October 21, 2013

"Key Man Discount" Factors Critical in Fair Value Business Disputes

Holland & Knight Shareholder Rights Blog
Michael J. Zdeb

Family business disputes oftentimes uncover who is actually calling the shots and making a big difference in the profitability of a company. As described in previous Shareholder Rights blogs, the Wisniewski shareholder oppression case shows how the Wisniewski siblings — Patricia Wisniewski, Frank Walsh and Norbert Walsh — disputed each family member's involvement in the transportation business their father had started in the 1950s. As their shareholder rights were analyzed during the 10-plus years of litigation, a crucial element emerged to determine the market value of the business.

An important consideration called a "key man discount" was presented at court in relation to the date of value to pinpoint the fair value for the business. According to the International Glossary of Business Valuation Terms, a key man discount is "... an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person."

Sibling Roles Affect Business Outcomes

It surfaced that Frank Walsh was instrumental in the growth of the business. However, when he was absent from the company (serving a prison sentence), the business suffered. When he returned, the business began to improve financially. It was noted by the trial court that Frank was "uniquely responsible for the company’s success." This was based on Frank's extensive relationships with customers, the impact of his absence and the effect of his return.

When the court set the valuation date, Frank was still involved in the business. However, by the time of the appeal and the later court actions, Frank had passed away. The parties argued whether a discount should be applied. The other brother Norbert, who was ordered to sell his shares, wanted to avoid a discount in the value of his shares. He argued that Frank's death had not materially impacted the business. The sister who was purchasing the shares wanted a discount, however, and relied on the initial trial court’s decision that gave her the benefit of the earlier valuation date.

Key Man Discount Case Precedents

A number of observations can be made about the application of a key man discount:

  • This type of discount has been rejected about as often in cases as it has been applied. As with all factors in a business appraisal based on fair value, the facts of the particular case and the applicable law will determine the outcome. The only constant is that the court will determine what it perceives to be fair.
  • This type of discount is more likely to be applied when: a business is ongoing (and not subject to liquidation); the "key man" is free to leave and compete; and the individual has unique abilities or relationships critical to the business.

Risk Factors When Assessing a Business' Market Value

Risk factors can be considered in a business appraisal proceeding in a variety of ways. One risk factor that could lead to a discount is the inherent lack of control of the market. A particular risk also could be considered such as a size discount or private company risk factor that could affect the discount rate as applied to a "discounted cash flow" analysis. Considerations include:

  • A size premium, which is a component of the capital asset pricing model (CAPM) or the rate of return or discount used in income capitalization or discounted cash flow methods (DCF). As noted in the fourth edition of Cost of Capital: Applications and Examples, "Because the size premium tends to reflect some factors of this type [such as dependence on key personnel], analysts should adjust further only for specific items that are truly unique to the subject company. Analyst must be careful not to include any adjustment for risk factors that may be included in other adjustments."
  • A private company discount addresses issues specific to a particular company and is not applicable generally to companies in the particular industry or market. It is possible that the effect of the loss of a key person could be reflected in this type of discount.
  • It is also possible for the loss of a key person to be reflected in the projected cash flow used in a DCF or as an adjustment to income in an income capitalization approach to value.

Because of the variety of ways that a key man discount could be applied, there is the potential for double counting. As the court noted in remanding the Wisniewski case back to the trial court, when considering the appropriate discount, the court should determine that such a discount was not already reflected in some aspect of the valuation.

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