The biggest manageable small business risk is the least talked about by small business owners
We don’t always talk about what we should
Talking about what would happen to your business if, an owner or key person suffered a serious illness or even died from a stroke, is not the usual topic of conversation around the BBQ with mates. But we do talk about what would happen if the shop burnt down, the computers were stolen or the roof was ripped off by a storm, and the warehouse flooded. Small business owners are particularly exposed to this risk. It’s the serious illness or death of your Key Person(s).
If you avoid difficult questions, ‘you’re outta business already and just don’t know it – but your suppliers might already suspect’.
The most important asset to a business is not the obvious physical assets but the key person or persons.
How to recognise a Key Person in your business
When it comes to Key People, there’s usually one in every business. But how do you recognise them and how do you measure the potential loss to your business if they suddenly stopped working?
Most businesses have one or more key persons whose skill, knowledge, experience and leadership ensure the success of the business.
- A Key Person is usually someone whose unique identifiable skill, knowledge, experience, leadership, or commercial profile contributes to the financial success of a business directly or indirectly.
- A Key Person in any business may generally be defined as one whose death, disablement, or early retirement may have an adverse economic effect on the business.
It is important to identify these key people and to quantify the adverse effect that is likely to be suffered by the business in the event of death, disablement or illness. Only then can you begin to see what's really at risk and begin to plan for the unexpected.
Insuring your business for Key Person Replacement
Key Person Replacement insurance cover provides a short term solution to a help a business fund the cost of a replacement where the business owner is a key person in their business, and a replacement is required if they are unable to perform their duties during disablement.
The biggest risk is often the easiest to protect - if you can recognise it first
Although the number of key people in a business will change from business to business, there will usually be at least one. A key person is usually someone whose skill, knowledge, experience, or leadership contributes to the financial success of a business directly or indirectly.
They’re someone whose potential absence from the business, because of serious illness (or even death), would have serious effects on the business's future profit. Whether that’s because customers and suppliers begin losing confidence in the business's future or because the loss of expertise means the immediate loss of capacity to complete a current contract, key people have a direct impact on the bottom line.
Key people might include:
Managing Director or Chief Executive Officer
Chief Financial Officer
Chief Technology Officer
Partner in a Partnership
Senior Sales Manager
A License holder or Copyright or Patent Owner
an Employee with a particular skill or technical expertise
Why don’t we talk about this more?
Some business owners take the ‘head in the sand approach’ saying ‘if it’s important my accountant will surely tell me about it,’ while the accountant says ‘if the client has an important question they will ask me about it’.
- And so the circle of dis-ownership and avoidance of essential questions goes around and never really gets sorted until the lawyers get involved later.
If your business employs staff, you’re legally required to have compulsory Worker Compensation Insurance in place to protect your employees from accidents in the workplace. But when it comes to your key people, this is one manageable business risk that’s usually left unprotected; even though it can literally mean ‘the end of the business itself and the income it provides.
Measuring the cost of loss of a Key Person
In the event of a key person’s death or disablement, a business may be forced to sell assets to maintain cash flow – particularly if creditors press for payment or debtors hold back payment. Similarly, customers and suppliers may not feel confident in the trading capacity of the business and its credit rating could fall if lenders are not prepared to extend credit. Outstanding loans owed by the business to the owners (or their beneficiaries) may also be called up for immediate repayment.
What happens if this risk is not managed and something happens?
This is when a business owner pays the full cost of not having that initial conversation about managing their key people.
The lawyers from the bank, the past shareholders (or even the estate of a past non-executive Director) begin to look for ways to recover their losses. They will start searching for someone to sue to allege professional negligence and demand compensation from:
- the company Partners or Directors, for breaching their various fiduciary duties, and
- the company Accountant or Business Coach or Advisor, alleging professional negligence for not proactively identifying a key business client risk.
Why is this important?
- Because the overwhelming number of small business owners and directors (and their families) have their personal assets on the line and at risk of forfeiture.
Key Person Insurance | Anthony & Gary's Story
How one business protected itself through a Key Person insurance strategy.
Anthony runs a small electrical engineering firm, providing IT services to a number of local councils and some local infrastructure managers.
Gary is the Sys Admin running the IT stack and is a Key employee of the business and is responsible for generating about $200,000 of business revenue each year.
- Anthony realises Gary is critical to the immediate survival of his business and estimates it would take 12 months to find and train a suitable replacement, if Gary became disabled or died.
- Anthony estimated that if Gary were unable to work, the net profit of the business would fall by $200,000 pa.
This would place the business, and Anthony, under significant financial pressure.
Anthony calculated the risk of the potential business loss as:
- Annual fall in net profit $200,000
- Cost to hire a replacement $25,000
- Cost to train a replacement $25,000
- Total business risk to be covered $250,000
As most businesses don’t have an idle $250,000 available, Anthony’s company took out a life insurance policy on Gary’s health and life for $250,000 to protect itself from the risk of suddenly losing its Key Person — Gary.
If Gary died or becomes permanently disabled, the insurance policy payout could be used to replace the fall in net profit of $200,000 over the next 12 months, and cover the cost of finding and training a replacement for Gary.
The Business now feels more stable with a Plan B in place, and the confidence it creates is felt by its customers too.
Taxation of Insurance Benefits
When it comes to an understanding of the tax position of this type of strategy, speak with your accountant first but usually, the purpose of the insurance cover will determine whether the premiums are tax deductible and how the proceeds are taxed.
- As a general rule, if the purpose of insurance is to protect the revenue of the business, through the replacement of lost sales or provision for increased expenses, the premiums will be tax deductible, and the payout assessed as income.
- A sample company record or minute document that can be used to record the purpose of the insurance strategy can be found here.
What happens if my Key Person is only temporarily off work?
The absence of a key person due to temporary disablement can place a business under the same significant stress that occurs in the event of serious disability or death.
- A temporary disability is statistically more likely to occur than a permanent disability or death. Temporary disabilities for a Key Person could be from any cause, including a physical injury, early-stage cancer or a minor heart attack.
- When it comes to understanding the risk of having multiple key persons in a business you can see our table here.
Confidence in business comes from the financial strength, present, and future of the business. So next time you’re having the BBQ with mates, you be the one to ask, ‘Who contributes the most revenue and value to your business’ and what would happen to the business's future, if that stopped tomorrow?
Don’t let missing a hard conversation force you to lose everything you’ve worked so hard for.
How We Can Help
Recognising your business's Key Person and Key Revenue Maker is an important part of protecting your business revenue and your family, from the business.
Contact us for a confidential chat about your needs.
