With apologies to all of you non-basketball fans out there, this blog entry will once again focus on LeBron James and his impending free agency. After all, it is the primary (only?) sports story in Cleveland this summer. As my colleague wrote in a previous entry, LeBron’s decision to stay or go this summer will have a dramatic impact the value of the Dan Gilbert’s investment in the Cavaliers. Here’s another perspective on how LeBron’s decision might be illustrative of the value of your business.
The concept of the “key person discount” is often bandied about in valuation circles. The idea is that a certain employee of the subject company, typically the owner-operator and founder, creates value due to his or her unique ability to run the business, enhance performance, or generate revenue. One might ask, "Why would that be considered a reason to discount the company’s value?" It seems as though such an individual creates a competitive advantage, and thus, a higher value. The key person discount contemplates the impact of the potential exit of that individual from the business, and the resulting sustainability (or lack thereof) of the business after that exit. In other words, the key person discount is a component of risk due to the fact that the success of the company is inordinately tied to a single person.
To get back to the LeBron analogy, think of the “stay” or “go” scenarios and the impact on the Cavaliers’ ability to perform with or without him. Take it one step further, and consider what the odds makers in Vegas are thinking right now as LeBron’s future is in question. One thing is certain – whichever team is able to sign LeBron will see a significant uptick in its likelihood to win the NBA Championship next year (i.e., improved odds). This volatility and uncertainty is simply an added risk associated with Cavaliers’ ability to win basketball games in the future.
In business valuations, we handle volatility through the discount rate. Therefore, an additional component of risk would be included in our discount rate for a key person, such as LeBron is for the Cavaliers. In the valuation world, this would drive a lower value due to the added risk of the related investment.
Of course, many subscribe to the “Ewing Theory” which was popularized by Bill Simmons. A summary of the theory is linked above, but the basic idea is a team may be better off without its superstar and, under the right circumstances, will actually perform better if the superstar gets injured, is traded, or leaves through free agency. In other words, it is a scenario of addition by subtraction. Simmons offers some very compelling examples of this notion. It is common for valuators to encounter this situation (e.g., an owner taking excessive compensation) from time-to-time, but we will hold that back for a later entry.
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