The winter of 2011 was shaping up to be a challenging time for a small firm in upstate New York. That year, Delta Engineers, Architects, & Land Surveyors was beginning to feel the full brunt of the economic downturn. It had already tapped into its line of credit to fund operating costs when it learned the company's corporate office building needed a new roof. Then, in February, came the most devastating news. One of the company's 16 shareholders, a 48-year-old husband and father, died unexpectedly. "His death added to what was already an extremely stressful time for our company," said Delta Chief Financial Officer Darlene Cempa. "It was the worst of all scenarios, a perfect storm."
For Delta, a lifeline came in the form of key person life insurance. Four years earlier, the company purchased life insurance policies on all 16 key employees when they became shareholders in the firm. "When our co-worker passed away, having this policy in place meant we really didn't have to worry or think about how we were going to meet our financial obligations during such an emotional and challenging time."
Although businesses like Delta can’t necessarily prevent the sudden loss of a critical contributor, business owners can minimize the impact felt by an employee's departure or death with key person insurance.
Key person insurance is designed to help businesses financially survive the loss of contributions from a highly valuable employee; it pays proceeds directly to the business at a time when it's probably needed the most.
There are no restrictions on how its proceeds are used, but if you're a business owner, key person insurance could be used to:
- Cover Potential Loss of Business
Your key employees make extraordinary contributions to management, manufacturing, sales, distribution and customer loyalty, and their departure or death can have devastating consequences. Customers may leave. Sales or production may be interrupted. Profitability may suffer. And at the same time, lenders may be less inclined to extend credit, knowing that a valued employee is no longer contributing to your company’s success. Key person insurance can help keep your business afloat while you adjust to the key employee's absence.
- Recruit a Successor
The proceeds from key person insurance can also be used to recruit, hire and train the key employee's replacement. Your business might use the proceeds to hire an executive search firm or to offer a signing bonus to your top recruit.
- Retain Valued Employees
A permanent policy offers additional benefits. Under certain circumstances, you may offer the cash value of a life insurance policy to a key employee in return for a commitment to stay with your company for a designated period of time. In other words, the very policy that protects your business in the event of a key employee's death may also be used to retain that same key employee.
In 2011, Delta used the proceeds from its key person insurance to meet three specific financial obligations:
- Retire a Bank Loan
When shares of that business were sold to the new shareholders in 2007, the transfer was partially funded by a bank loan, which was also backed by the company. After the loss of one of their key employees, Delta used part of the life insurance proceeds to pay off his portion of the loan balance.
- Buy Back Shares
Although his shares in the business were then willed to his surviving spouse, New York law states that a non-licensed professional cannot own stock in a professional corporation. She was required to sell her shares, and Delta bought them back using cash on hand from the insurance policy proceeds, allowing the company to fulfill its obligation to the family quickly and without creating a financial burden on the business.
- Make Capital Improvements
Delta also used part of the insurance payout to replace the roof on its corporate office, rather than having to obtain a second mortgage to make the necessary repairs.
Key person life insurance allowed Delta to successfully weather its 2011 storm. "Our people are key to our success, so we need to protect against the loss of their contributions through key person insurance," said Cempa. "It's no different than a business owner in a capital-intensive industry who carries replacement insurance on metal-stamping machines or whatever equipment is critical to their business. Without the insurance, you risk finding yourself out of business."
For more information about key person insurance, contact a financial representative.