Key-Person Risk: a Worked Example

A company on a balance sheet can be one individual in practice. The founder prices every job, knows which customer pays late and why, and is the only person the largest client will ring. None of that appears in the accounts. A bank lends against the cash a business will earn in future, so when that cash rests on a person rather than a process, the loan carries a dependency no covenant ratio measures. The management read asks whether the people running the business are good. This question comes after it, and it bites harder the better they are: the stronger the founder, the more there is to lose.

The dependency comes in four kinds. Customers follow a person rather than a firm. A skill or licence is held by one individual: the certifying engineer, the only operator who can run a process. Authority sits with one person: the sole director, the only signatory on the bank account. And money stands behind one person: the guarantor whose assets the bank counted when it said yes. US bank examiners' core procedures list key-man risk and the management succession plan among the management issues a commercial credit assessment should reach.

Each line is an estimate, and the work is in the evidence behind it. For the first, the lender asks who looks after each account, not only who the customer is. For the second, it reads contracts: some customers can end an arrangement if named staff leave, and some tenders score the individuals put forward. For the third, it asks what a replacement would cost and how long the search would take, since a founder often draws less than the market would pay a hired manager. The cover figure shows whether the loan survives the year of adjustment.

Authority is tested separately because it can stop a business within days. If one person is the only director, the company may have no one able to sign until a new director is appointed, and the route to that depends on the company's constitution or articles and the law of its market. A bank account with a single signatory can hold up the payroll in the same week. These gaps are cheap to close, which is why a lender asks about them early.

A geotechnical engineering and drilling firm, constructed for this page like every figure in it, has revenue of US$14.0m and EBITDA of US$2.4m. Its founder is 61, owns all the shares, is one of two chartered engineers, and personally holds the relationships behind 55% of revenue. The firm asks for a US$3.6m term loan to replace two rigs, repaid at US$0.72m a year over five years at 8%. After tax and maintenance capex of US$0.6m, the lender works through three cases, in US$m.

Death and retirement look alike in a forecast and are very different to a lender. The policy repairs the loan if the founder dies and pays nothing if he retires or sells up, which at 61 is the likelier way for him to go. So the bank approves with both: the policy assigned to it, a second director and signatory before the first drawing, and the second engineer introduced to the main clients with a stake that gives her a reason to stay. The attrition rates, cover amount and terms are the example's, not a market norm.

Succession is the planned version of the same event: the person leaves on a date, with time to hand over. Key-person risk covers the unplanned version as well, and a file can have a good succession plan for five years hence and no answer for next Tuesday. A change of control clause watches something else again. It fires when the shares move, and a founder who steps back while keeping every share may not touch it at all, so a lender that cares about the person has to name the person.

A personal guarantee is often offered as the answer and answers a different question, because it gives the bank a claim on assets and does nothing to run the business. In private equity and fund documents, a key-person clause usually means something narrower: a term that can suspend a fund's investing if named managers leave.

DEFINED IN ONE PARAGRAPH → · HOW BANKS ASSESS MANAGEMENT → · CHANGE OF CONTROL →

A one-person dependency is common in owner-run lending and seldom ends a file by itself. What it changes is the structure. A lender may shorten the term so that the debt is mostly repaid before the founder's likely exit, ask for faster amortisation, or lend less. It may write in a review event that opens a conversation if a named person stops working full time, or require assigned insurance and a date by which a named deputy is in place. A successor mentioned at a meeting does not count until the organisation chart has changed.

The risk also moves with the calendar: a five-year loan to a founder of 50 and the same loan to a founder of 61 differ in how likely the event is before maturity. A third-generation farm and a retiring patriarch make up Issue 03, a succession plan the bank hears about late.

ISSUE 03 · THE SUCCESSION FILE → · THE BANK'S REVIEW EVENT →