Key Person Insurance: How to lessen the blow when your business loses a linchpin
Posted: 01 February 2019
As much as you try to share skills, knowledge and information in your company, you probably have some people who are key to your business’ success.
It might be a Director or the CEO, whose vision made it a success in the first place. It might be your star salesperson, or someone in your IT area who knows the system backwards. It could even be someone who doesn’t create any revenue but does a fantastic job of boosting your company’s reputation or perhaps running your admin and back office systems.
Now, what would happen if you suddenly lost one of those key people?
And if you think it would never happen because they love your business so much, think again. Sure they may not resign. But they might decide to start a family and want to leave the workforce. Or what if they suffered a major illness or injury, or even passed away?
In addition to the obvious issue of lost productivity and their contribution to the business, you also have to spend time (and money) to recruit and train a replacement. And losing such a key person in your company could even affect your reputation and credit standing.
Could your business survive until you find someone who can fill their shoes?
Key Person Insurance can help you get back on your feet
Key Person Insurance can give you the financial support you need while you’re getting back on your feet. It can offset both your costs (e.g. hiring temporary help or recruiting and training a replacement) and your losses (e.g. not being able to do as much business until they finish their training).
It can also help with:
- business succession planning
- protecting your company’s equity value
- agreed funding to purchase the equity
- continuity of equity value for the surviving spouse
- funding re-payments of any capital loans or personal guarantees
- meeting requirements for bank business loans
- salary packaging benefits (depending on the person’s taxation affairs).
And you can take out a policy (which is usually tax-deductible) on anyone you feel is a key person in your company.
How much should I insure them for?
You can set the policy amount to be anything from $500,000 to $10 million. Of course, the amount you specify will depend on the size of your company and the person you’re insuring.
The amount can be calculated in a few ways, including:
- the ‘replacement cost method’, which is based on the cost is to replace the key person
- the ‘contributions to earnings method’, which is based on the percentage of their earnings towards your company’s revenue
- the ‘multiples of income method’, where their current salary is multiplied to determine their value.
Protecting your partners (and their partners) with a Buy/Sell agreement
What if the key person happens to be your partner in the company? Yes, the Key Person Insurance may well cover the finances involved in buying your partner’s shares from their family. But do you really want to be negotiating a deal at such an emotionally trying time?
Having a Buy/Sell Agreement in place can save everyone from a lot of anguish. It’s a legally binding agreement that determines what will happen to each stakeholder’s shares if they suffer a major illness or injury, or pass away.
It has two parts:
- The Disposal Mechanism (also known as a Business Will), which states what happens if a partner leaves the business due to death or disability. It usually contains a valuation method.
- The Funding Mechanism, which funds the Buy/Sell Agreement. This is where you would find the details of the Key Person Insurance policy taken out for each partner.
How do I arrange Key Person Insurance?
Before you take out Key Person Insurance you should first speak with your business advisor about the overall approach and then get into the details with an insurance broker. You need to make sure you get the cover you need without paying for the cover you don’t need. We can guide you in this area.
After all, it may well be the key to your company’s survival.