Death of a Key Employee

The untimely death of a key employee or a business owner, who is also a key employee can have a disastrous effect on a business.  Some of the “costs” of such an event might include:

• A weakening of the company’s credit rating.
• The financial cost (in time and dollars) to find, hire, and train a replacement.
• The distraction of other employees, resulting in deadlines not met, deteriorating morale, or a higher level of personality conflicts.
• A need for cash to fulfill promises made to the deceased employee’s spouse or family, such as salary continuation or deferred compensation.
• The inability to seize a business opportunity, because cash reserves is being used to recruit and train the new employee.
• A loss of confidence among both suppliers and customers.

Valuing a Key Employee

There is no easy mathematical formula to determine the value of a key employee. However, over the years business owners have frequently used three different methods to estimate the worth of an employee to their company.

The Multiple of Compensation Method: Assumes that an employee’s value is accurately reflected in his or her total compensation package. The “multiple” that is used (for example: 2 x annual compensation), will depend on the type of business and the estimated difficulty in finding a qualified replacement. This method is perhaps the easiest way to estimate the potential loss to the firm.

The Contribution to Profits Method: Estimates the impact a key employee has on the company’s net profit. The firm calculates the expected profit from a “normal” return on capital, e.g., the net book value of assets. Profit in “excess” of this normal return is assumed to result from the efforts of the key employees. An estimate is made of the percentage of profit attributable to each key employee. This percentage is then multiplied by total excess profit, to determine the dollar amount of excess profit from each key employee. This sum is then multiplied times the number of years needed to find and train a competent replacement.

The Cost of Replacement Method: Totals the direct, out-of-pocket costs involved in finding, hiring, and training a replacement, as well as the estimated “loss of opportunity” costs.

Read our article in Construction Executive on Protecting Your Balance Sheet.