Can your business operate without you? If not, then you have key man risk. See how to audit, plan, and resolve key man risk today

De-Risking Key Man Dependency: Founder-Led to Process-Driven

While growing a business, it’s common for the owner to build it around their strengths. But when those strengths become the business itself, a huge problem appears – key man risk.
Depending too much on someone is an issue. They essentially “run” the business. Without them, it stalls. This doesn’t just impact this individual’s workload, though. A far bigger issue can occur.
Selling a business becomes an issue. Key man risk can reduce the valuation multiple of the business, extend the closing period, and worse, possibly make the deal fall through completely. That’s why it’s important to understand, audit, and mitigate such a person. 

What is Key Man Risk? 

Key man risk happens when a business relies too heavily on a single person for sales, operations, etc. This is typically the founder or the owner. These individuals hold the “key” to success, and without them, the business isn’t operational or sellable. 

To learn how to remove key man risk from your business and improve your company’s valuation, contact our team at OCX Advisors.

Why Key Man Dependency Damages Your Business’s Value

The Owner’s Trap 

If the owner is the top salesperson, the primary client contact, and the final decision-maker on operations, the business cannot be sold.
Buyers evaluate whether a company can sustain performance after it has been sold. If the answer depends entirely on whether the owner is in the company or not, the buyer’s thesis collapses entirely.

Simply put, no acquirer wants to purchase a business where revenue drops as soon as the owner walks away. It needs to show operational integrity regardless of whether the owner is present or vacant. 

Reduced Business Valuation 

Key man dependency can directly impact your business’s value. This is commonly referred to as a “key person discount”. It’s a reduction applied to reflect the risk of losing the key person in the business.

How much this discount is ranges. Shannon Pratte, a company valuator, suggests this is anywhere from 15 to 20%. To put that into perspective, a company originally valued at $10 million may only be sold for $7.5 to $8.5 million. 

Stalled Growth and Innovation 

When every large decision must be filtered through a single person, growth and innovation are halted. That’s reflected in research as well. 71% of small businesses depend on one or two people for success.

If a company relies too heavily on one person’s bandwidth, everything slows down. Customers wait for replies, new initiatives wait for approval, and the team stops suggesting improvements because the process runs through a single gatekeeper. 

Weakened Buyer Confidence 

A company needs to operate even if key employees get sick or leave. However, fewer than 22% of businesses have a succession plan – a plan on who will take over certain roles if someone leaves, retires, or becomes unavailable.

During due diligence, buyers will review talent continuity just like they would financial strength. If the buyer believes the team is unable to operate with certain individuals, they may offer a low amount or even skip the deal completely. 

How to Audit Your Business for Key Man Risk 

Before you start reducing key man dependency, you first need to identify where it exists. There are two frameworks that work well for this. 

Using SWOT Analysis
The first framework is with SWOT. Apply it specifically to your leadership structure. 

 

• S – Strengths: Where does your team operate independently? Which functions continue without founder involvement? 

• W – Weaknesses: Where does the business stall when the founder is unavailable? Which processes lack documentation? Where is knowledge concentrated in one person? 

• O – Opportunities: Which team members could take on more responsibility with the right training? Where could documented SOPs replace informal knowledge transfer? 

• T – Threats: What happens if the founder has an unplanned absence? Which client relationship is tied exclusively to the owner? 

 

The above exercise will help you identify the key man risk. It’ll also help you identify how you can navigate such an issue. 

The Vacation Test

A test that you could potentially do is what we coined the “Vacation Test”. Take two weeks away from the business completely (yourself or the key person). No calls, emails, or check-ins. What brakes or slows down? If nothing, you’ve built a transferable business. If something, you need to develop a system that can handle such an absence. 

How to Reduce Key Man Dependency 

Once you’ve identified the key man risk, you need to reduce it. How you do this will depend on the individual and their roles. However, there are several techniques you can consider to help reduce the burden.

Developing SOPs

Whoever your key person is, you need to get their process out of their head an in formal, easy-to-follow documentation. This is through SOPs (Standard Operating Procedures).
SOPs can include anything.

It could be for client onboarding, financial close processes, sales workflows, or escalation procedures. Whatever the main responsibilities of the key person are, they should be documented in a way that others can follow.

Cross-Training 

Cross training ensure that two or more people can perform every essential role. In such an environment, if a key person is absent, the second, third, forth key person can comfortably take over their role without their current role being vacant.

For example, imagine your head of sales closes every deal over $100,000. If they’re not there, that’s a huge point of failure. Before such an event occurs, the sales team should be trained on how to manage these deals, regardless of whether they do it on a day-to-day basis.

Succession Planning

Succession planning goes a little deeper than cross-training. Rather than simply ensuring coverage, it guarantees replacement. It simply identifies who steps into a key role if the person in that role leaves permanently.

It doesn’t need to be complex. For each important position, document who the successor is and the responsibilities they’ll take over. Of course, they’ll also need to be trained and ready if this event were to occur. 

Benefits of Addressing Key Man Risk

If you’re able to audit, plan, and address key man dependency, then you’ll receive many benefits. 

Operational Resilience 

First of all, your business will be much more stable. Operations and projects can continue even if key people aren’t present. The organization simply adapts without disruption, allowing for better stability and scalability.

This level of resilience won’t only benefit operations. If a company has such resilience, buyers will value the company more. When this happens, you can increase your business’s multiple and get a higher sale rate. 

Increased Buyer Valuation 

Buyers will pay more for businesses with a lower risk profile. When you don’t rely on a single person to run your business, the business seems much less risky. As mentioned earlier, the “key person discount” can reduce the valuation of your company by 15 to 20%. Depending on your pre-key risk person planning, that could mean millions in extra cash.

Why this happens is clear as well. Buyers want businesses that’ll operate once you’re gone. If you have a structure in place that already caters to this, they’ll happily pay a premium rate knowing they can get a return on their investment. 

A Stronger Exit Strategy

When a buyer’s diligence team finds signs of de-risking key man dependency, they’ll be much more confident in the deal. If they can clearly see documented SOPs, a capable second-tier management team, and cross-trained staff, they immediately think this is a “good” buy. As a result, if a buyer wants to acquire your company as part of an M&A deal, they’ll want to accelerate the process. For sellers, this means a much faster, more desirable, and effortless exit strategy. 

From Founder-Led to Process-Driven

Key man risk will never resolve itself. Every month that it goes unaddressed, the dependency gets worse, and the gap between what the business is worth and what people are willing to pay widens. That’s why you need to transition from founder-led to process-driven. Remove the founder from the business and replace them with SOPs, cross-trained teams, and proper succession planning. By doing so, buyers will look at your company as high value, and it can continue operations without you.

To discover whether you have key man risk, perform an audit. A SWOT review or vacation test will help. Both will indicate exactly where the strengths and weaknesses are in your business when the founder isn’t there. If you’re considering exiting your company and would like to know how key man dependency can impact your valuation, feel free to contact us at OCX Advisors. One of our professionals will be more than happy to provide you with guidance.