Key Man Clause – Meaning, Importance, How to Implement and More

Key Man Clause is a contractual term that protects the lender or investor. The presence of such a clause prevents a company from taking decisions in case their key employee is not available. The idea is the absence of key employee could make the company less skillful, or they take a decision that may not be in the best interest of the investor or lender.

Though the concept is applicable to all the businesses, including manufacturing firm, technology oriented firm, investment firms, etc. The presence of this clause blocks the investment firm or a fund manager to make a new investment if a key person is not available at the time of decision. Or, if one or more key personnel arenot giving enough time to decide on the investment.

There is one more perspective to this clause where investment is being considered in a business, where the skills of one the promoters/stakeholder is of critical importance. Because, the business revolves around that core skill set which has by now got a reputation. And customer flogs to that business due to that skill set or reputation. Hence, in such a situation this clause mandates that the Key Man will not dilute his stake in the business beyond a set limit. In other words, till the loans or investments are there in the business the Key Man’s total stake can not fall below a minimum percentage. This is again to ensure that the business continue to enjoy and attract the business due to the presence and operational skill of that Key Man.

Who are Key Employees?

The key person here is basically a person whom the investment firm consults or a person responsible for making new investments, taking decisions, or having the core competency to run that business. Or, whose exit could result in a potential loss to the company. In such a case, the firm can continue with the new investment only if that key person is available or is back, or they have got an apt replacement for that key person. For example, sales head, operations head, other top managers, specialists doctor or software expert, design manager, etc.

One exception to this rule is the investments that the two sides agree on or made prior to the inclusion of the key man clause. This means the investor does not get the money back if it is already invested before the insertion of the clause. Rather, the investment firm will not use the funds for making a new investment. 

Key Man Clause – Why?

Investment firms, a mutual fund or a private equity firm, deal with massive amount of money that belongs to investors. So, a wrong decision could result in huge losses to the investors. Thus, to prevent such losses, investors ask for a key man provision. Such a clause ensures that their money is handled efficiently by those who have the requisite skills, knowledge and experience.

Same analogy remains applicable to the other types of businesses, where key skillset of key man is vital for the successfull and efficient operation of the business. Key Man’s presence helps and drives the business on its growth path. Basically key man steers the business ahead.

Generally, the fund managers exit a company or take a leave after an end of the cycle. But, sometimes the key personnel leave mid-way, and this is when the key man clause comes handy. It works like a hurdle for the person moving out and the entity and its management to ensure that the person stay put till the completion of a cycle.

Such a clause is mainly in place for smaller or new funds or thematic funds where the exit of a single fund manager or investment officer could risk the existence of the fund itself. Also, such a clause is practically more applicable to smaller firms than big companies in other businesses. This is because bigger companies may be able to diversify their risk in a better way or may have more than one such skilled personnel. Also, such companies do not usually rely on one or two key persons to take important decisions.

Importance of Key Man Clause

Following points help to bring out the importance of the key man clause:

Big Money at Stake

It is the responsibility of the investment firm to take proper care of investors’ money, which can run into a million or a billion dollars. In such a case, just one bad decision could wipe out investors life-long savings. 

Reputation at Stake

If a key man is missing, and the investment firm does not replace it, then it raises a question on the efficiency and efficacy of the management. Also, if the investment firm makes a bad decision, it would not only push their existing investors away but potential future clients as well. 

Gives Credibility and Shows Professionalism

Investors nowadays specifically ask for a key man clause before handing over their money to an investment firm. If the firm agrees to the clause, it gives investors some sense of security for their investment. Also, if an investment firm already has such a clause in place, it shows their professionalism.

All these point remain valid for other businesses too where the presence and skill of key man of utmost importance.

Key Man Clause

Triggers of Key Man Clause

Following are the situation when this key man clause triggers:

  • In case of the death of the key person.
  • When the key person is away and affected by some long-term disability.
  • If the key person has picked up a job with another company/competitor.
  • The investment firm has fired the key person without having its proper replacement.
  • If the key person is unable to give needed attention because of personal reasons or lack on interest and that may affect the business of the company.
  • If the key person is no more fit for the job.
  • This clause also triggers if the key person is convicted of a crime.

How to Implement?

There are no hard and fast rules to implement the key man clause. But, there are a few common steps that can help a company to properly implement this clause:

Create the Clause

 A company must determine all the key personnel that are crucial for their survival. These executives should be such whose exit could result in a considerable loss to the firm. For example sales head, operations incharge, and other top managers. Therefore, once identified, the clause has to be built into their appointment itself or a separate convenant or agreement with key personnels, not to leave the business or not to reduce their stake in the company, except in certain conditions as provided in the agreeement.

Design a Replacement Plan

The replacement plan detail all the measures that a firm will take in the event of a key person leaves, dies, or is not available for some reason. This plan also includes the timeline within which a company would get a replacement. Also, it may include a temporary reinstatement until the company gets the permanent replacement.

Key Man Insurance

A growing trend nowadays is to take insurance for the key employees. This helps a company, in case, that employee is not available or his inability to attend to the company’s business due to accident or otherwise. Or in the unfortunate event of Key Man’s untimely death. The insurance saves the company from any potential loss because of the absence of a key employee.

Final Words

Even though it is not mandatory for a company to adopt the key man clause, the businesses are now increasingly adopting it. This not only helps the company to prevent themselves from the untimely exit of a key employee, but also enhances their reputation. At the same time, it gives investors some peace of mind. This clause gives the company and to the lenders and investors an assurance that company can continue to grow and run its business without any such interruptions or disrutptions.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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