Most private companies depend on a small number of people. A founder who holds the client relationships, an engineer who understands the product, a head of sales who closes the large accounts. If one of them dies or becomes unable to work, revenue can fall quickly while the company is still paying the same costs. Key person insurance exists to cover that gap.
How it works
The company buys a life insurance policy, and sometimes disability coverage, on the key person. The company is the owner and the beneficiary. If the person dies, the company receives the proceeds and can use them to cover lost revenue, recruit and train a replacement, repay loans or reassure customers and lenders.
Sizing the coverage
There is no single formula, but companies commonly look at a few measures. One is the cost to replace the person, including recruiting and the time before the replacement is fully productive. Another is the revenue or profit that depends on that person. A third is any debt that includes a key person clause or a personal guarantee. Many owners also consider a multiple of the person's compensation as a rough starting point and then test it against the actual risks.
Why lenders and buyers ask
Lenders sometimes require key person coverage as a condition of a loan, because the borrower's ability to repay depends on a person. Buyers and investors look at the same risk when valuing a company. A business that can show depth below the founder, supported by coverage for the remaining risk, is easier to finance and to sell.
Practical points
Insurance is not a substitute for a succession plan, written procedures and a second layer of management. Get the key person's consent, since coverage on someone's life generally requires it. Ask your accountant how the premiums and proceeds are treated for tax, because the answer depends on the structure. And review the amount as the company grows.
This article is general information, not legal, tax, investment or insurance advice. Speak with your own advisers about your situation.
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