The No. 1 thing every business owner needs to do to protect their legacy

Small Business

Here’s a question every entrepreneur ought to consider: What would happen to your business if one or more of your key employees died suddenly or could no longer work because of a disability?

For many fledgling businesses, the loss of a key employee — whether a founder or top sales rep — can be fatal. Enter key man insurance, a form of business-to-business insurance that’s intended to help a company or nonprofit survive if a critical employee dies prematurely or can’t work because of a disability. Policy proceeds can be used to pay off a firm’s debts or cover its overhead costs, for instance.

“Many business owners would say that they’d lose hundreds of thousands, or millions, in revenue if, for instance, a key employee passed away in a car accident on their way to work,” says Alex Grammatic, a principal at Helm Financial, a Dover, N.H.-based business consulting firm and an independent insurance agency.

In his experience, business owners don’t tend to look for key man insurance until they come to the stark realization that their own death, or the death of a critical employee, could cripple what they’ve spent years building. Key man insurance, says Grammatic, can help take the financial pain out of recruiting and training a replacement employee or even cover costs associated with closing or restructuring a business.

Entrepreneurs may find themselves in the market for key man insurance, sometimes more appropriately called key person insurance, because potential lenders and/or investors insist on it. Take the town of Greenfield, N.Y., for instance. Its $2 million economic development revolving loan fund usually requires borrowers to obtain key man insurance, or some form of traditional life insurance, and to assign the policies to the town of Greenfield, a hamlet in Upstate New York.

Why does the fund impose this requirement? James Lee, CFP, a financial adviser who serves as its administrator, puts it this way: “Because we are dealing with small businesses, often the applicants are either founders or partners who are very critical to the businesses. If something should happen to them, it’s very likely the businesses could fail, and the town would not get repaid.”

“Many business owners would say that they’d lose hundreds of thousands, or millions, in revenue if, for instance, a key employee passed away in a car accident on their way to work.

Alex Grammatic

principal at Helm Financial

Lee speaks from first-hand experience. The fund’s insurance requirement has twice allowed it to recoup money lent to small businesses whose founders died prematurely. In one case, the founder of a welding business died and proceeds from his policy were used to pay his loan in full, which meant his family didn’t have to consider selling its home in order to do so, according to Lee. The home had been used as collateral for the loan.

Key man insurance “saved the home and allowed the business to continue despite the passing of its owner, which is what it’s designed to do,” says Lee.

As with any type of coverage, there are a number of issues to consider when mulling key man insurance. We tackle a few of them here:

Who is typically considered a key employee?

Very often, but not always, it’s the founder(s) of a business or nonprofit, particularly in the early stages of growth, when start-ups tend to depend heavily on one person’s idiosyncratic knowledge and/or skills or perhaps their ability to recruit talent and initial customers.

Sridhar Tayur, a professor of operations management at Carnegie Mellon University’s Tepper School of Business, says venture capital investors often insist that businesses carry key man insurance on the founders of their portfolio companies.

He should know. Tayur is not only an expert in entrepreneurship and venture capital, but the founder of inventory optimization software firm SmartOps Corp., which in 2001 raised an initial $10 million in venture capital funding. As a condition for the investment, SmartOps had to take out a multimillion-dollar key man policy on Tayur, its sole founder. In 2013 the company was acquired by SAP.

“The role of the individual is often quite high when a venture capitalist makes an investment,” says Tayur. “Therefore, it makes sense for venture capitalists to want to protect the downside.”

Tayur suggests asking the following question to help decide which employees are integral to a business or nonprofit: “What is the talent that is not easily replaceable?”

In addition to founders or owners, key people also frequently include top sales reps, doctors in medical offices, heads of research and executive directors of nonprofits, according to Zachary Taylor, a principal and exit planning specialist at Helm Financial.

How much does key man insurance cost?

Premiums vary widely and depend on such factors as the age, gender and health of a key person and the amount of coverage provided under a policy. Some companies pay as little as a couple hundred dollars a year, while others pay tens of thousands of dollars in annual premiums, says Grammatic of Helm Financial.

Like other independent insurance agencies, Helm Financial helps business owners shop around for policies and assess how much insurance they need. The firm has designed a proprietary calculator to help business owners get a sense of their coverage needs. It takes into account how much revenue a key person generates, how much he or she earns (including bonus), how many years it might take to replace that person and how long it might take for the replacement employer to become as efficient as his or her predecessor. In a highly specialized role, the latter can take years.

Businesses typically buy enough insurance to cover their operating expenses for at least a year if they were to lose a key employee or employees, says Taylor. “That gives them enough time to find a replacement, get that person up to speed and start making decisions about what to do next,” he explains.

Are there different types of key man insurance?

Yes. Key man life insurance is essentially term life insurance, except that a business or nonprofit typically owns the policy, pays the premiums and is the beneficiary. Key employee disability income insurance, on the other hand, helps protect a business from losses associated with the partial, total and/or permanent disability of a key employee. Businesses actually tend to face a greater risk of losing a key employee to disability as opposed to death, according to the Insurance Information Institute, an industry-backed nonprofit.

Any insurance company that sells life insurance will likely sell key man insurance.

As with other types of insurance, applicants for key man coverage must prove they’re, well, insurable. That means a key employee may have to undergo a medical exam and answer health-related questions. Insurers may also ask companies to provide financial documents, such as tax returns and profit and loss statements. The financial underwriting process helps insurers determine whether a specific employee is actually key, meaning that his or her death or disability would result in a significant financial loss for their employer.

What if the key employee just decides to leave?

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