Your small business is thriving; one of the 50% that survive five years or more after launching, according to the Small Business Administration. You've got a great business plan, enough capital, and solid growth. So what could go wrong?
How about the death of an important employee? It could be yourself, your top salesperson or some other leader within your small business. Two University of Central Arkansas researchers cite the loss of a key person among the top causes of small business bankruptcies.
What can be done to forestall this problem? Many top entrepreneurs choose "key man insurance."
What is key man coverage?
Political incorrectness aside, key man insurance is a policy that covers your business if someone critically important to the company dies. Many companies also insure these vital employees in the event they become disabled and can no longer perform in their current role.
The company pays the premiums and, in most cases, collects the benefits. The money generally is used for expenses until the business can find a replacement and resume regular operations, though it can be used for other means as well.
Deciding whether you need it
So do you need key man insurance? Take an introspective look at your small business, and be really honest with yourself. Ask yourself the following questions:
- Do you have a succession plan? Maybe you've already thought about what will happen to the venture in the event of your death. If not, consider who will run the business and designate that person well in advance. Nothing is more damaging to a company than a fight over control of it, but even a smooth transition can be traumatic. Will the new leader need a cushion to get up to speed running the venture.
- Are there other vital employees? As mentioned earlier, is there a key salesperson responsible for the success of the business? Someone who understands the technology behind the company better than others? Or even someone with a unique skill set vital to production? How long would it take to replace that employee or employees? Again, key man insurance could help keep things afloat while the company adjusts.
Finally, the choice might not be in your hands. Many investors require you to purchase key man insurance before they provide capital for a company. It's a smart way to protect their investment.
Advantages and disadvantages of coverage
Here's how key man insurance works. The company purchases and owns the policy and its benefits (more on this later). If cash value accrues over the life of the policy, the company has access to it (and it likely will be tax-deferred). If the employee dies, the benefits would be paid to the business, in many cases, tax-free.
One other potential advantage: Key man insurance could be used as a retention tool. You can restructure the death benefit to include a percentage paid to the key employee's family.
But there can also be some disadvantages; premiums aren't tax deductible, and creditors can make claims against the cash value of any company-owned life insurance.
And what happens if the key employee leaves the company? You could opt to drop the policy, but that means you lose what you've invested over the years. Otherwise, you continue paying for coverage for someone who no longer works for you.
A third and relatively new option, is to enter into a life settlement. Basically, you sell the policy to a third-party business, usually for only a fraction of its value. That company will continue paying the premiums, and collect the death benefit.
It's important, when you shop for key person coverage, that you discuss with your agent this scenario of the employee leaving the company.
How much do you need?
There is no set formula for arriving at a coverage amount, according to the Insurance Information Institute. Some business owners purchase coverage based on eight to 10 times the employee's annual salary. Others peg the amount at how much they would lose if the employee dies.
Either way, coverage generally ranges between $250,000 and $1 million, according to the National Federation of Independent Businesses.
How much does it cost?
As is usual with insurance, the cost varies according to the situation. The key person's age, physical condition and health history can affect the amount of the premiums, as will the amount of coverage you choose. But in general, expect to pay less than $1,000 per year for your premium, and possibly much less.
Again, as you should with all insurance purchases, shop your coverage with a number of providers to make sure you get the best deal. Premiums can vary widely among carriers.
Should you purchase coverage? Ultimately it's your decision. As a business owner, you certainly know taxes are inevitable. Unfortunately, so is death.