Having a successful business really depends on your ‘key person.’ Who is your ‘key person’? What is a ‘key person’ to you? To me, it is the person that brings in the business (i.e. the money).
PICTURE THIS:
Darrin, age 39, has become a ‘key person’ on Alan’s team. As the general manager of Alan’s company, Build Co, he has established important relationships with their customers, suppliers and the bank and is largely responsible for the company’s rapid growth. If Build Co were to lose Darrin as a ‘key person,’ the company could suffer lost revenue and the costs associated with getting the company back on track.
THE CHALLENGE:
Alan’s business could be seriously affected if Darrin left the company, passed away or suffered a critical illness. What would the price tag be to replace your ‘key person?’ Alan spoke with his advisors, and determined that the loss of Darrin’s expertise could mean a loss of about $500,000 due to:
• Reduced profit from loss of revenue. That may cause the bank to call in loans or charge higher interest rates on the remaining debt;
• Additional costs to find a replacement general manager. If Alan’s business can’t absorb these costs, its value could be seriously reduced, and its very existence may be threatened. He needs a financial strategy to protect against these risks.
The solution to protecting your business is ‘key person’ insurance. This insurance provides the financial means to stabilize a company during the adjustment period after the loss of a key employee or executive
When a death or disability occurs, the business may lose critical management skills and may experience periods of falling sales and productivity. Additionally, significant costs will be incurred identifying and training the person or persons that have the ability to take the place of the ‘key’ employee.
HOWDOES ‘KEY PERSON’ INSURANCEWORK?
Businesses and business owners regularly use life insurance, critical illness and disability insurance to protect themselves from the risks associated with the possibility of something happening. Using insurance, a business can buy policies on the ‘key employees’ to cover the amount of funds needed to adequately replace them in the event of a death or illness/disability.
In most cases, the cost associated with securing ‘key person’ insurance policies is very small relative to the potential benefit if a key worker can no longer contribute. With insurance in place if something happens, the business would be secure having the policy on the life of the ‘key person.’ The business would own the policy, pay the premiums and be the beneficiary in the event that something tragic happened to the ‘key person.’
After all, ‘key person’ insurance policies are designed to protect the business, not the key employee. If something happens to the key employee, the policy proceeds can be used by the company for any purpose. Normally, businesses will use the funds received from a policy to cover expenses associated with finding a capable replacement, or to cover short term revenue deficits.
THE ADVANTAGES OF THIS STRATEGY:
• The insurance lets you transfer some of your risk to the insurer.
• Your total cost is limited to the premiums paid for the insurance.
• The expense resulting from the loss are no longer unmanageable.
A SITUATION:
As you know, the success of your business depends on its people. Most businesses have ‘key employees’ whose contributions are critical to the growth and stability of the business. Customer relationships are a crucial part of any business as people don’t always buy based on price. The total financial impact could be anywhere from five to 10 times the employee’s annual compensation.
THERE ARE THREE MAIN SOURCES OF COSTRESULTING FROM THE LOSS OF A ‘KEY PERSON’:
1. Reduced Cash Flow — Cash flow will suffer because revenues drop when efficiency is reduced. Business performance will take some time to recover. Other employees may be enticed to other career opportunities during the confusion and uncertainty, compounding the problem.
2. Restriction of Business Credit — Lenders and suppliers may call in loans or tighten payment terms due to uncertainty about cash flow. This could be catastrophic, particularly in a period of time when cash flow may already be reduced by the absence of the ‘key person’.
3. Recruiting and Training Costs — It may be costly to find a competent replacement immediately. Recruitment firms charge about 25% of the new employee’s compensation. Offering incentives such as a signing bonus or above market compensation to attract a qualified individual from a competitor might be the only way to fill the position right away. Even then, additional training may be needed for the person to be as effective as possible.
ALTERNATIVE SOLUTIONS:
There are three strategies available to deal with the risk of losing a ‘key person.’ Namely, these are risk avoidance ,risk retention and risk transfer. Generally, it is not possible to use a risk avoidance strategy to deal with these risks. For example, we can try to live a healthy and safe lifestyle, but certainly nobody can avoid the possibility of disability/illness or premature death. Risk retention is an option. However, the impact of the loss of an owner-manager or ‘key person’ can often be enough to destroy the business.
The business may not have the cash flow or available credit to withstand the loss. The most viable option is rick transfer. ‘Key person’ protection involves transferring the risk to an insurer through the purchase of insurance on the ‘key person.’ The annual cost of the insurance is typically a fraction of the cost of the loss insured. This ensures there is an injection of cash to allow the business to quickly hire a suitable replacement, pay off nervous creditors, etc. And by now you can see how ‘key person’ insurance can be a critical asset protection plan for your business.
The insurance coverage will protect your company in the case of an untimely death or critical illness/disability of a top salesperson, executive or business owner. Business, owners and shareholders alike obtain peace of mind knowing that the business can continue without major disruption in the event of the loss of a ‘key employee.’
WHO MIGHT THEY BE?
‘Key employees’ are those who are critical to the success /profitability of the business. They have a direct impact on company earnings, or whose skills, talents and expertise are crucial to the continued growth of the organization.
EXAMPLES OF ‘KEY EMPLOYEES’ ARE AS FOLLOWS:
• Individuals with creative skills, such as software developers, inventors, etc.;
• Professionals with extensive experience and great relationships with customers;
• Executives that are responsible for managing the daily operations of the company;
• Someone whose death, critical illness or disability would negatively impact the businesses credit.
ARE YOU PROTECTED?
In many cases, and especially in small to medium-sized businesses, success depends upon a few top individuals that possess niche talents, skills and experience. These ‘key employees’ are critical to the long-term performance of the company. Losing one of these essential people due to a death or critical illness/disability can have a damaging effect on any business. Without ‘key person’ insurance in place, most businesses have no option other than to close the business, or sell it to a competitor at a significantly reduced ‘fire sale’ price.
Protecting against the loss of a key business figure is a crucial part of running a business. ‘Key person’ insurance protects a company from economic loss if a ‘key person’ dies, or leaves as a result of illness/disability. It is a sad, but true, fact that companies must continue to function despite the death, disability or illness of a colleague. The loss of a highly influential individual needs to be treated with great care, particularly when they are considered to be critical to the success and direction of the company. Insurance is one way companies protect themselves against a drop in revenue when they lose an important person, either temporarily or permanently. The influence of one or two individuals is substantial in companies where an individual can bring in upwards of 20% of the firm’s revenue every year.
Trying to calculate the value of a ‘key person’ to their company is a science. Sometimes their value is a multiple of the profits generated through their client base, or their contacts or unique skills. It could be a multiple of their salary, but it’s likely you have to get an accountant in to go through the books of the company to try to forensically audit the books. You only have one good kick at the can of packaging the desired coverage you want to have put in place with insurance. The pre-underwriting process is truly the most crucial part of the whole process. And that’s why you need to use someone who works in the corporate/professional market.
As an independent insurance broker, working primarily in the corporate and professional market place, I am very familiar with how to package the best products and know about all of the available coverage’s available. I’d be more than pleased to discuss long term financial and tax planning tailored to your specific needs. I look forward to hearing from you.