Basic Principles of Valuing Key Employees for Business Life Insurance Purposes

A conceptually sound approach to key employee valuation should measure the financial loss based on what the employee would have contributed to the future success of the firm and adjust the financial consequences for the timing of those lost contributions. It should also:

  • account for trends in the employee’s contributions; 
  • realize that, in every case, a key employee’s contribution to the firm will terminate at some point, either through death, disability, resignation, or retirement; and 
  • recognize that most, if not all, of the value of the key employee’s contribution to the firm can and will be recovered over time, either by hiring and training a replacement, adapting or changing the management practices and functions of other key employees, or some combination. 

Although an employee’s past contributions are often a major component in determining the employee’s present compensation, the cost to the firm of the employee’s loss depends on the future—on what the employee could be expected to contribute in subsequent years. In this regard, both the timing and trend of these future contributions are critical. The loss of an employee who is essential to the successful close of a major deal is much more costly if the deal is expected to close within the next few months than if it is not expected to close for a year or two. Similarly, the trend is important. It is much more costly to lose a relatively new “rainmaker,” who is still in the process of bringing new accounts within the firm, than to lose the same employee later, after many of those accounts have been acquired and become accustomed to and comfortable with the firm. 

One mistake frequently encountered in key employee valuations is the failure to account for the fact that every key employee, sooner or later, for one reason or another, will terminate employment with the firm. It is not a question of if the key employee is lost, but when. This is a simple fact of life that every firm must face. And while it is true that without proper planning the loss of a key employee could, in some circumstances, sound the death knell for a firm, it is usually entirely avoidable. If a firm can anticipate and survive a key employee’s retirement, it should also be able to plan for and survive the loss as a result of death, disability, or resignation. 

Any valuation based on the presumption of a permanent and irrecoverable loss will usually be invalid and overstated. The impact of the loss of a key employee’s contributions to the firm will virtually always diminish over time as the firm adjusts its practices and reallocates or replaces lost resources. And although a replacement may not be able to exactly replicate the contributions of the lost employee, over time much of the lost contributions can be recovered through training and experience. In addition, the replacement will frequently bring her own unique talents to the job, adding dimensions that the key employee may have lacked. Therefore, ultimately no permanent or ongoing loss to the firm should result. 

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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