Could Your Business Continue Without a Key Employee?
Imagine what would happen if your business suddenly had to continue without you, a partner, or key employee. Could the loss of this individual cause the business to lose something valuable, such as experience, knowledge, time or money? What can you do to protect yourself and your business?
Key Person Planning
Since the financial loss could be severe enough to destroy a business, enough cash should be available to compensate for this loss.
There are two common ways to accumulate cash:
1. Cash Fund – a specified amount saved each month by a company
2. Purchased assets that generate a return
These methods allow businesses to set aside cash to help offset expenses and/or losses should a key person die. But with both methods, businesses risk the chance that:
● The key person may die within a year.
● More than one key person dies.
● The business needs cash prior to the death and withdraws from the cash fund to meet other obligations.
Key Person Insurance
Another way to ensure the continuation of a business is to insure key employees. Life insurance can guarantee a cash payment upon the death of a key employee. The company owns the policy and is the beneficiary. The death benefit amount of the policy is determined by how important the employee is to the success of the business. If the insured dies, death proceeds are paid income tax-free to the company. Accumulated cash values are carried as a current asset on the books and are available for the use of the business.
How to Determine an Employee's Value
Determining an employee's value to the business – a dollar amount – is difficult. But there are several commonly used methods for placing a monetary value on a key person's worth to your business:
● Multiply the salary of the employee by three to 10 times. As the key employee's value to the business rises, the multiple used can also increase.
● Determine the difference between the key employee's salary and the salary that would be paid to a replacement for the employee. Then multiply the excess by the number of years projected to find and train the replacement employee.
Key employee valuation is flexible. Your financial professional can help you determine which method works best for you.
What if the Employee Quits or Retires?
Some policies allow you to change the insured from the terminating employee to another key employee. Another option is to cash in the life insurance policy*. Or your business can continue to hold the insurance until death – and still collect tax-free death benefits. If your key employee retires, you may decide to sell the policy to the employee for its cash or replacement value.
Key person insurance helps you and your business by providing funds for hiring a replacement, training costs and business expenses when a valuable employee dies. Do not overlook one of your most valuable resources, human resources, when reviewing your risk management program. Key person planning can help ease your business through a difficult transition.
*Subject to surrender charges. Unpaid loans and loan interest will be subtracted from the accumulated value.
Dave Starr is Regional Managing Director with Principal Financial Group in Sioux Falls.