Entrepreneurship is supposed to be a thrilling experience filled with hope, opportunity and, of course, hard, painstaking work. The last thing anyone wants to think about is what might happen to a budding business if a founder or critical employee within the company passes away.
But whether you’re just starting on your business-owning journey or already have an established operation, it’s critical to plan for the unexpected, especially if you want to protect what you’ve built and ensure any business partners or family are taken care of. The best way to keep the lights on? Through life insurance.
Covering key employees
When you think of life insurance, you probably picture personal insurance that gets paid out to your spouse if you pass away. It’s typically term insurance, which is a policy that expires, in most cases, after a set period, like 10 or 20 years. The payout often goes toward paying off a house or covering income that will no longer be coming in, which allows your family to grieve and move forward without worrying about their finances.
The concept isn’t much different in a business context, but the name given to the insurance you’ll buy is different. In a company setting, you’ll consider key person insurance, which is typically term life insurance for a person who holds immense value to a business. In smaller companies, this person is usually the CEO but as the size of a company grows, so too does the number of key people it may want to insure.
“What if something happens to a person and causes a drain on the business?” asks Phil Comtois, a Senior Vice President and Estate and Insurance Advisor with BMO Private Wealth. “You have to think about this as life insurance for your company.”
Key person insurance is triggered in two main instances: Mortality (when the employee dies) and morbidity (when a disability or critical illness leaves the employee unable to perform their duties, though you would buy critical or disability illness insurance in this case). The business decides how many key people it wishes to insure – it can include a finance person or a main salesperson – and for how much; it also pays the premiums.
In most cases, you’d purchase a policy that would cover between 18 months and two years of that key person’s salary, though the payout can be worth more depending on the value the employee delivered, and the financial stress or loss of revenue created by their absence.
If, for example, the key person is your bookkeeper or an employee who handles all financial matters, a company might decide to insure them for a greater amount of money to cover the time it would take to find a new person, but also to help pay for short-term expenses, such as temporarily hiring an accounting firm to balance the books. If it’s a salesperson, you might want to generate enough from the policy to cover their salary, which you can then use to pay someone else, but also any lost revenue that can’t be recouped. “Finding a replacement isn’t an immediate thing,” Comtois explains. “You have to factor in the amount of time it will take for the business owner to hire someone and get them up to the same speed and ability of the previous employee.”
If the policy is triggered by morbidity, companies will often use group benefits to pay the employee’s disability and use what’s called overhead insurance to keep things running in their absence. Overhead insurance is typically good for a maximum of two years. “If something happens to the CEO, the business still has to pay rent, salaries and other bills,” Comtois explains. “After two years, statistics show that one of two things is going to happen: either the person will have returned to work or the business is going to be sold.”
Paying off your partner
In business partnership situations, term life insurance is often used by the living partner to buy out any shares that a deceased partner’s family may inherit. Unless there is a succession plan in place where a child or spouse is expected to become part of the daily running of the company, families usually don’t want to be involved – and the remaining partner may not want them there either.
At the start of a partnership, the founders should create a buy-sell agreement. This is a legal document that dictates how ownership of a business will be handled during a major event, such as the death, disability or departure of one of its partners. It ensures a smooth transition of ownership by outlining how the departing partner’s shares will be purchased.
“The legal document would stipulate that partner A has to buy the shares from partner B’s family or the other way around,” Comtois notes. “The question is, how do they do that? They need liquidity to make that purchase and insurance is often the financial vehicle that facilitates those agreements.”
Usually, the business will get valued every five years to help determine how much the partners’ shares are worth. If a partner passes away, the insurance policy would pay out to the business, and the partner would use those proceeds to purchase that person’s shares. “We call it buy-sell insurance, but at its core, it’s still term life insurance for the amount that has been assessed as the value of the business,” Comtois says.
Plan ahead
The sooner a business starts taking steps to protect its financial interests, the better, Comtois explains. Entrepreneurs have a lot on their plates, particularly in the early days, and they don’t always recognize the danger of not insuring against the loss of vital personnel. “That key person could be the cog in the growth of the company,” he says. “You have to think about how not having them there would affect the business and how to protect against that loss.”
As for buy-and-sell insurance, and by extension buy-sell agreements, starting earlier is also a good idea. “This is an easier conversation to have when the business is young and people are just starting out,” he says. “They’ve just invested a lot of money and they understand if something happens to one of them, it could mean the end of the business. It’s a harder conversation to have when the valuation has grown and things are going well, because they’re making money, and they don’t see the need to put these measures in place.”
