Business Valuations Increase with Reduced Owner Role
One key factor of business valuations is the extent to which the owner is personally involved in the operation of the business. The more absentee the owner is, the higher the valuation. Conversely, the more involved the owner is in the day to day operations of the business (including dealing directly with customers, employees, and suppliers), then the harder it is for the buyer of the business to replace the owner. The risk and costs of replacing the owner drives down the business valuation.
What is ‘Key Person Risk’?
‘Key person risk’ is the phenomenon of placing knowledge, skills, and key relationships of a business in the hands of one individual (invariably the owner in the case of small businesses). If this individual leaves the business, then the business may greatly suffer due to the loss of this individuals’ irreplaceable knowledge, skills, and relationships. In many small businesses where the owner is actively involved in running the business, the ‘key person risk’ may be very high due to the owner’s knowledge of the business, the owner’s individual skill sets, and especially the owner’s relationships with customers, employees, or suppliers.
Why Manage ‘Key Person Risk’
Managing ‘key person risk’ on the part of an active owner-operator is a way to ensure that the business will continue to function if the active owner-operator becomes incapacitated or otherwise unable to fulfill their duties. If the active owner-operator reduces their own involvement in the business prior to its sale, then the valuation of the business will increase and the ‘key man risk’ will be reduced. But even if an active owner-operator can not reduce their own involvement in the business, they can and should reduce the ‘key man risk’. Doing so will ensure the business may at least continue operating and eventually be saleable if the active owner-operator becomes incapacitated.
How to Manage ‘Key Person Risk’
- The simplest way for an active owner-operator to reduce ‘key person risk’ is by imagining what would happen to the business if they were suddenly incapacitated and unable to communicate.
- Would the business grind to a halt for lack of leadership?
- If so, then it is only prudent to take steps in order to reduce this risk so that the business can still function (and be saleable) if the unexpected actually happens.
- Steps to take include obtaining a long term lease (if the business leases commercial space), naming a successor in writing, putting business-related contracts in the corporate name of the business rather than the owner’s personal name, automating payroll, and having an owner manual.
- Of course, the best way to increase the valuation of a business is by eliminating the ‘key person risk’ altogether by reducing or eliminating the owner’s active role in the business.
Long Term Lease
Leasehold rights – the right to temporarily occupy commercial real estate – is very important in the sale of most businesses (especially retail-related businesses). A great way to reduce ‘key person risk’ is by ensuring that the business has a long term written lease in place (typically at least five years). The lease should be in the corporate name of the business. If anything should happen to an active owner-operator, then the lease will continue to run so long as the rent is paid by the corporate entity (subject to the lease’s personal guaranty if applicable).
Name Successor in Writing
Often times, small business owners rely on a spouse or family member to take over their business if something should happen to them. In such cases, the business owner should still designate this person as the successor to the business. Importantly, the designated successor should be properly trained so that they may smoothly take over. If an active owner-operator does not have a designated successor in mind, then they must think of someone (such as an attorney, friend, or even a friendly competitor) who can capably run the business or appoint someone else to do so.
Put Business Contracts In Corporate Name
Another way of reducing ‘key person risk’ is by putting all company contracts (with employees, customers, suppliers, and creditors) in the name of the corporate entity rather than the personal name of the owner. The contractual relationships of the business will have a better chance of continuing with minimal disturbances. Contracts on behalf of a corporate entity rather than a personal individual are typically easier to transfer. This will help when it is time to sell the business.
Automating payroll is a relatively easy task to accomplish for a business owner wanting to reduce their ‘key person risk.’ With an automated payroll, employees receive their paychecks electronically, and all tasks related to employee payroll taxes are properly completed by the payroll company. If an active owner-operator is unable to perform his duties, then at least no interruption will occur with paying staff. This will reduce employee turnover in the event that an active owner-operator becomes incapacitated.
Create Owner Manual
- Any active owner-operator considering the sale of their business or seeking to safeguard the continuation of their business if they become incapacitated should write an owner manual that relates key information about the business.
- This type of owner manual should be strictly for the use and benefit of the owner or any successive owners.
- The owner manual should include names of all suppliers with their contact information, a customer list, prices charged to all customers with their contact information, names and functions of all employees, copy of the current lease with all addendums (if applicable), and an updated overview of the business.
- Additionally, the owner manual should describe the competitive advantages of the business as well as contain relevant information about its competitors.
An active owner-operator of a business should reduce their ‘key person risk’ to the best extent possible given their financial circumstances. If an active owner-operator is able to reduce their own role in the business, then that will also increase the valuation of their business when it comes time to sell.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.