Key man life insurance is a very often overlooked, yet extremely crucial piece of risk mitigation for small and large businesses.
Let’s step away for just a moment and imagine a scenario where it was not in place, so you can better understand why it’s needed. A small business, we’ll call it ZYX Widgets, has two owners who operate the business as equal partners. Both have a 50% stake in the company and share duties equally for their marketing, sales and all other aspects.
After several years in business, they have become the sole provider for what they make, and not another company in the nation has any product like theirs. However, after much success, tragedy strikes and Owner A dies in a car accident. No key man life insurance was in place.
So, what happens?
Owner B is now fully responsible for the continuation of the business and its daily operations, having to work double the amount of time to make up for where Owner A used to thrive. The amount of time and effort required in hiring a replacement would outweigh the benefits because they are so specialized.
The problem further escalates when Owner A’s wife approaches Owner B asking for continued income, because, after all, she now owns her husbands half in the business as his estate is transferred to her upon his death.
Not only does Owner B have to work twice as hard for half the profits, he is now in business with his previous partner’s wife.
How Key Man Life Insurance Works
Think of key man life insurance as a buy out which happens after an owner dies; the surviving partner or partners now own his stake in the company, and the life insurance proceeds are used to make this payment.
Considering this, let’s go back briefly to discuss what might have happened if ZYX Widgets had a key man life insurance plan in place.
After Owner A died, Owner B could have made a life insurance claim on behalf of the business. Within the documents drafted as part of the key man insurance plan, it was written that the ZYX Widgets would receive $500,000 in lump sum with two options for disbursement.
- Owner A’s wife would receive the $500,000 and Owner B is now 100% owner, able to do as he pleases.
- ZYX Widgets could retain the $500,000, keep Owner A’s wife as an equity partner, and use the proceeds to keep the business moving forward.
You see, if nothing else, the life insurance policy can help both parties buy time to make the right decision, as well as have immediate funds available to pursue either choice.
Other Ways Key Person Insurance Can Help
Outside of the ways outlined above, key man insurance can also operate in other ways to offset some type of financial loss, or to financially protect production within the business.
What if ZYX Widgets had a large amount of debt in which both owners had co-signed?
A key man life insurance policy could also be used to immediately remove all or a portion of debts which the passing party was responsible for.
For example, maybe Owner B uses the death benefit proceeds to pay off Owner A’s half of the debt, and then downsizes the company. After the downsize, he can continue his same workload but not be responsible to continue producing the amount of revenue previously required to pay the total debt liabilities.
In yet another way, key man life insurance could be earmarked to intentionally find a replacement. Finding and hiring someone new, especially for a specialized position which might require extensive training, can be very costly. If ZYX Widgets had to train a new manager from scratch, it would take away from what Owner B might be able to produce in revenue, so this would need to be supplemented.
Types of Key Man Insurance
What if ZYX Widgets had more than two owners?
What if ZYX Widgets had a key employee, other than the owners?
Different structures of key man life insurance are appropriate to accomplish different goals. In order to correctly structure how a key man policy works, work with a legal consultant to write up the instructions and disbursement provisions in order to satisfy every possible scenario.
You may also decide if using one of the top life insurance companies will be advantageous, as they have experts in putting together proper plans.
Here are some possible selections to consider:
- Stock Redemption
- Cross Purchase
- Buy / Sell
- Delayed Buy / Sell
But in order to know what kind you need, you have to first explore the final plan details by asking yourself and business a few questions. While these aren’t all encompassing, they’re a good start:
- How many total owners and stockholders are within the company?
- What is the difference in age among them?
- What portion does each own or control?
- Is any key person unable to be insured?
- What is the current and projected value of the company?
- Is this a family owned business and will there be additional generations?
- What is the tax treatment of each possible plan?
As each question is answered, it should help to point you closer to which type might be best to keep your business functioning effectively, both structurally and financially for a given scenario.
Always keep your end game in mind. If nothing else, get the bare minimum in place to allow the business to keep moving forward as decisions are made. Any number of combinations of illnesses, disabilities and deaths could occur, so it may be impossible to map out every single one.