Keys to Avoid Key Person Risk

PCB West is next week in the San Francisco area, can you go to the show and maybe visit a winery or two without the shop falling apart? If not, you have key person risk. Have you not taken a vacation in 3 years, and spent this past Labor Day doing board re-work? Is so, you may have key person risk.

Key person risk is exactly how it sounds: If a key person leaves the business, the business will suffer significant damages. It is common with smaller companies, but even large companies can have it, such as: Apple (Steve Jobs), Tesla (Elon Musk), Martha Stewart, and Papa John’s. Key person risk is bad for the company in general, but it can also reduce the value of the company when selling. In extreme cases, it can even make the business unsaleable.

The key person in a smaller company is most likely the owner, but it could also be a key employee, such as a salesperson who handles 90% of revenue, or a general manager who is the only one who can run the operation. It could be the IT manager who is the only one who knows all the passwords. In some organizations with old equipment, the repair guy is a really key person.

Key person risk is bad for a company in general, and it typically stunts growth. Although the founder/owner may have incredible skills, the business may be able to do even better if qualified employees are allowed to have more responsibility. For buyers, key person risk reduces value, makes the terms worse, and causes due diligence to be more intensive. Buyers will worry that the key person will leave soon after closing. If that person receives enough ‘walk away money’ at closing, they might not show up the next day. The key person may also suddenly have health issues, or get a better employment offer from another company. If the business is totally reliant on one person, it may be impossible to sell, or the majority of the deal might be in a long-term earn-out.

Some of the ways to avoid key person risk is to start many years in advance of a sale. Typically, delegating tasks and cross-training employees are ways to reduce reliance on one or more key employees. Owners often have difficulty in giving up responsibility, but many owners feel a sense of relief once they are allowed to focus on what they like to do (or what they are good at doing). If an owner has a lot of trouble delegating, they might consider working with a CEO coach, forming an advisory board, and/or joining a peer group. Other owners/CEOs have gone through the same process, and can be valuable advisors on the best way to go through it.

For buyers, it is important to incentivize key people to stay. For many people, cash is a powerful incentive. A transition services agreement or employment agreement is helpful, but unless there is a monetary penalty for leaving early, those agreements are pretty worthless. Typically, the higher the key person risk, the larger the amount of deferred compensation in a deal. It is also important for the buyer and key people to be on the same page as far as culture and policies are concerned, as money is not always everything. In today’s tight labor market, it is easy for key people to find other employment. Key employees may be excited to work for a larger company that has more resources and is positioned for growth. Without the owner and/or family members in top positions, they may be more opportunity for advancement. It is important to identify key employees early in the M&A process, and to develop a strategy to keep them in the business until the risk can be mitigated.

Most NFL teams fall apart if the quarterback gets injured, but the Philadelphia Eagles won the 2018 Super Bowl with a backup QB. A savvy owner has a team to back them up, which not only helps the company grow and run more smoothly, but will help increase value and eliminate risks involved when selling the business.

Tom Kastner is the president of GP Ventures, an M&A advisory services firm focused on the tech and electronics industries. Tom Kastner is a registered representative of and securities transactions are conducted through StillPoint Capital, LLC—a Tampa, Florida member of FINRA and SIPC. StillPoint Capital is not affiliated with GP Ventures.