Small businesses are the backbone of the US economy. It is estimated that roughly 35 million U.S. small businesses (as defined as employing 1 to 500 people) operate in various business stages - start-up, growth, mature or transition stage. Each stage of a business requires proper evaluation of the risks specific to death, disability, and retention for founders and key employees. Proper planning for these risks will help increase the probability of success for the business, its founder(s), and investors. Those specific risks include (i) the death or disability of a founder (owner), (ii) the death or disability of a key employee, (iii) lack of incentive plans to retain employees, and (iv) proper liquidity planning for the owner who is transitioning the business to the next generation and/or selling all or a portion of the business. These risks, if addressed ahead of time, are relatively simple and cost-effective to insure and protect against.
The following outlines the often overlooked risks for business owners and investors to consider insuring based on the stage of the business:
Start-up Stage
Let's face it, most start-ups are living day-to-day, and it often becomes difficult to think beyond the next quarter. An entrepreneur is making decisions critical for survival. With cash flow that typically fluctuates or is tight, term life insurance and short-term disability insurance protect the entrepreneurs basic risk - dying or becoming disabled.
Founder dies or becomes disabled: A start-up’s business is almost always completely dependent upon the founder. If that founder is gone, for either reason, the value of the business could be significantly reduced, a family may lose control of the business, and ownership transfers could become tricky if the beneficiary isn’t ready or doesn’t want to assume control.
The right life insurance and disability policy can help protect the business and the founder's family.
If the founder dies, the death benefit can help the family or estate continue with the business or pay off debt the business may have incurred.
In the case of a qualifying chronic or terminal illness, a policy with a rider for chronic or terminal illness can allow the death benefit to be accelerated to provide money for anything that might be needed.
In the case of disability, speciality disability products can provide liquidity to the business based on its cash flow needs.
Personal property as collateral for a business loan: Many times, a Start-up will be funded with a business loan . . . using personal property as collateral. A family could stand to lose so much if the business should encounter rough times. Unfortunately, many families may have experienced this in 2020. Many times, banks will require individual life insurance as collateral for a loan.
The right life insurance policy can help protect the business and the founder's family.
If the founder dies, a life insurance policy can be used to repay a business loan, if needed. Many times, a bank may require the business founder to buy a life insurance policy as collateral against the loan. The death benefit from a life insurance policy can give the family enough liquidity to keep a business afloat as they work through their loss.
Growth Stage
The growth stage for a business is an exciting time to start accelerating the business and to make critical decisions about growth. One of the most critical aspects of a business' growth stage is expanding the team. Proper compensation and equity plans are required to recruit and maintain the talent a business needs for growth. One element often ignored after investing a significant amount of revenue and equity into key team members is the risk to the business if it lost one of the key employees to death or disability.
Protection if a key employee dies or becomes disabled: There are usually some employees who are critical to a business’ success. If that employee should die or become disabled, there are impacts to many areas of the business. The business could experience disruption to management, operations, or product development. Some customers could leave. Credit could become impaired. And it could take significant time and money to replace them.
The right life insurance and disability policy can help protect the business resulting from the death or disability for a key employee.
A death benefit from a life insurance policy, used in a key person strategy, can help the business get through a difficult time if an employee who is critical to the business passes away. It can potentially help a business access credit, which may be needed more than ever. These proceeds could assist with a search for new talent that could provide the skills and expertise needed by the business.
A lump sum benefit from a specialty disability policy, insuring a key person, can help the business properly plan and transition (if needed) as the result of a key employee's short-term or permanent disability.
Mature Stage
Businesses that survive and thrive through the start-up and growth stages, face the next challenge which is how to develop a long-term sustainable business with the proper planning in place to survive various changes that can impact a mature business. These include business succession, lack of liquidity upon the loss of a key owner(s) and employees, and turnover from a key executive being wooed away by other companies.
No succession plan: As a business matures, the business’ value will grow. There may also be interest in the business lasting beyond the original generation. There is potential need for liquidity because of tax issues, parents may have difficulty in equalizing an inheritance for children who aren’t in the business, and/or loved ones may be dependent on the business for income with nowhere else to turn.
No retirement plan: Owners often create plans for their business to live on without them, but they fail to create a plan for them to live on without their business. If they don’t adequately plan, they may find it hard to maintain their lifestyle in retirement. Also, if they haven’t taken an active interest in diversifying their assets, they may find themselves with “all of their eggs in one basket” . . . and the owner may have an unrealistic expectation of their business’ value, too.
A key executive is being wooed by other companies: There are certain executives who are so valuable to a business that they need to be protected and kept secure. If these executives should be wooed away to a competitor, it could have a major effect on a business.
The right benefit plan, legal agreements, trusts, and insurance policies can help protect and fund the unique risks for a mature business.
A life insurance policy used in a Buy/Sell Agreement can help ensure that business owners have an established plan for transferring the business to those whom the owners agree upon, when one passes away. This type of plan can help ensure that the business continues smoothly, and that the remaining owners aren’t forced to work with family members of the deceased owner if they don’t want to, and can help establish boundaries for other family or interested party involvement.
A life insurance policy, designed for tax-efficient investing, can be used to supplement income in retirement for the retired owner. This can help fill in any income gaps that might exist through gaps in planning.
A life insurance policy, used in an executive compensation arrangement, can be used to create a financial incentive for a critical employee to remain with the business or to attract new talent. This can help that employee to “pass” on offers from competitors and remain satisfied in that decision. There are various types of incentive plans available for a mature business to consider.
Transition Stage
The ultimate goal of the business owner is to successfully transition the business and/or create a value-realizing event (VRE) through a sale of some or all of the business ownership. This stage can be the most critical to properly plan well in advance of a transition. There are many options available to the business owner, especially when working with a team of advisors around tax, financial and estate planning.
No business ‘exit’ strategy: It’s important for a business to have an owner “exit” plan. If there is no plan in place, it leaves the business, the owners, and the families at risk. Many times a thriving business will falter when an owner wants to retire because there was never a clear plan in place to transition it.
Unequal distribution of assets among children: If an owner’s children and family members are not equally involved in the business, there may be an inequitable distribution of wealth when the owner passes away. Having a great difference in inheritances can cause messy estate issues, not to mention hard feelings among family members.
There are a myriad of planning options around tax, financial and estate issues. Our firm focuses on leveraging life insurance to help affluent families and entrepreneurs maximize the amount of wealth transferred and to provide liquidity at the proper generation to cover expenses around taxes (income, capital gain and/or estate) and other liabilities.
A survivorship or single life insurance policy structured to provide estate equalization to children not active in the business. The policy can be owned and structured to pay the proceeds income and estate-tax free.
A term life insurance policy can be used during a buy-out, earn-out or other "at risk" period of time when a business sold or transitioning.
A life insurance policy can be paid for by the business pocket book in the form of a loan or split-dollar life insurance arrangement. This approach can minimize the cost to the business owner as well as provide a discounted structure to fund the required liquidity upon death.
Take a moment to read about our Client Success stories and what we have done for business owners. We would love to have the opportunity to talk with you and determine how we can insure some of the overlooked risks in your business . . . regardless of the business stage.
This material is intended for informational purposes only and should not be construed as legal or tax advice. It is not intended to replace the advice of a qualified attorney, tax advisor, or financial provider.