I read a stat recently that stated 71% of small businesses depend heavily on a few individual owners and/or employees. This number makes quite a bit of sense, once you consider the limited resources most small businesses have to work with. It also presents a great deal of risk. Losing a key employee, manager, or professional could easily be the death knell for businesses without much bench strength.
To protect themselves, their families, and their businesses from this possibility, many business owners use life insurance. As you probably know, life insurance comes in many shapes, sizes, and forms. Depending on your business and objectives, there is probably a way to minimize the risk of your or your colleagues’ premature death using life insurance.
There is a lot to write about on this topic – in part because there is such a wide variety of life insurance products available. This post will review 8 considerations when protecting your business with life insurance. If you’re dipping your toe into the subject for the first time, this is a good place to start.
1) There May Be Lives Other Than the Your to Insure Too
Most people think of life insurance as a means to protect their family members. If you die prematurely with a policy in force, the insurance company will cut a check to the beneficiaries of the policy. Pretty important tool if your family relies on your income or production.
When you think about using life insurance as a tool to protect your business, you may want to think about incorporating your employees or other stakeholders. What would it mean to your business if your top salesperson or lead manager died this year? If the financial impact is significant, you may want to consider a key person policy. Key person life insurance is a policy owned by your business that covers the life of an important employee.
2) It Can Be Used as Compensation
Not only can key person insurance be a helpful risk management tool, it can be structured as a benefit as well. For example, a split dollar life insurance policy is a cash value life policy owned and paid for by the business. The death benefit of the policy is used to protect the business, but the cash value is a benefit to the employee. If the employee doesn’t die before retiring, they get to walk away with the cash value remaining in the policy.
There are many variations of the example above, including reverse split dollar policies (the death benefit goes to the employee’s family, the business controls the cash value). Again, the structure is flexible & can be tailored toward the business’s circumstances and objectives.
3) Solopreneurs Need Life Insurance Too
One misconception about using life insurance to protect your business is that solo shops don’t need it. If there are no partners or employees, who would be impacted if you died early?
The obvious response is your family. Yes, life insurance can help replace your future earnings and business profits that your family would miss out on. But it can also be used as a continuity plan. Whether it’s forming a buy/sell agreement with another professional to buy your business with life insurance proceeds, or simply a little extra cash to incentivize a colleague to ensure your clients are well taken care of, life insurance can be very convenient.
4) Life Insurance Buys Your Family Time
About half of small businesses do not have a continuity plan. If you fall into this category and die without setting up a formal plan for your business, your family will probably left to pick up the day to day operations where you left off. Chances are that your family is not as excited about (or adept at) running your business as you are. Being forced to pick up the reins and learn on the job to “keep the ship afloat”, while grieving, would probably be a horrendous burden.
Plus, it’s not uncommon for surviving families to be backed into a corner financially after the death of a business owner. Whether they need the money to service debt, make payroll, or pay their living expenses, the worst case scenario is a forced fire sale of assets to raise cash. Life insurance can help prevent this situation, and at least buy them some time to figure things out.
5) Life Insurance Can Prevent Collateral Damage
Many small businesses out there are financed with bank loans, using personal property (like your home) as collateral. On top of that, banks will often include covenants that make the loan due upon the death of the business owner. This can be a recipe for disaster if left unmitigated. Coming up with the cash to repay a bank loan (or risk losing your home) would be a terrible chore for a grieving family. Life insurance is a very convenient way to cover these future liabilities.
6) A Trust is the Cadillac of Continuity Planning
“Cadillac of Continuity Planning” was not a phrase I could pass up. In it’s simplest form, plain old term life insurance can be obtained to protect your business and your family if you die prematurely. Your beneficiaries receive the death benefit, and all is well financially. Life insurance alone won’t help you with continuity planning, though. Who will take over your business? Will it continue operating or be liquidated/sold off? Who will take care of the clients, and who is in charge?
This is where a trust can come in handy. With the help of an attorney, a trust can help formalize your wishes for what happens to your business after you die. You state your wishes, and appoint a trustee who would be legally empowered to carry them out. The trust can be funded with life insurance as well. Not only might this help your family, partners, employees if you die prematurely, it could also be used to pay the trustee for their work.
7) Term Insurance is the Chevy of Shrinking Your Risk Profile
I’ll need you to cut me some slack with this one. After racking my brain for 10-15 minutes and actually looking up the wikipedia page for auto brands in the US, I’m sorry to say that this is the best alliterative car analogy I could come up with. Nevertheless, its important to remember that term insurance will almost always be your least expensive option for insuring your life.
Term insurance won’t offer anything fancy. It’ll only offer consistent premiums for a certain number of years (the “term”). That said, if your objective is to protect your business or your family with life insurance there’s a good chance you don’t need anything fancy. If you’re in your 40s and plan to build the business up before selling it in your 50s, a twenty year term life policy would likely be sufficient. There are many insurance salesmen out there who love to come up with fancy reasons to obtain fancy policies. It’s not uncommon that this complexity is unnecessary. And expensive.
8) More than Three Owners: Entity Purchase Agreements > Cross Purchase Agreements
With a one-person shop it’s relatively easy to determine how much life insurance you might need to protect the business and your family. With multiple owners things get a bit more complicated. One common way to protect a two or three owner business is to establish a buy/sell agreement using cross purchase agreements. Basically, the ownership group drafts a legal document that establishes what happens to an owner’s shares if they pass away prematurely. To protect their respective families, such an agreement typically stipulates that the deceased’s ownership share will be purchased for a predetermined amount by the remaining owners, perhaps subject to a valuation by an independent third party. Owner dies, their family inherits their share of the business, which is then bought by the remaining partners pursuant to the agreement. This document can be used to mandate that owners’ behavior be in the best interest of the firm, too. (What happens if an owner succumbs to substance abuse? What if they decide to strip down naked streak through the field at Yankee Stadium?).
In a two person firm this is a pretty straightforward process. The partners obtain life insurance policies on each other, corresponding to the other’s ownership share and the value of the firm. They could then have the business valued every year or every other year & adjust the death benefit accordingly. But with three or more owners things start to get complicated. Each owner would need to obtain a life insurance policy on all the other partners’ lives. This gets pretty complex with an ownership group of four or greater.
This is where an entity purchase agreement comes into play. Rather than have the owners hold life insurance policies on each other, an entity purchase agreement allows the business to purchase a deceased partner’s share from their beneficiaries. Those shares are then retired (or redistributed to the remaining owners, pro-rata).
There are additional nuances and tax implications of either set up. But for most buy/sell agreements, the choice between a cross purchase agreement or entity purchase agreement depends on the size of the ownership group.
What do you think?
Have you successfully used life insurance to protect your business?
What complications were there?