A Professional Key Employee Valuation Method for Business Life Insurance Purposes

The figure above presents a key employee valuation worksheet that incorporates the principal elements of a complete and systematic method of valuation.

The method estimates the difference between the key employee’s and a replacement employee’s contributions to the firm each year over a transition training period. The present value of the differences is an estimate of the amount of insurance required to carry the firm through the transition period. 

The following factors are required inputs:

  • 1. The number of years that would be necessary to locate, hire, train, and develop a replacement for the key employee until the replacement could be expected to match the contributions expected from the key employee. In general, this would be expected to take five years or less, but the worksheet could be expanded beyond five years, if necessary.
  • 2. The firm’s estimated gross revenues for each year of the transition period assuming the key employee were still with the firm. (Line 1)
  • 3. An estimate of the percentage of gross revenues attributable to activities of the key employee. (Line 2) This percentage may be assumed to be equal each year, or it may be varied, depending on the firm’s development plans and the key employee’s role in those developments.
  • 4. The expected total compensation to the key employee each year over the transition period. (Line 4)
  • This may be determined as a percentage of revenues or sales, as might often be the case with a key salesperson, or as some anticipated combination of salary and bonus, as might often be the case with key executives. This amount should include all compensation, including various employee benefits, such as medical benefits and pension contributions, as well as Social Security payments.
  • 5. The total direct (and indirect) costs of locating, recruiting, hiring, installing, compensating, and training a replacement for each year of the transition period. (Line 8) Direct costs, especially in the first year, would include payments for the services of a professional recruiter; advertising; reimbursement of travel, meals, lodging, and local transportation expenses for replacement candidates; moving expenses and the like for the new hire; office outfitting and other possible expenses, such as the cost for a salesperson’s automobile; and the similar costs of recruitment for necessary new support positions, such as an administrative assistant to the replacement key employee; as well as the legal fees often associated with negotiating employment contracts with high-level executives and top salespersons. Indirect costs that should not be overlooked are the opportunity cost of management time spent in the recruitment effort as well as the additional burdens placed on remaining key employees and management, both to cover the lost key employee’s duties until the replacement employee can fully shoulder the burden and to help train or acclimate the new employee.

1. An estimate of the contribution the replacement employee could be expected to make each year to the revenues of the firm relative to the contributions projected for the key employee (as a percent). (Line 6)
Virtually nobody can be expected to step in and immediately match the performance of a true key employee. (If it were easy, the employee would not be considered a key or vital contributor to the firm’s success.) The transition period generally depends on the qualifications and experience of the specific person hired, which is difficult to estimate before the fact.
However, there is usually a tradeoff between the time it takes for the replacement employee to develop her full contributory potential and the initial compensation level of the replacement employee. Trying to attract a person who is extremely well qualified and a better immediate match for the key employee will usually require a premium compensation package and may take more search time, sometimes a year or longer for specialized positions. Thus, it may be more an issue of management preference, than total cost, which route is taken to replace the key employee. If management plans to go the premium replacement route, higher compensation levels (generally even higher than that paid to the key employee) and recruitment expenses should be entered in line 8. Also, correspondingly higher relative performance percentages should be entered in line 6, but perhaps deferred for a year or so to reflect the longer expected time to find the premium replacement. The worksheet can be used to help evaluate the relative benefit or cost of each replacement strategy.

2. The discount rate for calculating present values. (Bottom of Work Sheet)
The discount rate should reflect the firm’s cost of capital or borrowing rate. The rate should be adjusted for the firm’s tax rate. Although death benefits will (usually14) be tax-free, the returns on investment will be subject to tax.

The rest of the worksheet operates as follows. Line 3 computes the total projected revenues attributable to the key employee. Line 5 shows the key employee’s net projected contribution to the firm based on the difference between the key employee’s compensation and contribution to the firm. The replacement employee’s contribution to the firm relative to the contribution of the current key employee is calculated in line 7. The replacement employee’s net contribution (plus or minus) is computed in line 9. Line 10 computes the difference between the net contribution of the current key employee and the replacement employee. The discount factors for computing present values should be entered in line 11. The formula for computing each year’s discount factor is shown at the bottom of the worksheet. Line 12 computes the present value of each year’s loss in net contribution. Finally, line 13 shows the cumulative present value of the loss in net contributions to the firm each year. The value in the last year of the transition period is the present value of the total loss and represents the amount that should be insured.

In this case, the firm’s plans are such that the key employee’s relative contribution is expected to decline somewhat (as indicated by the percentages in line 2) as the firm moves into some new operations. However, as indicated in line 3, the key employee’s contribution is still expected to be substantial and growing. It is assumed the relative contribution of a replacement employee will start at only 50 percent of the key employee’s contribution, but grow to 100 percent in five years. Although the replacement employee’s compensation is expected to be less than the key employee’s, the first-year expenses of recruitment and placement, together with compensation, are expected to exceed the key employee’s compensation. In subsequent years, the replacement employee’s compensation is expected to be less than the key employee’s, but the replacement employee’s net contribution will still remain lower than what the key employee would have contributed. Based on the projected figures, the insurable value of the key employee is about $482,000.

The worksheet may be a useful tool in justifying the desired amount of key employee coverage and convincing the insurer that there is sufficient insurable interest to issue the policy. In addition, it may be helpful in supporting the accumulation of contingency funds in excess of what may otherwise be allowed under the excess accumulated earnings provisions if challenged by the IRS.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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