(Excerpted from Chapter 20 of the book Buy-Sell Agreements for Closely Held and Family Business Owners)
Key Person Discounts
It is indisputable that some owners are more important to a business than others. The term used in the valuation literature to describe this concept was called, historically at least, the “key man” discount. Now we use the term “key person.”
In practice, it is appropriate to assess the riskiness of earnings in the discount rate. If there is a key person in a business, this may be an element of specific company risk that appraisers may appropriately take into account. What I am objecting to in this example, however, is the application of a nebulous and unsupported key person discount that lacks specific reasoning and support. Again, two appraisers could value a corporation at $1,000. If one applies a key person discount of 25% based solely on unsupported judgment, a valuation dispute is likely to become the result.
According to prevailing business valuation standards (see Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners), any valuation premium or discount must be described and supported, and the rationale for its application must be stated.
If you are a key person and you know you will always be a buyer in buy-sell agreement transactions, this concept of a key person discount might not bother you. But you may well be a seller one day. That’s no time for a big surprise in valuation.
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