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 to devote the necessary time to the investment. A key man is an important employee or executive who is critical to the operation of the business, and whose death, absence, or disability may have a significant negative effect on the operation of a company. Key people possess skills, knowledge, leadership abilities, and experience that are considered crucially important for the continued success of the business.
Some businesses, such as private equity firms, mutual funds, and other institutional finance managers evidence a significant dependency on particular executives. If one or more of the named executives dies, quits, spends too much time on another job, or is otherwise unavailable, the key man clause puts investing on hold. The firm cannot make new investments until a suitable replacement is found. In small companies, the exit of a key person – for example, a hedge fund manager – may actually mean that the investment firm must end, depending on how critical the person was to the business operation.
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 with a company that is a going concern. Large investment firms often employ a few important decision-makers, and the exit or absence of one of these key people may put investors’ money at risk. A key man clause helps to reassure investors that no huge changes in the firm’s approach will occur without the presence and input of a good steward for their money.
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 may remain in place for several years, the key man will be tasked with making critical decisions during 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 exits the fund or ceases to be involved in managing the fund. In large investment firms, a key man clause helps the firm to quickly provide an effective replacement for top executives when necessary.
A business may also purchase key man insurance. Key man insurance compensates the business for potential financial losses arising from the extended absence or death of a top decision-maker. The insurance does not indemnify the business from actual losses but provides a fixed monetary sum, specified in the insurance policy, to facilitate business continuity. The insurance compensation helps to offset any lost income from delays or cancellation of business projects the key person was in charge of, from lost sales, and from loss of specialized skills. The compensation also helps finance the recruitment and training of a replacement and paying 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 clause protect the company’s interests, but it is also reassuring to the company’s investors.
Create a Key Man Clause
The first step in creating a KM clause is to identify all the important decision-makers who are at the center of the business operations, and whose exit may result in substantial 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.
Key personnel may include sales directors, heads of product development, operations managers, investment managers, and other top executives.
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 the work of the former executive. For big companies, the plan will dictate who takes charge in an acting capacity until a permanent replacement is found.
Key Man Insurance
A company may take steps to insure key personnel to cushion the company against their unexpected departure. The insurance compensates the business for potential losses that may be caused by the loss of the key person.
Thank you for reading CFI’s explanation of a key man clause. To continue expanding your knowledge of business and investing, check out the following CFI resources: