Bridging the Valuation Perception Gap

Introduction

Every business owner believes their company has value. After years of building operations, developing relationships, and generating profits, this confidence seems justified. However, when preparing to sell, owners discover an uncomfortable truth: what they perceive as strengths, buyers often view as risks.

This misalignment stems from opposing perspectives. Owners possess intimate familiarity with operations while buyers lack institutional knowledge and must protect against unknowns. This caution drives wedges between parties. Among various transaction risks, key personnel dependence stands out as particularly prevalent and consequential.

Understanding Key Personnel Dependence

Key person dependence arises when a company's performance relies heavily on one individual or a small group. This risk transcends company size, industry, and geography. Key personnel contribute far beyond formal job descriptions. They hold institutional knowledge, maintain customer relationships, manage internal dynamics, and generate new business. These qualitative strengths manifest in measurable outcomes: revenue growth, operational efficiency, profitability, and sustainable cash flow.

Which Businesses Face Greater Risk?

While all organizations risk losing talent, certain structures create heightened vulnerability. Sole proprietorships show peak reliance on a single individual who handles everything from client acquisition to strategic direction. Even in larger organizations, shareholders often drive business activity. Only when they cede meaningful management does this dependence diminish. Industry characteristics also matter. Service-based businesses require both process expertise and relationship management. A plumbing business needs technical skill, but that alone proves insufficient without client relationship abilities.

The True Cost of Expertise

Key person dependency centers on subject-matter expertise. Experts are rare, expensive to hire, challenging to retain, and difficult to replace. The job market favors talented employees, not employers. Buyers and sellers must recognize that driving off talent comes at enormous cost.

Consider the classic ship repair story. When a ship's engine breaks and no one internally can fix it, management calls a retired employee. He quickly identifies the problem, turns a single screw, and the engine starts. His invoice: $10,000. Arriving with a screwdriver cost the company $2. The remaining $9,998 reflected his knowledge of exactly which screw to turn.

Expertise is expensive because it is irreplaceable. When experts leave, consequences can be catastrophic. Now imagine this ship had recently been acquired. New investors retained executives but dismissed operational staff who actually kept operations running. Buyers who inherit such vulnerabilities may spend the equivalent of $10,000 on fixes that would have cost a fraction with existing employees.

Identifying Key Personnel

How do we identify these critical employees? It is challenging without direct knowledge. You can only learn so much through calls, emails, and websites. Site visits become vital. We interview shareholders and managers, and these conversations frequently reveal individuals crucial for operations who hold no executive title. Their departure would leave gaps difficult to replace.

As firms grow, it becomes tempting to assume only shareholders and C-suite managers qualify as key personnel. This often misses the mark. Some managers have impressive titles but minimal functional expertise. Other non-titled employees keep operations afloat. In a sale, sellers must identify which individuals need retention through the transition. Failing to address this can lead to decreased valuations or failed deals.

Mitigating Risk in Valuation

Valuation professionals can compensate for key personnel risks through two primary methods. First, modify pro forma targets when a key person's performance directly relates to sales activity. Second, increase the company-specific risk premium in the discount rate when the true impact remains less clear. Whether through projection adjustments or discount rate modifications, the goal remains the same: capture the financial impact of losing critical personnel and communicate that risk properly to all parties.

The AI Factor

Artificial intelligence is reshaping discussions around key person risk. Shareholders and managers face pressure to determine which employees are irreplaceable and which functions can be automated. AI will likely handle rote, repetitive tasks and may eventually encroach on more complex areas, forcing firms to reassess staffing needs.

However, downsizing decisions carry danger. Organizations risk removing institutional knowledge or specialization that proves impossible to replace. Even highly automated firms remain effective only when systems are properly managed. AI also elevates the importance of soft skills for navigating flatter organizational structures. While AI can optimize scheduling and logistics, it cannot replace physical laborers such as plumbers or electricians.

Conclusion

Since valuations and asset pricing are directly tied to financial performance, a firm's improper handling of key personnel costs income in the short term and value at time of sale. Ultimately, the true value of a business is inseparable from the people who run it. A seller who understands, protects, and communicates the value of their key personnel will preserve valuation goals and foster trust and transparency in negotiations with buyers.

Source: NACVA QuickRead, August 2025