One of the most misunderstood principles of business deals with the one or few individuals in a small business operation who are critical to operations. This individual is referred to as the Key Man. The best example is that of the primary wage earner in the family unit. A sudden medical setback or death can wreak havoc on the family’s financial affairs.
This also is true in business. Think of the one physician office with a staff of 3 nurses. Without this physician, no services can be rendered and ultimately the nursing staff will be out of work. Worse yet, the entire business will cease operations and go out of business. Although a simple example, it gets more complicated as a business grows and prospers. This article will describe how a business entrepreneur or the human resources officer identifies the key man. In addition, I’ll describe and illustrate how to place a value on this individual and finally how a small business reduces or eliminates the various risks associated with the key man.
How to Identify the Key Man
In the introduction section above, I used the example of the physician as the key man in that business operation. It is a simple and basic example. His presence is based on his knowledge and a license to operate as an MD. However, in many businesses, the key man doesn’t necessarily exist because of his knowledge but for some other reason. They include the following:
The sections below cover these characteristics of key individuals in small business operations.
Many businesses do not rely on skilled labor to deliver the service or product to their customers. But for those operations that do, well, your key man most likely carries the skill needed to provide that service or product. As an example, imagine an operation whereby metal fabrication is the service/product provided. Of the employees, maybe only one has certification to weld certain materials. For the owner, if this skill were lost, how easy is it to replace? How many certified welders are there out there willing to come to work at a small business? Often, shipyards and energy companies place a high demand on the limited pool of individuals with this skill. This leaves very few potential employees for your business. As an owner, you need to ask yourself ‘How critical is this skill to the overall business?’ Secondly, ‘How difficult will it be to replace if I lost this employee?’
This type of situation exists for several types of businesses. The following is a short list:
- Mechanical HVAC
- Tile Setters
- Brick Mason
- Trim Carpenters
Industrial Equipment Maintenance
- High Pressure Lines
- Fiber Optics
- Diesel Motors
In many small businesses, the owner generally has this skill and it is easy to identify him/her as the key man. However, over time age or health issues present problems and the business hires someone with this skill to substitute for the owner. If this is the case in your business, the key man shifts to someone new. The underlying critical factor is ease of replacement with a substitute. If extremely difficult, then this skilled individual should be looked upon as the key man in the business.
Some of your family owned businesses that have recurring business with customers rely on reputation as the driving force in generating revenue. The question here is: ‘What single one or two individuals drive this reputation?’ Often it starts out with the owner(s) and as time goes on, it can shift to a particular employee. You see this in many professional operations; younger partners foster new relationships or mature into existing relationships with clients. Clients call and request this employee as their go to person. Here, the owner of the business needs to look at the business dealings and identify the one, two or certain individuals that drive the revenue stream.
Again, how difficult will it be to replace them? With this particular characteristic, it will be nearly impossible because reputation is a time related variable of the key man identification process. Sometimes you can buy reputation, but the price will be higher than what many small business owners believe or are willing to pay.
This characteristic is similar to reputation as described above. However, in most situations dealing with experience, the key man doesn’t necessarily generate greater revenue, but he actually reduces costs. Think of estimators for large contractors. Time becomes an asset for this individual. He or she has experience in so many different scenarios a new project is not a challenge to them. Thus their experience allows the company to reduce costs or avoid risks.
Some individuals are essential to businesses due to their creativity. This is often true in the arts or entertainment industries. Without their input, the business will not be as appealing to the customer/buyer of these skills. Think about how difficult it is for advertisers to provide variety in generating advertising or marketing for clients. I can’t imagine how hard it is to create a radio ad for a potential business because creativity is not one of my characteristics. Many of our modern multi-millionaires exist because of their creativity. Think of Steve Jobs (Apple) or Mark Zuckerberg that created Facebook.
Most business owners don’t think of this as one of the key man characteristics. But in some businesses, this is one of the requirements. The best examples of inspiration are leadership positions such as coaches, pastors in the church, or non-profit organization management. In the world of sales, those that inspire others to push on against the odds keep the company moving forward; think of real estate or auto sales.
The above characteristics are the primary ones that an owner needs to review when analyzing his business. In so many cases, the business is a family owned business and it easy to identify the key family members. But as the business prospers, this may shift to someone new or is acquired by a younger member of the family. When looking to identify the key individual, ask yourself if any of the above characteristics exist with one or maybe a second employee within the organization. If true, you now have identified the key man in your company.
How to Value the Key Man
This section is not going to describe how to place a financial value on the key man; that is reserved for another article for another day. This section describes the overall value on the organization as it relates to the day to day and the effect on other employees, customers, vendors and the business as a whole. The more cascading the outcome from his/her absence increases the value this individual brings to the company.
Let’s take a look at the situation in a low level non- immediate effect from the absence of a key man. The best test is when this individual goes on vacation. What happens in the company? What is the impact? Do other employees know what to do? Does the business continue to function? In the doctor example in the introduction section above, the nursing staff isn’t fully needed when the doctor goes on vacation. However, one of the nurses is needed to respond to phone calls from the patients as it relates to prescriptions and ongoing referral issues related to specialists etc. Typically, the doctor calls in each day to confirm or deny a prescription issue or address phone calls from patients.
Now let’s extend this out a little further. Now suppose the doctor becomes very ill and must be out of the office for a month. Now, it is a different story. I would imagine an RN would need to stay on the staff to deal with the day to day medical issues from patient calls etc. But the front office lady isn’t really needed because there are no appointments to address or office issues to fill her time. Therefore, there is a strong possibility she will seek employment elsewhere because she may not afford being out of work for an extended period of time. This is the thought process an owner of a business needs to explore when addressing the absence of a key man. How does his or her absence affect the company? How about an extended absence?
It may not be noticeable right away. Suppose the key man is in management and his short term absence has no effect on the company. However, a protracted absence begins to create problems. Maybe certain orders are not completed or documents are not filed. Worse yet, the company fails to get a work order or an estimate into a customer thus losing a contract. Imagine the impact on a company if you lose this contract. It will impact future employment, vendor relationships, and possibly the overall viability of the company to continue. Notice the cascading effect from the absence of this key individual.
This is how an owner should look at the value of the key man. The greater the cascading impact the more valuable this key man is to the company.
Remember, an entrepreneur goes into business to fulfill three primary goals. The first is to make a profit. The absence of the key man will impact this dramatically. The second reason is to provide security to employees – security provides retention and higher productivity. Any change to the staffing security feeling will change the demeanor of the staff and ultimately other employees may leave. The third reason you are in business is to fulfill some goal such as helping others or building something. Maybe it is providing products or services. How does the disappearance of the key man affect this tertiary goal?
Now the owner can truly understand the impact of this key man. Given this, how do you reduce or eliminate the impact of the absence of the key man? The next section will describe different tools used in industry to reduce or eliminate this risk.
Risk Reduction – Key Man Issue
There are four direct tools to reduce the risk associated with the key man absence issue. They are as follows:
- Contractual Agreement
The following sections describe the tool in more detail and illustrate how to use the tool.
In some situations it is possible to substitute the key man with another equal and qualified individual. This is usually the preferred method in licensing situations such as medical offices or in engineering/architectural firms. It is a little more difficult to find a substitute for issues related to reputation, creativity or inspiration based key individuals. It may not be an overwhelming barrier for knowledge based or experience issues in substituting an individual in your business. But as the owner, you need to look at the totality of the situation to determine if you can use a substitute for your key man if something should go wrong. There will be a price to pay for the substitution method but it should be temporary as you build or train a new individual to fill the role of the key man.
With this tool the owner identifies an issue and begins the process of training someone else to do the same job as the key man. The problem with this is the volume of revenue and corresponding cost. Margin needs to increase to cover the costs of compensation for the new man. In addition, there are training costs, a learning curve and longevity issues to pay. This method is more effective when dealing with the characteristics of skills and reputation. The drawback to this solution is the corresponding increase in volume of work needed and the expansion of the operations. This can be overwhelming especially in those businesses whereby one more marginal unit of production creates a significant cost in capital. Read more about operating within your range of production to understand the concept of marginal costs associated with an increase in production. Read: Operate Within Your Range of Production.
This is by far the easiest and cheapest method to address any sudden death or illness of a key man. Insurance cannot be used to address a departure due to conflict. Many insurance companies sell ‘Key Man’ policies for death or extensive medical disabilities for the key man. Premiums are paid by the business but are not tax deductible. It is considered a tax adjustment item for your accountant in preparation of the corporate or partnership tax return. But the actual premium can be paid via the business checking account. The cost of the policy is relatively inexpensive in comparison to other tools.
If something were to happen to the key man, the policy makes you whole again and you use the proceeds to offset revenue losses and maintain security for staff. The idea isn’t to stop the cascading effect but to reimburse for the associated costs. It will take time to replace the key man, but the insurance proceeds provide the funding to complete the transition.
In professional sports, a contract is signed between the team management and the athlete. This binds the athlete to the team. Well, the same business principle is used for a key man. You create an agreement whereby departure or reduction in output is penalized and in some situations, the penalty is severe. This locks the key man to the business and reduces the risk associated with internal conflict. The agreement spells out the relationship. his is a very effective tool in maintaining growth for the company.
Most small business owners use a combination of the above to reduce the risk associated with the key man issue. Of course, a really successful operation tries not to depend on any one single individual as their primary source of revenue or production. Unfortunately this is difficult to achieve so use the above tools to reduce the risk associated with the key man issue.
Summary – Key Man
Identify the key man by reviewing the characteristics as stated above. If any of the following characteristics exist with a single individual in the company, you may have an issue:
In most cases, the small business owner has identified himself as the key man. This is not uncommon. However, as the business grows, others begin to fill that role. Review the characteristics as stated above frequently. As others become the key man in the business, use one of the four or a combination of the tools illustrated above (Substitution, Duplicity, Insurance, and Contract) to reduce the risk associated with a sudden death, medical illness or internal strife. Knowledge is Power.