Key Man Clause

A contractual prohibition against new investments by one or more key persons in a company

What is a Key Man Clause?

A key man clause is a contractual clause that prohibits an investment firm or fund manager from making new investments if one or more key persons are not available or they fail to devote the required time to the investment. A key man is an important employee or executive who is critical in the operation of the business, and his/her death, absence or disability may negatively affect the operation of a company. Key people possess skills, knowledge, leadership, and experience that are important for the continued success of the business.

 

Key Man Clause

 

Some businesses such as private equity firms, mutual funds, and other institutional finance managers demonstrate huge dependency on particular executives who oversee the smooth running of the business. If one or more of the named executives dies, quits, spends too much time on another job or is convicted of a serious crime, the key man clause puts investing on hold at the earliest time possible. The firm cannot make new investments until a new suitable replacement is found. In small companies, the exit of a key person may mean that the investment firm must end, depending on how critical the person was.

 

Importance of the Key Man Clause

The key man clause is common in investment firms that handle millions of dollars of other people’s money. Before entrusting these investment firms with such large funds, investors want to be certain that they are investing wisely and in a company that is a going concern. Large investment firms often employ a few important decision-makers, and with a key man clause, they will be confident in the firm’s ability to keep their money safe. The exit or absence of the important decision-makers puts investors’ money at risk, and this may result in losses.

A key man clause serves as a form of guarantee that the firm makes to the investors, assuring them that only the most qualified and senior executives handle important decisions. Since investments run for several years, the key man will be tasked with making critical decisions in the course of the investment period to ensure the highest possible returns. One of the concerns of investors is what happens if a key person overseeing their investments exit the fund or ceases to be involved in managing the fund. In large investment firms, a key man clause allows them to replace its top executives and do so quickly to eliminate any negative effects.

A business may also purchase key man insurance such that, when a key man leaves the organization, it receives compensation from the insurance company. Key man insurance compensates the business for the financial losses arising from the extended absence or death of a top decision-maker. The insurance does not indemnify the business from the actual losses but provides a fixed monetary sum that is specified in the insurance policy to facilitate business continuity. The insurance compensation helps to offset the lost income from delay or cancellation of business projects the key person was in charge of, lost sales and loss of specialized skills. The compensation helps finance the recruitment and training of a replacement and pay temporary personnel.

 

How to Implement a Key Man Clause

Although it is not a requirement for businesses to adopt a key man clause, it is becoming a common trend among businesses that want to protect themselves from the exit of important executives. Not only does the key man clause protect the company’s interests, but it also lets the investors know that their investments are safe. Businesses can implement the key man clause in the following ways:

 

Create a Key Man Clause

The first step that the business should take is to identify all the important decision-makers who are at the center of the business operations, and whose exit may result in losses to the business. The owner of the business can insert a key man clause in the contracts of all key persons in the organization.

The key persons may include sales directors, head of product development, operations manager, head of ICT and other top executives. Any new replacements that come in or employees who are promoted to the senior management level should sign a new contract with a key person clause.

 

Create a Replacement Plan

A replacement plan outlines the steps that the company will take in case a key person dies, resigns, is fired or is absent for an extended period. It also lays out the timelines for recruiting and training a replacement to continue with the work of the former executive. For big companies, the plan will dictate who takes charge in an acting capacity before a permanent replacement is found.

 

Key Man Insurance

A company may take steps to insure key person to cushion the company against the unexpected resignation or death of key persons. The insurance compensates the business for any losses caused by the resignation of the key person.

 

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