Boards of directors can no longer claim to be ignorant of the term ‘key person risk’. The term has been around a long time. Yet there still appears to be some apathy towards, or avoidance of, preventing it, managing it or reducing its impact. Simon Franklin, Dequity Partners.

1. Key Issues Risk Management
Key person risks and
corporate responses
By Simon Franklin, Partner, Dequity Partners
Boards of directors can no longer claim What is key person risk?
to be ignorant of the term ‘key person
• Most organisations have Most organisations have one or more
risk’. The term has been around a
key people in their business who, if
one or more key people long time. Yet there still appears to be
not available either temporarily or
whose absence can some apathy towards, or avoidance of,
permanently, can have an adverse effect
preventing it, managing it or reducing
adversely affect business on the business. These effects range
its impact.
from minor inconvenience to challenging
• Best practice to conduct There are plenty of examples to learn
the viability of the business. We need
a key person risk review to identify these effects and determine
from, such as the tragedy of the ‘Busby
whether we need to take any action. Each
annually, and include all Babes’ in 1958 to more recent events such
organisation will have a different appetite,
processes and procedures as the Sundance Resources plane crash in
tolerance, philosophy and ability to
2010. Yet many organisations appear to
regarding the attracting, respond to losing a key person. Hence, we
be ignoring the risk. Why?
recruiting, developing, need consider a range of solutions; one
retaining and exiting Is it because they don’t know how? Is it
size does not fit all.
of people because the risk is hard to predict? Is it
because the subject matter is confronting? Key person risk considerations
• Planning for worst-case Is it because it’s difficult to determine? Is
it because the likelihood of it happening If we examine key person risk in more
scenarios is essential, not detail, we need to consider issues
is low? Is it inconvenient? Is it just another
just to prevent loss of key compliance tick list item of no value? including the following.
people but to deal with it • Who exactly is a key person?
when it eventuates The answer is yes, a combination of all of • Why might you lose a key person?
the above and probably more. No matter • Why specifically is that individual a key
which methodology or framework you person?
use for managing risk, most practitioners
would agree that the basic considerations • What is their actual value now and in
for risk management usually involves: the future to the organisation?
• identifying the risks • If we were to lose them, what
• identifying their likely impact measurable effects would we see?
• identifying their probability of occurring • What is the process for dealing with key
person risk?
• determining the potential cost or impact
to the business • What strategies can we adopt to
prevent or deal with key person risk?
• identifying a range of mitigation
strategies and their value • What examples are there of key person
risks eventuating?
• determining what to do with any risks that
cannot eliminated, reduced or insured. We need to avoid fuzzy language and hazy
definitions. Every item in the list above is
This is exactly the approach needed to definable and measurable which can lead
evaluate key person risk. to a planned response.
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2. Key Issues Risk Management
When we have identified the above, we can Why specifically is that individual • a projection on future earnings if
commence the risk management process. a key person? the person is successful and meets
performance criteria
Loss of a key person could result in:
Who is a key person? • a loss of profits • a factor that takes into account a
person’s impact over time and varying
Most organisations have one or more • a loss of commercial standing
contributions
key people who, if not available, either • a loss of confidence of staff, investors or
• a recognition that a person’s
temporarily or permanently, can have an the market
contribution to the business will end at
adverse effect on the business. Key people
• a loss of key relationships, partners some point
can be defined as those whose absence or
or clients
reduced capacity would have an adverse • a replacement cost.
economic effect on the business. An • a loss of unique intellectual property
Each organisation will have to use
interesting fact is that many key persons • a loss of license conditions information available to it to determine
are not always top performers, leaders or the value of the key person and the level
• a loss of experience and track record
rising stars. Key persons are often spread of risk. The sophistication and sensitivity
throughout the organisation in areas such • wasting time and the expense of
of any financial model is dependent on
as product development, sales, accounting appointing a successor.
available data and critical assumptions. In
and technology. Lazy and flawed thinking practice, many organisations simply put a
that only senior management must be rough projection on the key person value
critical because we pay them so much, What is a key person’s actual and then gauge what response to take.
causes many of the problems in key person value now and in the future to While this might seem an unsophisticated
risk evaluation. the organisation? response, it certainly beats doing nothing.
This is perhaps the single question that
Key persons may not necessarily be causes the most discussion and often
employees. In these days of outsourcing and What is the best key person
leads to paralysis in the risk management
contracting, key people may not legally be risk process?
process. Life insurance actuaries have
employees and the concept of key people built incredibly sophisticated models to It is good practice to conduct a key person
should be considered in a wider context for determine the lifetime value of a person It risk review annually. This review should
each business. A key person could be an is possible borrow from their experience, look at the organisation as a whole with
adviser or an entity such as a service provider reduce the complexity and develop a the narrow focus of key persons. It should
or counterparty. Notwithstanding the above, model for the employee lifetime value. We follow the standard risk management
in this article we will call all key persons don’t need to reinvent the wheel to deal process described above, in line with best
employees for convenience. with key person risk but we may have to practice standards and guidelines such as
think laterally. ISO 31000:2009.
Why might you lose a key person?
More straightforward models might The review should identify all key risk
You might lose one or more of your key include such items as: individuals and why they are deemed to
persons for a number of reasons. A key • the person’s salary with some multiple be a key risk and the scale of that risk.
person might: based on expected time in the business, We might start with a long list of key
• get a better offer and resign their age, their service record, their person candidates and then reduce as
• have to be dismissed for a breach of contract conditions and fees to recruit the process unfolds and new information
contract, inappropriate conduct, policy and train a successor comes to light. The review should assess
or fraud • capitalisation at some discount rate, the organisation’s vulnerability and over-
the direct earnings that can be reliance on key persons. Best practice
• have the organisation lose confidence in
attributed to the key person or their reviews take both a top-down and
them to perform
effect on share capital bottom-up approach.
• lose the confidence of the market,
clients or staff • the value of the going concern, goodwill Ideally, the review should be conducted
or share price that could be attributed with the cooperation and input of those
• be having an adverse effect on morale
directly to the key person responsible in the organisation for human
• take maternity, paternity or long-service
• the insurance value determined by the resources or learning and development as
leave
insurer. well as senior and executive management.
• fall ill, be injured or die.
More comprehensive models might include
such items as:
280 Keeping good companies June 2012

3. The scope of the review should include • job mirroring Lazy and flawed thinking that
all processes and procedures regarding
attracting, recruiting, developing, retaining
• knowledge transfer programs only senior management must
and exiting of people. The review should • key person insurance be critical because we pay them
cover strengths as well as weaknesses and • strong, rigorous compliance programs. so much causes many of the
offer ideas for improvement. The review
should incorporate live interviews with
However, these strategies rarely account problems in key person risk
for wider issues such as loss of market
those deemed to have a high level of key evaluation. We don’t need to
confidence, reduction in credit rating,
person risk. In practice, simply conducting
star quality, track record and relationship reinvent the wheel to deal with
the review and analysis will significantly
reduce the key person risk.
dependence. These risks need some lateral key person risk but we may
thinking and creativity.
have to think laterally.
Specifically, the review should evaluate
Lateral, non-standard approaches include:
how the organisation:
• identifying replacements from outside
• deals with poor performers
the organisation
• deals with top performers or star talent
• commissioning a recruiter to approach
• identifies and manages emerging talent potential candidates and keep a short list
• deals with conflicts • offering lucrative consulting
• deals with staff conduct issues opportunities to leavers
• shares information, knowledge and • keep track of past employees
intellectual property • rotating employees regularly
• evaluates third party outsourcers and • finite contracts with planned
providers termination
• plans succession • pre-written, ready for release public
• shares experience relations material announcing change
of people.
• establishes key shareholder confidence
There are many other mitigation strategies
• establishes insurance valuations. that can be put in place to retain key
Once we have identified who the key employees in individual cases. However,
person is, why they are a key person, what after that has been done and the
impact their loss or absence would have, probability of adverse events occurring has
we can turn our minds to risk prevention been reduced, there is still some residual
and reduction strategies. As a Partner in risk. Residual risk, the exposure left after
a Big 4 accounting firm once said to me, all risk treatments have been applied,
‘Simon, don’t bring me risks; bring me will never go away. This is where the risk
solutions’. Good advice which I have lived tolerance and appetite of the board and
by ever since. senior executives comes into play. If the
residual risk is still deemed intolerable,
more risk mitigation will be required.
What strategies can we adopt
to prevent or deal with key The other issue we need to consider
person risk? is compliance. Policies and procedures
There are a number of simple things we can mean nothing if there is a culture of non-
and should do to reduce key person risk compliance. In the case of the Sundance
exposure. Standard approaches include: Resources disaster detailed below, the
• treat and pay people well company had a policy of not having key
company personnel travelling together.
• cross-training programs
However, because of the time that would
• travel policies and procedures have been ‘wasted’ in complying, it was
• succession planning decided to take the chance and to ignore
it. This is an understandable decision
• documentation and backups
which is very easy to criticise in hindsight.
• skills development programs
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4. Key Issues Risk Management
In practice, simply conducting It would take a strong executive to stand More recently, in 2011, a plane crash in
up in this situation and require compliance Russia killed the entire Lokomotiv Yaroslavl
the review and analysis will with such company rules. We can all ice hockey team while en route to a match.
significantly reduce the key imagine how this would be regarded
person risk. Once we have both at the time and later on if nothing Closer to home was the loss of successful
adverse had actually happened. However, Manly-Warringah Sea Eagles coach Des
identified who the key person is, key person risk can only be managed in Hasler to a rival rugby league club. Reports
why they are a key person, what a compliance focused organisation. The of internal club politics, breaches of
impact their loss or absence culture of compliance must come from contract and disputes proved correct when
the very top, in the case of Sundance the multiple Premiership winning coach
would have, we can turn our Resources, the very top people in the left shortly after the winning grand final
minds to risk prevention and organisation breached simple compliance in 2011. As is often the case in sport, the
reduction strategies. rules with devastating outcomes. coach immediately began recruiting players
loyal to him, compounding the loss.
Examples of key person risks Misconduct
In UK there was recently had the case
Loss of board and management of News Limited’s News of the World
(and market confidence) newspaper which initially was forced to
The most recent, well known, Australian sack a number of its key employees due
example of unexpected risks occurring to the phone hacking scandal. The cost of
is Sundance Resources. In 2010, several this could have been great but in the end
board and key senior executives of it was overtaken by the cost of closing the
the company boarded the same small whole newspaper.
aeroplane in Africa which crashed killing
all on board. It was later reported that the However, the effect is still playing out
decision went totally against company with News International Chairman Rupert
travel policy. When the plane crashed, Murdoch again appearing before the
it left the company without many of Leveson Inquiry into the culture, practice
its key executives. However, due to the and ethics of the press in April 2012.
quick thinking and fast reaction of the
shareholders and management, a ready
Loss of CEO
made replacement, in the form of a When Steve Jobs resigned as the CEO of
previous Chairman, stepped in to run the Apple, it was a shock announcement but
business and steady the ship. one that traders were given time to digest.
The market sensitive information was
Star talent loss held back a few hours so that it was not
There are a number of cases in sporting announced during trading hours. Apple
endeavours where several members of had a ready replacement in Tim Cook and
professional teams were injured or killed a full succession plan in operation and
in a single accident. These include the Steve Jobs was to stay on as the Chairman.
Munich air disaster of 1958 where the By the time Steve Jobs passed away, these
majority of the Manchester United ‘Busby strategies had significantly reduced the
Babes’ team were killed or injured. This impact on market confidence. This has set
was a very famous English football team the benchmark in succession planning.
of young players playing in Europe who
all boarded the same plane in a storm in Stories and examples of key person risks
Munich after playing a European fixture. eventuating help to make it real for
They were nicknamed after their Manager, people. It is the single biggest factor in
Matt Busby, who himself barely survived creating buy-in for risk management.
but eventually recovered and rebuilt the While you have to be careful that you
team which took many years and a good don’t alarm people, it is important that you
deal of expense. It was almost the end of make them aware. Using stories that have
Manchester United football club. an example of the risk eventuating, its
impact and an example of the successful
282 Keeping good companies June 2012

5. strategy employed will create discussion with key person risk is insurance. While • ensure no single person has business
and demonstrate understanding. insurance may be a legitimate response critical information or knowledge
to key person risk, like all business risks, • foster a culture of strong, rigorous
it needs careful consideration before compliance.
Conclusion simplistic solutions are applied to it. The
effect of losing a key person such as a When prevention fails, my top tips for
Managing key person risk is something
team member or team leader, transcends dealing with key person loss are to:
that all businesses should examine
monetary value so, in practical terms, is • understand the likely reaction to such
and should do so regularly. For large
not fully insurable. Insurance is not the news internally and externally
organisations, the loss of one or more
key employees can be expensive and take only response. • have a short-term and long-term
a long time to recover from. For a small successor ready
business it may result in the closure of the While prevention is always better than
• prepare your communication plans
business which may affect not only the cure, key people will almost certainly leave.
in advance
business and its employees but also the Statistically, they are far more likely to
family of the owner. leave or be sacked than die. When they • release your information at the right time.
do, the more preparation you have done,
A bit of thought and planning up-front the lower the adverse impact will likely be. Simon Franklin can be contacted
can save a lot of costs and prevent other on (02) 9258 1972 or by email at
adverse effects on any business should the My top tips for prevention of key person simon@dequitypartners.com.au.
unexpected and unwanted happen. loss are to:
The most common policy for dealing • identify replacements, successors and
workarounds
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