Life insurance needs are unique to everyone. This is particularly true if you're a small business owner who is keen on protecting both your business and personal interests after you pass away.
However, calculating your exact life insurance needs is not easy. An unexpected death can negatively affect the financial certainty of your small business and family if you don't prepare for it. With the right life insurance coverage, you can make sure that your financial obligations are taken care of.
Before we talk about how much life insurance you need, let's go over some important points.
Life insurance for your family
If you have family members or others who depend on you, term life insurance is the simplest insurance option. You choose the amount you want your beneficiaries to receive when you die (the death benefit) and the period you'd like to be covered for (the term).
For instance, you can pick a death benefit of $700,000 for a term of 25 years. Should you die at any point in the next 25 years, your beneficiaries will receive the full $700,000 amount to cover their expenses.
Should you survive the term, you lose out on the death benefit. You can still renew your policy, but keep in mind that premiums are more expensive the older you get. This means you will pay a higher monthly premium when renewing your term policy.
Term insurance to pay off business liabilities
Your death might not mark the end of your business. Perhaps you'd like for your family or business partners to carry on the company without experiencing financial distress. You can designate part of your death benefit for this purpose.
There is often a transition period after your death. This allows the business to have enough capital to pay off its liabilities, such as loans (personally guaranteed by you), wages, suppliers, and rent. This way, operations can continue in the short term while the business figures out ways to generate the same level of income you were bringing in.
Life insurance to buy out a business partner who passed away
When you die, the business owes your estate your share of the operation. If there was a buyout (buy/sell) agreement in place, the surviving partners have the right to purchase your share from your estate.
While buy/sell agreements don't need a funding element to be valid, many businesses use life insurance – usually term insurance. This ensures the remaining partners have enough money (or part of it) to buy out your beneficiaries.
Permanent life insurance is another option. With this type of insurance, premiums are paid throughout the policyholder's life. There is also an investment component to it, because the premiums earn interest over time. Upon the death of the policyholder, the beneficiaries will receive the death benefits as well as the interest.
If a business partner were to leave the company before their death, the death benefit will be lost, but the interest can still be claimed.
Permanent life insurance can also be used to fund a buy/sell agreement. However, it can be five to 15 times more expensive than term life insurance.
Insurance for key employees
There are other people in the business whose death could affect the company negatively. For example, a company could have a salesperson who is responsible for a large portion of the sales generated. This person's death means the business will suffer in sales, making them a key employee.
An insurance policy on this high-performing individual (key person insurance) can help the business cover the revenue that person would have brought in for a certain period. This allows the business to look for a replacement with little to no financial setback.
It is best to take out a term life insurance policy on key employees, because they may only be employed for a few years.
Other needs for life insurance
Life insurance also provides the liquidity necessary to handle challenges for both your business and beneficiaries after your death. These are some other possible purposes:
- Settling taxes incurred for the transfer of ownership due to the appreciation of the business, which can be significant.
- Paying lawyers to ensure that your estate and your interest in the business is distributed smoothly and equally among your beneficiaries. This can be extremely useful if you intend for some of your beneficiaries to become or remain shareholders while excluding others.
Calculating your exact life insurance needs
Now that we've discussed when you need life insurance, it is time to calculate how much life insurance you need.
Term life for family and business liabilities
To make sure that your family is covered, as well as the liabilities of the business, follow these three steps:
Step 1: Calculate your family expenses.
This is the amount of money your family will need after you are gone. A common formula people use is DIME:
Each letter in the acronym is a category for grouping expenses. For example, for debt, you can include:
- Personal loans
- Auto loans
- Credit card expenses
- Other related expenses
For education, you can include the cost of your children's college tuition.
Once you add up all the expenses from each category, you will know the amount of money needed to cover your family.
Step 2: Calculate the total projected business liabilities.
Start by listing all of your current (short-term) and long-term liabilities. These are some examples:
- Accounts payable
- Taxes on investments
- Salaries payable
- Interest payable
Add them all up to find out just how much your business owes.
Step 3: Add it all up.
Add the results from steps one and two. This is your total term life insurance needs for your family. You can purchase term life insurance for this coverage amount.
Term life insurance for buy/sell agreements
Take these steps to find out how much it would take to buy out each partner in case they die:
- Use Clearbanc's evaluator to connect your sales, marketing, and accounting data and get a business valuation within 24 hours.
- Divide the amount you get by the number of business partners. That is how much term life insurance is needed to fund the buy/sell agreement for each partner.
- Don't buy insurance based on price alone. Consider other factors like the coverage length and conditions to make sure it covers your needs.
Key person insurance
Follow these steps to find out how much insurance you need for your business's key individuals:
- List every one of your key employees.
- Calculate the amount needed to cover the transition period for each of these employees to continue operations until a replacement is found.
If you have dependents, you likely need life insurance. As a small business owner, you fit the bill.
Life insurance ensures that you leave your business and beneficiaries (your family in particular) financially secure. It also allows your business partners to buy you out when there is a buy/sell agreement in place. Taking out life insurance on your key employees as well ensures that you have funds to cover the transitional period if they leave the company or die.
Calculating how much life insurance you need is important. Luckily, you have all the information you need right here to get started.