Business Succession Planning Part 2: How Life Insurance will insure the Life of Your Business
As a follow up to my first article on Business Succession Planning, there are a number of ways that Life Insurance can be fit into the life of a successful business owner.
There are two basic ways in which a business owner will want to look at Life Insurance for the life of their business:
Buy-Sell Agreement Funding
As referenced in my previous article, if an owner dies in a situation where there are multiple partners (or even as few as two) who own the company, the shareholder's agreement likely has provisions for the deceased owner's shares to be bought by the other owners.
Here's the rub: depending on how the shares are valued and depending on how large the company is, the other owners probably don't have the cash kicking around to buy out the deceased's shares at the drop of a hat. Nor does the company have that kind of dough in the bank.
In fact, many a company has gone bankrupt or into unshakable financial duress due to improperly funded buy-sell agreements and the consequent inability to carry the terms through.
Structuring Life Insurance for Buy-Sell Agreement Funding
The way around this mess is to purchase Life Insurance on the lives of each of the owners. The beneficiaries are the surviving company owners. That way if Bob dies, a life insurance policy on his life will give the other owners the cash to purchase Bob's share of the company. The company remains solvent, and Bob's estate (family) receives the money from Bob's share of the business.
The good news is that depending on how the policy is structured and the type of business, the life insurance premiums are often tax-deductible, and the insurance proceeds are also tax-free. It's a great way to process a relatively small tax-deductible expense with the promise of receiving a relatively large tax-free lump sum of money just when it is needed.
Key Man Insurance (Key Person Insurance)
Business owners are quick to insure the company against the loss or damage of its property on the basis that office equipment and inventory are valuable assets. Such assets, however, may not be as valuable as key employees.
Consider a top salesperson who is unsurpassed at bringing in new accounts, or a manager who handles the day to day operation of the business. Key employees like these are a firm’s most valuable resource.
If a key-person died suddenly, profits could be impacted and there might be considerable costs incurred in recruiting, hiring and training a suitable replacement.
So why insure the life of a key employee? Although it won't replace the work that the key employee did, the extra cash will provide a cushion to:
- Keep the business running
- Offset expected reductions in sales revenue
- Find and train a new person to assume the deceased’s role
Believe it or not, when applying for substantial business loans, some banks will actually look for key man insurance depending on the structure of the firm to ensure that an unexpected death won't be the end of the company (and an end of the loan payments).
Examples of key employees would be anybody whose special skills contribute significantly to the bottom line, like:
- Active business owners
- Employees who have strong relationships with major customers
- Employees with specialized knowledge that is hard to replace
Structuring a Key Man Policy
The company purchases a life insurance policy on the employee. Both the owner and the beneficiary of the policy is the company. So if the employee dies, the money goes to the company (tax-free).
Obviously the amount of insurance needed is dependent on the level of value the employee has on the company's operations. Things to consider include:
- How much would it cost to replace the employee? (including recruitment fees, etc)
- How much net profit does the employee's work result in?
- How much would it cost the company if the employee died today?
- How much can the business afford (or how much is the business willing to afford) for this insurance?
The need and desire for Life Insurance (either Key Man or Buy-Sell funding) will vary from company to company and person to person. It is an intricate situation that incorporates the nature of the business, the needs of the owner(s), as well as their respective family situations. No one piece of the pie can be examined in isolation from the others.
And with so many things, life will continue to change, so periodic re-evaluation of needs (along with a "gut check") is always prudent.