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Punching Out! How to Avoid Key-Person Risk

PCB West 2018 is next week in Santa Clara, California (September 11–13). Can you go to the show and visit a winery or two without your shop falling apart? Have you taken a vacation in the past few years? Can you afford to not do board rework on a holiday weekend, like this past Labor Day? If you answered “no” to any of these questions, you may have key-person risk.

Key-person risk is exactly how it sounds: If a key person leaves the business, the business will undergo significant changes and possibly suffer damages. It is common with smaller companies, but even large companies can experience it, such as Microsoft (Bill Gates) and Tesla (Elon Musk). The key person in a smaller company is most likely the founder or owner, but it could also be an 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 also be the IT manager if they are the only person who knows all the passwords. In some organizations with old equipment, the repair person is key.

Key-person risk is bad for a company in general and typically stunts growth. Although the 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 receive a better employment offer from another company. If the business is totally reliant on one person, it may reduce the value of the company and make it impossible to sell, or most of the deal will be in a long-term earn-out.

One way to avoid key-person risk is to start many years in advance of a sale. Delegating tasks and cross-training employees can reduce reliance on one or more key employees. Owners often have difficulty giving up responsibility, but many 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 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 do it.

For buyers, it is important to incentivize key people to stay. For many, cash is a powerful incentive. A transition services or employment agreement can be helpful, but unless there is a monetary penalty for leaving early, these agreements are largely 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 regarding company culture and policies because money is not 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 better positioned for growth. Without the owner or family members in top positions, there may be more opportunity for advancement. It is important to identify key employees early in the M&A process and develop a strategy to keep them in the business until the risk can be mitigated.

Most NFL teams fall apart if the quarterback becomes 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 helps the company grow and run more smoothly, increases value, and eliminates risks involved with selling the business.

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