Planning for the Risk
All businesses, regardless of their size, have key people – people whose contributions have a significant impact on the bottom line.
The loss of a key person is difficult for any business, but it is especially difficult for small businesses that rely more completely on the contributions of a few very talented people.
In a small business, each employee usually has a more direct effect on the bottom line due to fewer employees interacting with customers, creating products and performing services.
Small businesses typically don't have multiple people to perform key job responsibilities. The loss of a small business employee causes a greater setback to the business while a replacement employee is found.
A small business can lose a key person for a number of reasons:
- Voluntary termination
If the departure is planned, as in the case of retirement or voluntary termination, the business can prepare for the loss and take steps to minimize its impact. However, if the employee becomes disabled or dies, the loss is unpredictable and leaves the business exposed to financial, business, and other risks.
Key-person planning can help small business owners offer attractive incentives to retain key persons, while planning for a potential business loss.
Identifying Key Employees
One definition of a key employee is someone who contributes substantially to the success of the company. The main considerations are:
- The importance of the employee to the firm.
- The degree of financial loss that would occur if the employee were removed from the scene.
There are no black and white rules for helping you identify key employees. Here are some guidelines:
Key employees are more often found in smaller companies with little management depth.
In a privately-held company, there are rarely several people with the same skill level who could easily step in and replace a departing employee. As a result, each employee’s contributions have a greater degree of impact in a small company.
Key employees are usually part of the management team.
Because the employee’s contribution to the success of the company is significant, your employee has probably been given managerial responsibilities. Because certain employees must make business decisions in their capacity as managers, these employees understand the functional aspects of the company’s operation, making them uniquely qualified to successfully manage the business.
Key employees are usually more highly paid.
If the employee’s contributions are significant, the company usually rewards the employee with high compensation in order to retain his/her talents.
Key employees enjoy the respect of customers, creditors, suppliers, and vendors.
Key employees are people whose contributions are visible to those outside the company, such as salespeople who handle the company’s major accounts or an officer who has the confidence of potential creditors. Because these people represent the company to the “outside world,” they are instrumental in the company’s success.
Key employees often have direct responsibility for sales or production/service.
A company’s products or services and its ability to sell them are the lifeblood of a business. As a result, employees who are responsible for sales or production/service are often considered key people.
Key Person Life Insurance
Key person life insurance provides cash following a key employee’s death. Whether the proceeds are used to replace lost revenue or to fund the recruiting, hiring and training of a new employee, key person life insurance is a critical aspect of a business’s risk management.
Many businesses address key person needs with term insurance. However, managing this risk with permanent insurance offers additional benefits.
Permanent key person insurance can:
- Provide cash in the event of an emergency.
- Give the business an asset (the cash value) it can use as loan collateral.
- Allow the business to provide an income tax-free death benefit to the insured employee through an endorsement split dollar arrangement.
- Help the business make payments under a nonqualified retirement or other benefit plan.
- Provide cost recovery to the business for benefits it is currently paying.
Key Person Disability Insurance
The loss of a key employee due to a partial or total disability creates a double loss of profits. The first loss is the loss of profits that would be attributable to the key employee. The second is the cost associated with finding a replacement.
Disability key person insurance compensates an employer for the loss of a key employee and helps support the business’ long-term success, value and ability to produce income by:
- Providing benefits that can be used to hire and train a qualified replacement.
- Providing benefits that can help offset some of the revenue lost because of a key employee’s inability to work due to a disability.
If an owner becomes disabled, income is reduced or stopped, but the ongoing overhead expenses of the business or practice still need to be paid.
Disability overhead expense coverage reimburses the owner for covered overhead expenses that continue during a total or partial disability. It buys the time an owner needs to get well and return to work, or to make the decision to sell the business while it's still profitable.