November 2022
According to the International Glossary of Business Valuation Terms a “Key Person Discount” 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.”
In Revenue Ruling 59-60 Section 4.02(b), the IRS guide to business valuations for estate and gift tax purposes, states “The loss of the manager of a so-called ‘one-man’ business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence of management-succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may be factors, which offset, in whole or in part, the loss of the manager’s services. For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager’s services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager’s services in valuing the stock of the enterprise.”
Due to the relatively small size of most closely-held companies, management is usually concentrated in one or a few individuals. This concentration causes additional risk, and is considered in the valuation process by a Key Person Discount. According to a 1992 article, when a discount is warranted, the discount ranges from 0 to 30%. This range of discounts was quantified by analyzing the changes in the stock prices of public companies that lost their chief executive officer. Presumably, the discount for smaller closely-held companies, which typically have less back-up management, would be even higher. This discount can be mitigated, in varying degrees, by the existence of key man life insurance payable to the company, and by adequate successor management.
As an alternative to the application of a Key Person Discount, a business appraiser can achieve the same result by increasing the applicable capitalization rate via an increase in the discount rate or reducing the applicable market multiple. This is the trend we have seen in the business valuation industry. Presumably this is so because there are few objective means of determining the applicable Key Person Discount and its level of subjectivity is similar to that of the specific risk adjustment made when determining the applicable capitalization rate in an income approach.
In order to determine whether or not the Key Person Discount is dead or alive, we did a quick search for U.S. court cases in the last 15 years in which a Key Person Discount was considered. Of the few court cases we found that acknowledged the potential application of a Key Person Discount, none actually applied one. Therefore, although not dead, the Key Person Discount appears likely to be on life support. However, although the Key Person Discount as a percentage may be on life support, the principle of lowering the value of a business in other ways for the presence of a key person is alive and well.
Relevant Court Cases
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Ramcell, Inc. v. Alltel Corporation
d/b/a Verizon Wireless,
Court of Chancery of the State of Delaware,
C.A. No. 2019-0601-PAF,
decided October 31, 2022
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Edward Deane v. Robert A. Maginn, Jr.,
Court of Chancery of Delaware,
2017-0346-LWW,
filed November 1, 2022
Recent Business Valuation Articles
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“The Valuation of Loss Firms:
A Stock Market Perspective,”
by Hannes Mohrschladt and Susanne Siedhoff,
dated October 6, 2022
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“The New Risk and Return of Venture Capital,”
by Francois Burguet, Loic Marechal and Alain Mermoud,
dated November 7, 2022
Recent Engagements
- Valuation of an undivided tenant-in-common
interest in real property on a minority interest
basis for estate tax reporting purposes.
- Valuation of 100% of the common stock
of a custom manufacturing and machining company
on a controlling interest basis for planning
purposes.
- Valuation of the common stock and the preferred
stock of a communication service provider
on a minority interest basis for gift tax
reporting purposes.
- Consulting regarding 100% of the equity of
a niche industrial service firm on a controlling
interest basis for planning purposes.
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