Key Person Insurance
During the course of my career I have valued hundreds of businesses. Often I am asked how valuations have changed over the last three decades. It is an easy question for me to answer by reference to appraisals I prepared in the 70s. At that time much of our effort was focused on tangible assets. In effect, we counted things up and put great emphasis on the cumulative “hard” assets of an enterprise. While we recognized the intangibles, they were given more of a skeptical view and, absent a compelling argument of earning power, generally neglected on a relative scale.
Today we look at enterprises in a very different manner. While tangible collateral is still important with bankers, its importance with valuation professionals has diminished. In its place you find a greater emphasis on the intangibles. Although we still consider the cumulative value of the tangible assets, few enterprise valuations are so limited.
Today earning power is what drives values. That earning power is in turn driven by people power!
Nowadays when I count assets, I am really counting directed talent. An enterprise’s most valuable resources are leaving the building at the end of the day, if they are even there at all and not remotely logging in. We hope they return tomorrow. If they do not, the value of the business will be adversely affected.
So what does this have to do with Key person insurance? Everything! Considering how vulnerable a business is with the loss of a key employee, associate or partner; you would think most businesses have addressed the potential economic impact of the loss of their services. The surprising truth is most companies have not.
In the course of valuing organizations we often hear how precious a particular person is to the enterprise. At that point I typically inquire how much insurance the company is carrying on that individual. Usually the question is greeted with, “Gee, I really should get some insurance”.
So where do we start? The first thing to determine is who is a “key person”? The answer is simple: anyone whose absence or loss of services will adversely affect the business. This can be the President or your cousin Bernie (who you depend on for careful counsel as well as collateral to support your lines of credit!). Seriously, some positions are more obvious than others. While you have certain employees who are critical to the operations of your enterprise, do not forget those directors, financial backers and advisors who help you get through the tough times and supply the vision.
I approach the question of Key person insurance the same way I approach every form of insurance. What is my vulnerability? In other words, what are my economic losses in the event that person dies or is incapacitated? The latter distinction is important because incapacitation also deprives the business of their skills and services. What will it cost my business if they are not here?
A brutal analysis will determine the need. Here are some things to consider:
• What is the immediate impact on earnings? If this is a valuable sales person, production/project manager or executive, your income or production will be impacted. You need to determine how much in real dollars.
• What will the learning curve cost? Even with a solid transition plan in place the smartest person will take some time to get up to speed.
• In the case of a key sales person, you have relationships forged over years, if not decades. This is not easy to replicate. In addition, you can NOT count on the competition being asleep at the wheel. In fact, assume they will see it as an opportunity to pick up some of your customers.
• How will that loss impact my borrowing capacity? In the case of Cousin Bernie, the bank may pull the line of credit or restrict its usage. Remember, your tragedy does not relieve the bank of its responsibility to depositors or shareholders.
• Do not forget the person in the back room who does all the strategic planning or is working on the next generation of your software.
• Remember the loss of a key person may also cause the delay of an important business project. The result may be a loss of future revenue or customers. Few good businesses are static! A solid enterprise is planning for 2015 in 2011.
It is also important to remember often the key person may have some ownership or equity interest in the company. This creates a potential demand for cash to purchase their shares. While many businesses have buy-sell agreements, the key question is: does the funding/insurance reflect the current value of the enterprise. Often we see insurance funding that made sense----in 1977!
Once you have determined your economic impact as a result of the loss of a key person it is now time to consider how you are going to fund the loss. Insurance is the natural answer. Unfortunately your problem just got a lot more complicated. You need to determine the best way to insure, the correct amount to put into place and the most sensible tax and financial structure for the insurance. It is not as simple as just going out and purchasing a policy.
I will discuss the various considerations involved in acquiring key person insurance in the next article. For now a needs assessment is the first step.
Undergoing this analysis has derivative benefits. The process requires you to give careful consideration of how your organization is impacted by key personnel. If you have an individual who is indispensable to the business, you may want to consider restructuring to make the organization less vulnerable. When we value companies we take discounts if an enterprise is put at risk with the loss of a key executive. The best companies, while adversely impacted by the loss of a key person, are nevertheless able to withstand the event regardless of insurance coverage. As such, you should always remember that even the best Key person insurance policy is a poor substitute for having a corporate structure able to withstand the loss.
The bottom line is the loss of a key person is a very real possibility. Smart business owners prepare for unforeseen events and protect their enterprises so they can weather all unexpected losses.