What Business Owners Must Consider Before Putting a Company on the Market
A superstar or key employee can have a major impact on the value of a business. The important question is whether that employee makes the business more transferable or makes the business dependent on one person.
From a buyer’s perspective, the key question is simple: “What happens to the earnings of this business if this person leaves shortly after closing?”
When a Superstar Increases Business Value
A great employee can increase value when he or she is part of a strong management structure rather than the only person capable of producing results. For example, suppose a company generates $1 million of EBITDA and has a strong general manager who runs day-to-day operations, manages employees, handles major customers, and plans to remain after the sale.
That can be extremely valuable because the buyer is not simply buying a job. The buyer is acquiring a company that can continue operating without the seller.
This becomes particularly important when an owner currently works 50 to 60 hours per week. If some of these responsibilities can be transferred to capable managers before the business goes to market, the company generally becomes easier to sell and may command a higher valuation multiple.
When a Superstar Can Hurt Business Value
The problem arises when there is key-person dependency. Suppose a commercial HVAC company has one salesperson who generates 60% of its new business. If that salesperson leaves, revenue and profitability could decline dramatically.
Even if the company currently produces $1 million of EBITDA, a buyer may not be willing to pay a normal multiple on that $1 million because the future earnings are at greater risk.
The same issue can arise with a superstar technician, estimator, project manager, doctor, engineer, chef, designer, operations manager, or other employee whose knowledge, relationships, or skills are difficult to replace.
Key-Person Risk Can Affect the Multiple, Not Just Earnings
Consider two companies that each produce $1 million of EBITDA. Their financial performance may look identical, but their values can be very different.
| Factor | Company A | Company B |
| EBITDA | $1 million | $1 million |
| Customer base | Diversified | Diversified |
| Management | Strong management team | One superstar employee |
| Processes | Documented systems | Knowledge concentrated in one person |
| Customer relationships | Handled by multiple employees | Controlled by superstar |
| Key-person risk | Low | High |
For illustration, Company A might justify a 5x EBITDA multiple, producing a $5 million value. Because of the additional risk, a buyer might only be comfortable paying 4x EBITDA for Company B, producing a $4 million value. The result is a potential $1 million valuation difference even though both companies report identical EBITDA.
A buyer may also attempt to address key-person risk through an earnout, retention arrangement, seller financing, or another form of contingent consideration.
Compensation Must Be Considered When Recasting Earnings
Key employees also affect the calculation of normalized EBITDA or seller’s discretionary earnings. A superstar who is underpaid can cause normalized earnings to be overstated.
For example, suppose the owner’s son serves as operations manager and earns $60,000 per year, but replacing him in the open market would cost $120,000. A buyer should not assume the existing $60,000 expense represents the true cost of operating the company. Normalized EBITDA may need to be reduced by an additional $60,000.
The opposite can also occur. If a family member receives $175,000 for a position that would normally cost $90,000, there may be an $85,000 adjustment to normalized earnings.
Two questions should therefore be asked about every key employee or working family member:
- What does this person currently earn?
- What would the company have to pay someone in the open market to perform the same job?
Preparing the Business for Sale
Ideally, a superstar should become part of the company’s value rather than the source of the company’s value. Business owners preparing for a sale can reduce key-person risk by spreading knowledge and relationships throughout the organization, documenting processes, cross-training employees, developing a second-in-command, and making sure multiple employees have relationships with important customers.
Where appropriate, retention incentives, employment agreements, non-solicitation provisions, or other arrangements may also help increase a buyer’s confidence that important employees will remain after a transaction.
The Bottom Line: Buyers Pay for Transferable Earnings
There is an important distinction between saying, “This company has a superstar employee” and saying, “This company cannot function without this employee.” The first can be an asset. The second represents risk.
For privately held businesses valued on SDE or EBITDA, key-person concentration should be considered alongside customer concentration and owner dependency when determining the appropriate valuation multiple. Two businesses with identical financial statements can legitimately have very different values because one has substantially more transferable and sustainable earnings than the other.