What is key person risk?
Auditing standards require a year-end risk assessment. One potential source of risk may be a small business’s reliance on the owner and other critical members of its management team. If a so-called “key person” unexpectedly becomes incapacitated or dies, it could disrupt day-to-day operations, alarm customers, lenders and suppliers, and drain working capital reserves. Key person risk is a very serious matter and companies need to watch out for it.
Who does key person risk affect?
No one is indispensable. But filling the shoes of a founder, visionary, or rainmaker who unexpectedly leaves a business is sometimes challenging. These risks are usually associated with small businesses, but they can also impact large multinationals.
Consider the stock price fluctuations that Apple experienced following the death of innovator Steve Jobs. Fortunately for Apple and its investors, it possessed a well-trained, innovative workforce, a backlog of groundbreaking technology and significant capital to continue to prosper. But other businesses aren’t so lucky. Some small firms take years to fully recover from the sudden loss of a key person.
Factors to consider
Does your business rely heavily on key people, or is its management team sufficiently decentralized? The answer requires an evaluation of your management team. Key people typically:
- Handle broad duties,
- Possess specialized training,
- Have extensive experience, or
- Make significant contributions to annual sales.
Other factors to consider include whether an individual has signed personal guarantees in relation to the business and the depth and qualification of other management team members. Generally, companies that sell products are better able to withstand the loss of a key person than are service businesses. On the other hand, a product-based company that relies heavily on technology may be at key person risk if the said person possesses specialized technical knowledge.
Personal relationships are also a critical factor. If customers and suppliers deal primarily with one key person and that person leaves the company, they may decide to do business with another company. It’s easier for a business to retain customer relationships when they’re spread among several people within the company.
Ways to lower your key person risk
Your auditor’s risk assessment can help determine accounts and issues that may require special attention during audit fieldwork. The assessment can also be used to help you shore up potential vulnerabilities.
Training and mentoring programs can help empower others to take over a key person’s responsibilities and relationships in case of death or a departure from the business. Likewise, a solid succession plan can help smooth the transition.
Also, consider external replacement options. This exercise can help you understand how much it would cost to hire someone with the same knowledge, skills, and business acumen as the key person. In addition, a key person life insurance policy can help the company fund a search for a replacement.
We can help
Key person risk is a real — and potentially significant — possibility, especially for small businesses with a limited operating history and charismatic, innovative leaders. Contact us to help identify key people and brainstorm ways to lower the risks associated with them.