The sudden death or departure of a key individual—often the founder or owner—can devastate a small business’s viability and value. When operations, customer relationships, or specialized knowledge hinge on a single person, the loss can shift a business from a going concern to distress. This white paper examines the financial, operational, and valuation consequences of key person loss, particularly in manufacturing, and offers practical guidance for lenders and appraisers to assess and mitigate this risk under SBA SOP.

I. Introduction

In closely held businesses, especially in technical industries like manufacturing or professional industries like CPA practices, the owner often serves as manager, engineer, salesperson, and strategist. Their unexpected departure can trigger operational chaos, erode cash flow, and jeopardize loan repayment. For lenders evaluating businesses under SBA SOP, key person risk raises critical questions about ongoing viability and valuation reliability. This paper explores these challenges and provides actionable insights for SBA-compliant valuations.

II. The Role of Key Personnel in Business Value

Key personnel drive intangible yet critical value through:

• Institutional knowledge (e.g., proprietary manufacturing processes).
• Customer relationships (e.g., personal trust with major clients).
• Vendor/supply chain management (e.g., negotiated terms).
• Technical skills (e.g., niche engineering expertise).
• Leadership continuity (e.g., employee morale and direction).

Losing such a person can cripple these capabilities, requiring years—or an inability—to rebuild.

Assessing Key Person Dependency
Lenders and appraisers can evaluate dependency using this framework:

• Revenue exposure: What percentage of revenue relies on the key person’s relationships? (e.g., >30% is high risk.)
• Knowledge documentation: Are proprietary processes codified in manuals or held tacitly? (e.g., undocumented processes signal vulnerability.)
• Replacement feasibility: How long/costly is it to replace specialized skills? (e.g., 6–12 months for a niche engineer.)
• Management depth: Are other staff trained to assume critical roles? (e.g., no cross-training increases risk.)

III. SBA Valuation Considerations

SBA SOP requires valuations to reflect documented financial performance and risks to ongoing viability. Key person loss disrupts this analysis by:

• Causing a sharp decline in cash flow, undermining income-based methods.
• Requiring a key person risk adjustment in the discount rate or earnings projections.
• Potentially shifting to orderly or forced liquidation value if the business ceases to be a going concern.

Valuation Method Impacts

• Capitalization of Earnings: Increase the discount rate by 2–5% to account for heightened risk.
• Adjusted Net Asset Method: Tangible assets dominate when intangibles like goodwill erode, often lowering value.
• Market Approach: Comparable sales are scarce for businesses with high key person dependency, reducing reliability.

Red Flag: A business with >50% of revenue tied to one person’s relationships or undocumented processes may warrant higher discounts.

IV. Empirical Data: Business Closures After Owner Death

Research underscores the prevalence of key person risk:

• The U.S. Bureau of Labor Statistics notes 20% of small businesses fail within one year and 50% within five years, with succession issues as a leading cause.
• A SCORE study found only 30% of small businesses have a formal succession plan, exposing most to disruption.
• The U.S. Census Bureau reports many businesses dissolve within 1–2 years of a founder’s death without strong management continuity.
• Recent SBA data suggests manufacturing businesses face elevated risks due to reliance on owners’ technical expertise, with 15% higher default rates in succession-related disruptions.

While diversified businesses with robust management may recover, most small businesses lack such resilience, amplifying valuation risks.

V. Case Example: Manufacturing Business in Decline

A $2M-revenue manufacturing business (15 employees) suffered after the owner’s sudden death. The owner, a mechanical engineer, held exclusive knowledge of a patented production process and managed 60% of client relationships. Impacts included:

• Staff lacked training to replicate the process, halting 40% of production.
• Sales dropped 45% within six months as clients defected to competitors.
• Profitability turned negative, with a $200,000 operating loss by year-end.
• The valuation shifted to a forced liquidation scenario ($300,000), as future cash flows were unprojectable, down from a $1M going concern value.

This case illustrates how quickly value erodes when institutional knowledge and relationships are non-transferable.

VI. Valuation Adjustments and Red Flags for SBA Lenders

Appraisers and lenders should:

• Identify if the owner performs multiple critical roles (e.g., engineering and sales).
• Verify if operating knowledge is documented or shared among staff.
• Apply a higher discount rate (e.g., 2–5%) or normalize cash flows downward to reflect risk.
• Reassess whether income or adjusted net asset methods apply or if liquidation value is appropriate.
• Confirm the existence of a formal succession or contingency plan.

Valuation Impact Table Example

Scenario	Going Concern Value	Liquidation Value	Key Driver
Strong Succession Plan	$1,000,000	$800,000	Minimal disruption
High Key Person Dependency	$700,000	$300,000	Loss of intangibles
No Succession Plan	$500,000	$200,000	Operational collapse

VII. Mitigation Strategies

To reduce key person risk, businesses and lenders can:

• Develop a succession plan: Identify and train successors over 1–3 years.
• Document critical processes: Codify proprietary knowledge in manuals or software.
• Purchase key person life insurance: Cover financial gaps (e.g., $500,000 policy for revenue replacement), common in SBA loans.
• Cross-train staff: Ensure multiple employees can perform key roles.
• Engage consultants: Hire external experts to bridge skill gaps during transitions.

Lenders should require evidence of these measures in loan applications to safeguard repayment.

VIII. Conclusion

Key person risk is a pivotal factor in SBA 7(a) loan valuations. The sudden loss of an owner can dismantle operations, cash flow, and marketability, often forcing a liquidation-based valuation. SBA-compliant appraisals must adjust for this risk through higher discount rates, normalized cash flows, or asset-based methods. Lenders should proactively require succession plans, verify process documentation, and review key person insurance to ensure business resilience. By addressing these risks early, lenders can better protect loan portfolios and support small business stability.