Common Methods of Valuing Key Employees for Business Life Insurance Purposes

Various ad hoc rules of thumb and approaches have been used to estimate the value of a key employee. These rules, although simple to apply, are conceptually limited. For example, estimating an employee’s value as some multiple of salary is entirely arbitrary. What multiple is appropriate? In addition, it takes no account of the timing of cash losses. The effect, in many cases, may not actually appear in revenues until future periods. Alternatively, a key employee’s value is sometimes estimated by capitalizing the corporate earnings attributable to the employee’s efforts, skills, knowledge, talents, contacts, sales results, or other attributes. A similar approach is to estimate the percentage reduction in the firm’s going concern value that would result from the loss of the key employee and to multiply that percentage by the firm’s going concern value. One problem with these approaches is that they implicitly or explicitly require a valuation of the firm in order to value key employees.

Although key employees are an important component contributing to a firm’s value, the relationship is not often clear or direct. And although up-to-date and continuous knowledge of a firm’s going-concern value would always be welcome for a host of reasons, it is usually neither easy nor inexpensive to perform such valuations, especially in small closely held businesses. A second and more basic problem with these approaches is that they implicitly assume the key employee is irreplaceable, and his or her loss is a dead weight and irrecoverable loss to the firm. These approaches tend to overestimate the loss to the firm. In virtually all cases, if there is adequate liquidity to cover the transition period, a replacement can ultimately be found who can fulfill many, if not all, of the functions of the lost key employee and the company’s management practices can be adapted over time to compensate for the loss. 

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

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