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Key person risk

Key person risk is the risk that a business loses value if one individual leaves or stops performing. In small businesses that person is often the owner.

Also called key-person risk

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Definition

Key person risk is the risk that a business loses value if one individual leaves, falls ill or stops performing. In small businesses the key person is often the owner, but it can be a head chef, a lead developer, a qualified professional or a top salesperson. The risk is greatest when that person holds relationships, knowledge, licences or skills that nobody else in the business has.

Worked example

Wattle Creek Veterinary Clinic is a fictional Australian practice with SDE of A$600,000. The owner is one of two vets, handles the most complex cases, holds the relationships with local farms and is the only person who understands how the practice software and supplier accounts are set up.

A fictional buyer asks what would happen if the owner left at completion. The honest answer is that farm clients might follow, the second vet could not cover the workload and revenue could fall sharply. The buyer asks for a 12-month handover, an earn-out tied to farm revenue and a new employment contract for the second vet.

Seller's discretionary earnings (SDE)

Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.

Earn-out

An earn-out is part of the purchase price paid only if the business meets agreed targets after the sale. It can bridge a gap between the seller's price and the buyer's view of the evidence.

Why buyers care

You are buying the business, not the person, and much of what a person brings does not transfer with a sale. Test how the business runs when the key person is absent: ask what happens during their holidays, look at who is copied on customer emails and meet the next layer of staff.

Reduce the risk before completion where you can: documented processes, relationships introduced to others, key staff tied in with contracts or incentives and a transition period with clear duties. Loupe's valuation tool applies a negative adjustment when the owner works more than 40 hours a week or holds key relationships, licences or skills, and a positive one when a manager runs the business day to day.

Transition period

A transition period is the agreed time after completion when the seller stays involved to hand over knowledge, relationships and processes to the new owner.

Related terms

  • Transition period

    A transition period is the agreed time after completion when the seller stays involved to hand over knowledge, relationships and processes to the new owner.

  • Customer concentration

    Customer concentration describes how much of a business's revenue comes from a small number of customers. The higher it is, the more the business depends on decisions it does not control.

  • Restrictive covenants

    Restrictive covenants are promises that limit what a seller can do after a sale, such as competing with the business or approaching its customers and staff.

  • Earn-out

    An earn-out is part of the purchase price paid only if the business meets agreed targets after the sale. It can bridge a gap between the seller's price and the buyer's view of the evidence.

  • Adjusted EBITDA

    Adjusted EBITDA is EBITDA after normalising adjustments, showing what a business would earn with a paid manager in the owner's seat. Larger small-business deals are usually priced on it.

Guides

  • Owner dependence and how to test it

    In many small businesses the owner is the salesperson, the expert and the person every decision waits for. This guide explains why that lowers value and sets out practical tests you can run, from reading the listing to the last weeks of diligence.

    9 minutes to read

  • The first 100 days after you buy

    How to use the first 100 days after completion: keep customers, staff and cash steady, learn the business before you change it, and start fixing the risks you found in diligence.

    8 minutes to read

Red flags

  • The owner does the selling or holds key relationships

    When the owner wins the work and keeps the important relationships, part of the revenue may leave with them. Test how much of that revenue would stay without them before you agree a price.

    Severity: price it inOperations and people

  • Key staff not tied in

    If the people who hold the business together have no written terms, no notice periods and no reason to stay, a sale is the moment they are most likely to leave. Find out who matters and what keeps them.

    Severity: fixableOperations and people

  • Undocumented processes

    When the way a business runs lives in one or two people's heads, the handover gets harder and early mistakes get more likely. It is usually fixable if you find it before you sign.

    Severity: fixableOperations and people

  • Licences or permits that do not transfer

    If the licence, permit or registration a business needs cannot pass to you, or cannot be obtained in time, you may be buying a business that is not allowed to trade. Confirm the route before you commit.

    Severity: deal breakerLegal and compliance

Free tools

  • See a low, likely and high value from the figures you have, and whether the asking price holds up.

  • Answer about 15 quick questions about a listing to see which areas need checking.

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