When valuing a closely held business, I frequently pose the following questions to the business owner regarding him/her and key employees:
(1) What do you think the business is worth without you? When a business is sold, the selling owner does not go along with the deal. The seller might agree to work for the new owners for a limited period of time, but the buyer must be confident that the business can stand alone and continue to generate cash flow without the seller.
(2) What is the business worth without your key employees? If they are critical to the success of the business, their possible departure represents a risk to the business.
Scenario 1: The business is dependent upon the owner.
It is a difficult problem when the owner is “key” to the business and can’t easily be replaced. We see this most frequently when the current owner was the founder of the business and retains the principal customer contacts or the “know-how” essential to the business.
One of the solutions to this problem is to develop key employees – i.e. employees that can gradually take-over the customer relationships and/or business know-how, and are properly incentivized. This process will be lengthy – at least several years – and relatively high risk because the talent must be hired and developed internally to manage the customer relationships. Frequently it is not possible to do this, especially within the owner’s exit time-table.
Another solution is to find a buyer – usually a larger company in the same industry – that has a management team in place that can absorb the seller’s customers and provide the service needed to keep those customers. The seller here typically acts as a facilitator in the transfer of the customer relationships from himself to the buyer. This solution has the drawback that a significant percentage of the sales price (as much as 50%) will be deferred and based on how much of the company revenue can be successfully transferred to the buyer.
Scenario 2: The business is dependent on key employees.
There are legal steps that you can take to protect the business from the departure of such an employee – you can have the employee sign a non-compete agreement. This might prevent the employee from leaving and competing with you in your geographic area for a limited period of time (maybe two years – ask your lawyer!). However, key employees can always leave and take a job or start their own business out of your area. Much more effective is to establish a key employee incentive bonus plan that will encourage your key employee to remain with your company and increase your profits!
Successful key employee bonus plans tend to share certain characteristics:
- Are specific and are in writing;
- Are tied to performance standards that are within the employees scope of work;
- Give the employee an opportunity to make a substantial bonus;
- Handcuff the employee to the Company.
Components of key employee bonus plans:
(1) The plan must set out clear standards for the employee to meet and must be clearly explained. The employee must thoroughly understand the plan and understand how she can earn the bonus. This is best done in face-to-face meetings.
(2) The bonus is tied to objective standards that are tailored specifically for the employee. These bonuses are most commonly used for sales personnel who are given specific sales objectives, but they can be designed for any type of management employee. These standards might pertain to the employee’s specific department, the company overall, or a portion of each.
(3)The standards must be ones that are within the employee’s ability to achieve and that increase the overall performance of the company.
(4) Finally, the plan has a vesting schedule.
In either case – if the business is overly dependent on the owner or on key employees, the prudent owner will try to reduce this risk (and increase business value) by a strategy to develop and retain key employees who have incentives aligned with those of the business owner.