Author Paul Krumberger, Performance Sciences LLC
Anybody who has started a new business would agree that things never go exactly as planned. Key person insurance, known as “key man insurance” during less politically correct times, addresses situations when things go seriously wrong, such as the death or disability of a company owner or valued employee.
Startup Companies are Highly Dependent on the Skills of a Few Key People
In a startup business, the loss of a key person can result in significant financial hardship, in some cases the failure of the firm. More than other businesses, startups are highly dependent on the skills and contributions of very few key employees. It is common to find that investors or lenders will insist that a startup company maintain key person coverage to protect financial interests. In fact, the SBA 504 Loan program often requires key person insurance coverage, especially on sole proprietors.
Who Should be Covered by a Key Person Policy?
A company can take out a key person insurance policy on the life or health of the owner or any employee whose knowledge, work, or overall contribution is considered critically valuable to the company. Key person insurance is a prudent and inexpensive way of managing the risk of an “unthinkable’ situation.
How Much Key Person Coverage Should a Company Purchase?
A startup company typically finances itself with funds from its owner/managers, borrowings from lenders, equity from outside investors, and trade credit from its suppliers. During the first year or two, successful companies will pass the point of “maximum cash exposure”. This is the point in time when business startup costs have been paid out, purchases of furniture, fixtures, and equipment have been made, inventory and accounts receivable have been funded, but little or no revenue has yet been collected. It is the point in time of maximum cumulative negative cash flow. From a financial view, the point of maximum cash exposure would be the absolute worst time to lose the services of the company owner or a critical employee.
Green Bay based Performance Sciences, a business-planning consultancy, recently added a risk analysis to the custom financial model it prepares for all of its business startup clients. That model calculates the funds at risk from company principals, lenders, investors, and suppliers at the point of maximum cash exposure, also taking into account the projected cash on hand and rapid liquidation value of accounts receivable and inventory. The Performance Sciences model recommends the amount of key person insurance a startup company should carry based upon the unthinkable happening at the worst possible time.
In the event of an untimely death or disability of a single proprietor, the prospects for business continuity are not good. In this situation, the proceeds from the key person policy might allow an orderly liquidation of the business in a way that keeps suppliers, investors, lenders, and the owner/manager’s estate whole.
In a business partnership, the proceeds from the key person policy provides funds to allow the surviving partners to buy out the deceased partner’s ownership position. In this situation, the amount of coverage carried on each partner should be the estimated value of the business times the percent of ownership for each of the insured.
What Type of Key Person Policy Should be Purchased?
Some insurance brokers will push cash value policies for key person coverage. This is seldom the best answer. Term insurance is much less expensive. The rate of return on the investment portion of a cash value policy is generally much lower than the return that can be earned by investing those funds in your own business.
What Other Risk Management Steps Should be Taken?
In addition to carrying key person insurance, it is a good idea to put together a written business continuity plan that defines how the business will function without the key employee. As the value of the company grows, the amount of key person coverage generally should be updated. It is a good idea to review this with your accountant and insurance broker every year or two.
Summary
We often hear business owners say that their company’s most important assets are its people. This becomes painfully apparent when an owner/manager or a critically valuable employees dies or becomes disabled. Business continuity planning, risk analysis, and key person insurance are prudent and inexpensive ways protecting your business’s stakeholders even if a catastrophe happens at the worst possible time.