Most people don’t incorporate dying into their business plans. Nor do they plan on key personnel suddenly passing away. But in case tragedy does strike, it is important to have a safety net in place. Both key-person insurance and buy-sell agreements help ensure that a business continues to hum smoothly after losing a partner or key employee.
Randy Donsky, a financial and business planner with Sander A. Kessler & Associates Inc., believes that businesses can benefit greatly from having these safeguards in place.
“Key-person insurance is to indemnify and minimize interruptions to a company’s cash flow if a key person dies,” he says. “The buy-sell agreement is very important, because it establishes continuity and sets the value of a company with minimal distractions.”
Smart Business spoke with Donsky about the importance of having key-person insurance, who should be covered, and how buy-sell agreements should be valued and funded.
What is key-person insurance and how does it work?
It’s an insurance policy that is going to protect the business from the death of a key employee. The proceeds from a life insurance policy go into the company’s till, and they use that money to indemnify themselves against the loss of the sales or the revenue generated by that key person. The monies can also be used to provide the capital to fund a search for the replacement. This includes using a headhunting firm or putting an ad in the paper. It’s really a two-pronged purpose.
Why is it so important for a business to have key-person insurance in place?
If you have a key person who is the rainmaker for the revenues of the company, the loss of that person could have a severely detrimental affect on the cash flow. Let’s say that you have a person who is really good at bringing in business and another person who is good at operations. Without one, the other is not as strong. If you lose the rainmaker, the person inside won’t have a way to bring in new sales and vice versa.
How should a business determine who should be covered?
They should review how important a person’s function is. Without that person, how would it affect the company and how quickly could they replace that person? Would that person not being there have an adverse affect on the company’s ongoing success? If the answer is yes, then a policy would be warranted. Typically, these policies cover senior management, but it could be a senior sales person or technology person. The policy should cover up to ten times the salary of the key person.
What is the purpose of a buy-sell agreement?
A buy-sell agreement is a document between business owners or partners that obligates a buyer and seller and sets the price of the transaction that is going to occur. In other words, if you and I are in business together and something happens to me, it obligates you to buy my shares from my estate and it obligates my family to sell to you. It’s a very, very important document. It puts everything in writing, and it minimizes areas of disputes and distractions that come along with the loss of a partner.
How is value established with a buy-sell agreement?
A business can have an appraisal done by a third party, or through that third party it can identify a formula like a percent of sales or revenues or income. That formula is made part of the buy-sell agreement so it is an ongoing, moving target. Sometimes parties will agree on a price that is good for 12 months. Then they revisit the issue and establish a new price, which is good for another 12 months, so the process is ongoing.
How are buy-sell agreements funded?
Having just a buy-sell agreement without a funding source is not a good thing. You must have a funding vehicle, and that is typically done through a life insurance contract. An entity purchase is where the corporation would be the buyer of the policy and it would buy the shares from the deceased family’s estate and retire those shares. A cross-purchase is where both partners take policies on each other’s lives.
RANDY DONSKY is a financial and business planner with Sander A. Kessler & Associates Inc., a property and casualty insurance and employee benefits firm. Reach him at (310) 309-2233 or [email protected].
