What is a key person discount? The definition in the ASA Business Valuation Standards Glossary is:
An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.
Appraisers sometimes reach a preliminary conclusion of value at the marketable minority / financial control level of value and then state something like the following: “Mr. Jones, the controlling shareholder, is a key person in the management of ABC Company. He is responsible for a significant portion of the Company’s sales, he is responsible for achieving below peer cost of sales, and is a key manager of the business. For these reasons, we apply a key person discount of 20% to the initial indication of value…”
While Mr. Jones may be a key person, the application of a judgmental discount, such as noted above, is not a reasonable valuation procedure, despite the definition describing the key person discount as such.
The value of ABC Company, like the value of any company, is a function of its expected cash flows, the growth of those cash flows, and the risks associated with achieving those cash flows. The same is true for the value of interests in ABC Company (or any company), where the value of the interest is based on the expected cash flows to the interest, their growth, and the risks associated with achieving them over the expected holding period of the investment.
The preceding paragraph states the essence of the Integrated Theory of Business Valuation. The third edition of Business Valuation: An Integrated Theory (Mercer and Harms), which is published in the Wiley Finance Series, is now available. This post examines the so-called key person discount in light of the Integrated Theory.
Three Takes on the Key Person Discount
The following examples reflect the efforts of three appraisers to determine the impact of the “keyness” of Mr. Jones on the value of ABC Company. The examples assume similar initial assessments of risk and expected growth, and similar assessments of the basic earning power of ABC. The examples reached the same conclusion for purposes of convenience and clarity.
- Appraiser 1 applies a key person discount of 20%.
- Appraiser 2 examines the key person issue in terms of incremental company specific risk.
- Appraiser 3 analyzes the potential impact of the loss of Mr. Jones on expected growth and on expected cash flows.
The examples are shown in the figure below.
Appraiser 1 builds up a discount rate of 15.18% in rows 1-8 above. He assumes long-term expected growth of 3%, which yields an equity capitalization rate of 12.18% and a multiple for net cash flow of 8.20x. His assessment of a single period income for capitalization is $1.0 million of net cash flow to equity. His initial conclusion of fair market value of ABC at the marketable minority and financial control level of value is $8.2 million. Assume that this basic assessment is shared by the other two appraisers. At this point, Appraiser 1 sticks his finger to the wind and divines that the key person discount should be 20%. Applying that discount yields a conclusion of value of $6.56 million.
Assume also that Appraiser 1 got lucky and that this is a reasonable conclusion reached by unreasonable means. There is no market evidence to provide a basis for assessing the reasonableness of a judgmental key person discount.
Appraiser 2 comes along with a similar assessment of ABC Company. He is aware of the “keyness” of Mr. Jones to ABC. Appraiser 2 elects to apply an additional company specific risk premium of 3.07% (he got lucky – I used Goal Seek). His assessment of the discount rate was otherwise the same as for Appraiser 1. The equity discount rate for Appraiser 2 is 18.24%, which is higher than for Appraiser 1. Appraiser 2 observed that his discount rate appeared reasonable in light of the implied discount rates in transactions of similarly risky companies as ABC. Appraiser 2 assumes the same expected growth as Appraiser 1 and develops an equity cap rate of 15.24% and a multiple of 6.56x. Applying that multiple to expected net cash flow yields an indication of value of $6.56 million.
Appraiser 2 reached the same conclusion as Appraiser 1 but employed a reasonable method of increasing risk while maintaining the same assessment of capitalizable net cash flow. Appraiser 1 should realize that any time he uses a judgmental key person discount, anyone can solve for the implied incremental company specific risk that is implied and, in that light, assess the reasonableness of his conclusion.
Appraiser 3 has a similar assessment of underlying risk as Appraiser 1, but recognizes that the absence of Mr. Jones could have a significantly negative impact on the net cash flow of ABC Company. This manifests in two ways for Appraiser 3. He lowers expected long-term growth from 3.0% to 2.5%. His cap rate therefore lies in between those of Appraisers 1 and 2, as does his multiple of 7.89x. Appraiser 3 did an extensive analysis of the impact of the loss of Mr. Jones on the expected cash flows of ABC Company. Based on his estimate of potential for lost sales to key customers and the potential for increased cost of goods sold in his absence, Appraiser 3 estimated that capitalizable net cash flow should be $831 thousand. Applying his multiple of 7.89x to this cash flow yields an indication of value of $6.56 million.
Appraiser 3 applied another reasonable method in achieving his concluded value. Appraisers 2 and 3 developed their conclusions of value based on their respective assessments of expected cash flow, risk and growth for ABC Company. Appraiser 1 did not, and his method is flawed as a result.
The purpose of this short post is to suggest that the key person discount, like many valuation questions and issues, can and should be examined in the context of expected cash flows, their growth, and the risks associated with achieving them. This consistent focus on these three key elements of value lies at the heart of the Integrated Theory of Business Valuation. You can obtain your copy of Business Valuation: An Integrated Theory Third Edition here.
Until next time, be well!