Bridging the Valuation Perception Gap

Key Personnel Dependence in Sell-Side Business Valuation

This article examines one of the primary issues that CVAs encounter when advising clients who are preparing to sell. By identifying challenges early in the valuation process, CVAs can better educate sellers on weak points in their business and prepare them for potential poor reception that they may face from prospective buyers.

Introduction

Business owners preparing to sell often underestimate the risks that prospective buyers perceive in their companies. This misalignment stems from two primary factors: an owner’s intimate familiarity with firm operations and the buyer’s lack of direct involvement or institutional knowledge. These opposing forces prompt both parties to exercise caution. This caution causes a gap in valuation expectations. This gap often drives wedges in negotiations, breeds distrust, and stalls productive discussions between the negotiating parties.

This article examines one of the primary issues that CVAs encounter when advising clients who are preparing to sell. By identifying challenges early in the valuation process, CVAs can better educate sellers on weak points in their business and prepare them for potential poor reception that they may face from prospective buyers.

The perspective on these issues is shaped by a career devoted entirely to valuation work, previously working for a sell-side investment bank and now owning a valuation firm. Many clients are founders or long-time owners preparing for retirement. For most of them, this sale is the first and only business transaction of their careers. Because of their limited transaction experience, sellers often have little awareness of how buyers will identify and scrutinize operational weaknesses. It is a valuator’s role to identify these weaknesses and explain their implications before the marketing process and negotiations begin. Among the risks commonly encountered by CVAs, key person dependence stands out as one of the most prevalent and consequential.

What is Key Personnel Dependence?

Key person dependence arises when a company’s performance and firm value relies heavily on one individual or small group of individuals. Key personnel are central to the firm’s overall operations. This risk affects organizations of every size, industry, and geography. Since businesses derive their value from the knowledge, skill, and relationships of their employees, there is an inherent requirement for competency in personnel for creating and maintaining systems, serving clients, and in driving results.

Key personnel contribute far beyond their formal job descriptions. Among their many contributions, they hold deep institutional knowledge, maintain critical customer relationships, manage internal dynamics, and generate new business. These qualitative strengths form the foundation of a company’s success. Over time, their effectiveness manifests in measurable financial outcomes such as revenue growth, operational efficiency, profitability, and (most importantly) sustainable cash flow.

Which Firms are Susceptible to Key Personnel Risk?

While all organizations risk losing good talent, some firms are more reliant on people than others. In a business where the sole shareholder is the only employee, the reliance on a single individual is extremely high. The owner of such a firm is likely responsible for all operations, from client acquisition to the overall strategic direction and focus of the firm itself. Even slightly larger (yet still small) organizations often rely on their shareholder(s) to drive business activity and strategy. It is only until the shareholder(s) cedes some management to others, that the organization is not primarily reliant on the shareholder(s). While the reliance on the shareholder(s) is likely to diminish as firms grow over time, there are still people who are critical for operations. Losing them can destroy a previously successful, thriving business.

While the size and organizational structure of a given firm is a driver of key person dependency, some industries are more reliant on single individuals or small groups. Many service-based businesses have someone who is an expert in the processes themselves and have others who are the client relationship managers. Keeping both skillsets in-house during and post-transaction is critical to the long-term success of an organization. One cannot have a plumbing business without the requisite training, experience, and licensure. However, it is hard to have success as a plumber if one is unable to create and maintain client relationships.

The Importance of Functional Expertise

Key person dependency typically involves subject-matter expertise. Key employees are functional experts in performing their respective roles. That is why they are so valuable to firms. Experts are rare and expensive to hire. They are also challenging to retain and are even more difficult to replace. Key people are talented and likely have many other firms offering them opportunities. Supply and demand characteristics of the job market for key people favor personnel, not firms. Buyers and sellers of firms need to behave accordingly and recognize that driving off talent comes at a huge cost. If key personnel plan to retire or leave, mitigation by sellers should occur before bringing the firm to market.

When functional expertise is brought up, one can be reminded of the classic story involving the ship repair man. In this anecdote, the ship’s engine is broken down and no one inside the organization can fix it. A retired employee is called in for consulting support. He quickly identifies the problem, takes out a tool, turns a single screw, and the engine starts working. The former employee gives the company an invoice of $10,000 for his quick consultation (full story at: https://medium.com/@oceanbcreative/the-ship-repair-man-story-dd959a4469d8).

The man explained that showing up to the site with a screwdriver cost the company $2. The remaining $9,998 of the invoice was from him knowing exactly which screw to turn. The lesson is clear: expertise is expensive because it is irreplaceable. Expertise is the lifeblood of operational efficiency, organizational health, and stability. For buyers, the cost of losing a critical employee without adequate transition planning or replacements can be staggering. When experts leave, the consequences can be catastrophic; the “ship” stops moving.

In this story, the expert retired. In other transactions, they may be let go. In either case, the cost of fixing the resulting problems often far exceeds what it would have taken to retain them in the first place.

Now, imagine that this ship had recently been acquired by a new investor. It is likely that the C-suite executives were retained, but the operational staff who actually knew how to “keep the ship moving” were let go. Buyers do not want to inherit personnel vulnerabilities in transactions. If they do, they may quickly find themselves spending the equivalent of $10,000 on fixes that would have been covered internally for a fraction of the cost by key employees already on payroll.

The ship repair example highlights the risks that prospective buyers encounter when buying a firm. Buyers cannot simply look at employees’ titles to see who is skilled and who is necessary to maintain and expand operations.

Identifying Key Personnel

A question that arises from clients and analysts is: How do CVAs identify these key personnel? The simple answer is that it is challenging to know who is key to operations without having direct, on-the-ground knowledge or experience. A great way to identify which employees are key is to visit the company in person. After all, one can only learn so much about a company through phone calls, e-mail exchanges, and descriptions from a firm’s website. A vital component of our detailed valuation reports is going on a site visit. In site visits, CVAs should interview the shareholder(s) as well as managers. Regardless of the subject firm in question, those conversations are incredibly revealing. One frequently learns of individuals who are vital for operations but hold no executive title. Still, these are individuals whose departure would leave a gap that would be challenging to replace.

Once firm growth occurs, it is also tempting for valuators to assume that the shareholder(s) and the C-suite managers are the only key personnel, but that is often far from the truth. There are some managers who have impressive titles, but very little functional expertise. There are often other non-titled employees who are primarily responsible for keeping operations afloat.

The key takeaway for valuators is that companies are delicate organisms with complicated structures. In a sale, sellers need to communicate with buyers and identify the individuals who need to be retained through the transition. This disclosure is often overlooked in offering memoranda but failing to address it can lead to decreases in value or failed deals.

Mitigating Key Person Risk in Valuation

As stated in the CVA training process, there are two ways to compensate for risks associated with potential loss of key personnel. The first is to modify the pro forma targets, and the second is to increase the company-specific risk premium in the discount rate. The first option could be more appropriate when a key person’s performance is directly related to sales activity. The second option is more likely to be appropriate when the true impact of the key individual(s) is opaque.

Whether through adjustments to projections or modifications to the discount rate, the goal is for valuators to capture the financial impact of losing critical personnel and to communicate that risk properly to all parties.

Artificial Intelligence’s Impact on Key Person Risk

The rapid integration of artificial intelligence (AI) in business operations is likely to reshape the discussion around key person risk. Shareholders and managers will face increasing pressure to determine which employees are irreplaceable and which functions can be automated. This will be exacerbated as the sophistication of AI increases, and it becomes more cost-effective. AI is likely to take care of rote, repetitive, process-driven tasks. Over time, it might encroach on more complex areas, potentially forcing firms to frequently reassess broader staffing needs and operational structures.

The risk-reward equation will become more nuanced over time. Firms may downsize or restructure, viewing roles as redundant. However, decisions carry the danger of inadvertently removing institutional knowledge or specialization that is challenging to identify in the immediate term and impossible to replace. In some cases, firms have offshored their entire workforce or replaced them with AI systems. However, even firms that rely heavily on AI and are highly automated/streamlined are still only effective when those technological systems are properly implemented and managed.

The rise of AI also makes soft skills much more important, particularly for navigating environments with fewer decision makers or flatter organizational structures. In certain industries, the adoption of AI may shift responsibility directly onto shareholders, especially in small or family-run firms. For service-based businesses, the limits of AI’s capabilities may also spur greater investment in human training. While AI can optimize tasks like scheduling, logistics, and diagnostics, it is hard to imagine that AI will replace physical laborers such as plumbers or electricians.

Conclusion

As valuations and the pricing of assets 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. 

---

John Shipp is the Managing Partner and Founder of Meritage Valuation Services (MVS), a valuation and advisory firm, in Fort Worth, Texas. MVS specializes in providing business transition planning, M&A advisory, and strategic consulting services for closely held businesses. He launched the firm after serving as an Associate in investment banking and M&A advisory practice at Generational Equity.

Active in the local business community, Mr. Shipp is committed to helping business owners plan for the future. He is known for his clear communication, strategic thinking, and ability to guide clients through complex decisions with confidence. His skill in distilling financial information into actionable insights has made him a trusted advisor to business owners, attorneys, wealth managers, and other professionals.

Mr. Shipp earned the Certified Valuation Analyst (CVA) designation in 2025. He holds a Master of Science in Finance from Southern Methodist University, graduating with beta gamma sigma distinction, and a Bachelor of Business Administration in Finance from Texas Christian University, graduating magna cum laude. While at TCU, he was in Honors College. He was also one of 32 students in his graduating class selected as a Neeley Fellow. This highly selective, cohort-based program emphasizes leadership, intellectual rigor, and interdisciplinary learning.

Mr. Shipp can be contacted at (617) 348-0213 or by e-mail to jshipp@shippneedham.com.