include:
- Financial – Is the business unable to meet its commitments through debt or other cash flow issues?
- Revenue – Is the business likely to lose its customers or sources revenue?
- Legal – Is there any legal issues that present a risk to the ability of the business to continue to trade?
- Technical (or operational) – What is likely to go wrong with the core operations of the business?
- Key person – To what extent does the business rely on key people?
Each of these risks can be dealt with in some way – they can be prevented, reduced, insured against or accepted.
However the key person risk is the one thing that cannot be dealt with easily – and the impact is significant.
A business with a high level of key person risk means that there are people that are so central to the business that if you took them away the business performance will suffer.
Key persons are typically the owners of the business but can include key staff such as the sole Sales Manager that handles all customer enquiries, or occasionally a key operations person that is the only person that knows how the business operates and delivers products or services.
Some examples include:
- A single person medical practice that provides specialist services such as psychiatry,
- A 2 person automotive repairs business owned by someone with no automotive skills – in this case the automotive repairers are the key to the business.
- A single person fitness coaching business.
- A food manufacturer whose owner is the only person with customer contact and relationships.
- A 10 person business where the employees are employed on a "handshake deal" and any ownership change exposes the new owners to increased employee costs and potential liability for past wages at award rates.
What makes key person risk the worst type?
Most risks can either be prevented, reduced or insured against – key person risk can only be reduced or removed through a lot of effort and time, and in some cases cannot be dealt with at all.
It can result in loss of revenue or substantial increases in costs which make the business unprofitable.
But worst of all it can also mean the business simply disappears because:
- Customers leave and follow the key person or go to the competitors.
- The costs increase to make it unprofitable.
- The equipment can no longer be operated effectively or at the right quality.
- The key people have re-established the same business in competition.
So after someone has paid hundreds of thousands of dollars (or even millions), the profits of the business take a dive and the new owner is left to react to the situation rather than proactively manage and prevent it from happening.
What are the indicators of key person risk?
Some of the key indicators that a business has a high level of key person risk include:
- Having a single person(s) trained and undertaking key parts of the business such as sales or operations.
- >No documented procedures or processes in place.
- Lack of organisational structure and written position descriptions.
- Limited use of technology in automating or managing the business.
- Owner's wages not reported within the wages costs of the business and taken from profits.
- Intellectual property held by key people and not distributed throughout the organisation.
A good way of finding out if the business has key person risk is to interview a number of people in the business and ask them all the same questions such as:
- Who handles customer inquiries?
- Who operates the equipment and how is product or service quality determined?
- How many people are able to make key decisions such as accepting an order, making a product or service to making key marketing decisions?
These questions will usually identify if there are key people that the business relies upon and to what extent it may influence how well the business can perform without them.
What are the benefits of low key person risk?
A business that does not rely on key staff typically has the following characteristics:
- Available or unused capacity to meet increased demand.
- Low levels of customer complaints and/or high customer satisfaction.
- Flexibility in dealing with changing customer requirements and demand.
The most significant benefits of low key person risk is that the business is more likely:
- To produce consistent profit margins and secure consistent revenue growth.
- Attract a higher earnings multiple when selling the business.
This means that low key person risk can result in a higher price for the business.
How do you reduce key person risk?
The key strategies that reduce the key person risk basically come from "reverse engineering" the indicators listed above, such as:
- Key processes and procedures documented and multiple people trained in each role.
- Staff structure in place with key roles documented with position descriptions.
- Multiple people able to make key decisions in managing and operating the business.
- Ongoing commitment to training staff and distributing the intellectual property of the business.
- Evidence of technology used in key aspects of the business.
- Increased level of automation in the business.
There can be a trade-off in reducing key person risk through increased costs, but often it means the business is worth more in the long run and will be easier to sell.
About the Author
Mike Williams is CEO of Exit Value Advisers and an expert in SME business valuations. He has an MBA in Corporate Finance and more than 18 years' experience consulting to SME's. He has valued over a 1,000 privately held businesses across all industries over the past decade and has facilitated the strategic sale of businesses to create innovative exit strategies for business owners.