Business Startup

The Executive Effect: How a Successful Executive’s Exit Impacts a Company

I recently read a New York Times article that discussed investor reactions to a successful chief executive deciding to exit a company. The article discussed how Manchester United’s coach, Alex Ferguson, announced Wednesday that he will retire at the end of the season. As a result, Manchester United’s shares fell nearly five percent Wednesday morning. Today’s post explores the impact of Ferguson’s exit, as well as the general impact of exiting executives.

A Brief Background
Manchester United, the English soccer club, raised $232 million in its IPO last year. During the IPO process, there were serious concerns about the club’s financial projections once Ferguson retired. Many believed that the club’s success over the prior two decades was attributable in large part to Ferguson. Manchester United cautioned in its IPO that “we are highly dependent on members of our management…Any successor to our current manager may not be as successful as our current manager.”

Investors Weary of Risks
Any time an executive of a successful company decides to exit, investors fear that the successor executive will fail to maintain the company’s success under the prior executive. This fear often results in stock prices falling because the demand to sell is higher than the demand to buy the company’s shares.  This is why investors prefer a solid employee pool of shares to use as incentives for key persons. When Manchester United’s manager announced he would retire at the end of this season, shares fell substantially. The sharp decline in stock prices indicates Ferguson’s relative value to the team and investors’ lack of trust in the future success of Manchester United without Ferguson. Ferguson is considered what is known as a key person.

What is a key person?
The IRS defines a key person as “an individual whose contribution to a business is so significant that there is certainty that future earnings levels will be adversely affected by the loss of the individual.” The IRS goes on to explain that, in determining whether to apply a key person discount, the following factors are to be considered: (i) whether the claimed individual is actually responsible for the company’s profit levels; and (ii) if there is a key person, whether the individual can be adequately replaced.

How to Account for Key Persons
Generally small closely-held businesses are hit harder by the exit of a key employee because larger (especially publicly held) companies have an easier time finding replacement employees and executives. Further, companies that sell products are generally better able to withstand the loss of a key employee than service-based companies, which depend largely on the experience, knowledge and reputation of the key employee.

When it comes to valuing a company, key employees and executives are often taken into account by applying a key person discount. The idea of the key person discount is simple: when a business is highly reliant on one or more key employees, a valuation discount may be appropriate to account for the risk of reduced future earnings if these individuals exit. Typically, valuators will use one of three methods to take into account the key person discount when valuing the company: (i) adjust future earnings to reflect the risk of losing a key employee; (ii) adjust the discount or cap rate; or discount calculated value by a certain percentage (similar to a marketability or monthly interest discount calculation). Typically the range for these key person discounts is 4 to 6 percent, but there is little empirical support to substantiate these percentages.

 

            


Gavin Johnson

Gavin enjoys craft beer and is learning the art of brewing.


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