Key Employee Insurance

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Dun & Bradstreet conducted a survey of 17,000 business failures.  It revealed that over 95% of the failures studied were due to management weaknesses such as incompetence, unbalanced or no managerial experience, or neglect.

The study highlights the importance of key people, those individual able to consistently make the right business decision.  The untimely death of a key employee or a business owner who is also a key employee can have a disastrous effect on a business.   Some of the "costs" of such an event might include:

  1. A weakening of the company's credit rating.
  2. The financial cost (in time and dollars) to find, hire, and train a replacement.
  3. The distraction of other employees, resulting in deadlines not met, deteriorating morale, or a higher level of personality conflicts.
  4. A need for cash to fulfill promises made to the deceased employee's spouse or family, such as salary continuation or deferred compensation.
  5. The inability to seize a business opportunity, because cash reserves are being used to recruit and train the new employee.
  6. A loss of confidence among both suppliers and customers.

Additional problems if key employee is an owner:

  1. Disagreement between heirs and surviving business owners or key employees.
  2. Lack of cash to buy the interest of the deceased owner, requiring a sale of the business to an unknown "outside third party."
  3. Surviving owners may be forced to work with someone who is either not competent, or not motivated enough to make the business thrive.
  4. The business may have to be sold to pay estate taxes.

 

Valuing a Key Employee

There is no easy mathematical formula to determine the value of a key employee.   However, over the years business owners have frequently used three different methods to estimate the worth of an employee to their company.

  1. The Multiple of Compensation Method:  Assumes that an employee's value is accurately reflected in his or her total compensation package.  The "multiple" that is used (for example: 2 x annual compensation), will depend on the type of business and the estimated difficulty in finding a qualified replacement.   This method is perhaps the easiest way to estimate the potential loss to the firm.
  2. The Contribution to Profits Method:  Estimates the impact a key employee has on the company's net profit.  The firm first calculates the expected profit from a "normal" return on capital, e.g., the net book value of assets.   Profit in "excess" of this normal return is assumed to result from the efforts of the key employees.  An estimate is made of the percentage of profit attributable to each key employee.  This percentage is then multiplied by total excess profit, to determine the dollar amount of excess profit from each key employee.   This sum is then multiplied times the number of years needed to find and train a competent replacement.
  3. The Cost of Replacement Method:  Totals the direct, out-of-pocket costs involved in finding, hiring, and training a replacement, as well as the estimated "loss of opportunity" costs.

 

Financing the Replacement of a Key Employee

There are three methods commonly used to finance replacing a key employee:

  1. Establish an Accumulation Fund:  However, dollars kept in a savings account represent lost business opportunities.  For example, if each $1.00 put into a marketing campaign returns $10.00 in sales, and the company has a 15% profit margin, the return on each $1.00 invested in marketing is $1.50.  On an annual basis, this would be a 50% return.  If the same dollar (along with the profits) were reinvested two or three times a year, with a similar increase, the ultimate return would be many times that earned in a bank account.
  2. Borrow the Funds: This option assumes that the loss of a key employee does not seriously damage the firm's credit worthiness.  Each dollar borrowed must be repaid, with interest.  If the loan is amortized over a 10-year period, at 12% interest, for each $1,000 borrowed the company would repay a total of $1,770.
  3. Life Insurance Policies: Many business owners choose life insurance to protect themselves against the loss of a key employee.  The premiums are small compared to the lump sum which would have to be quickly raised, out of earnings, or by borrowing, when a death does occur.  Although the premiums paid on a life insurance policy are not a deductible business expense, the proceeds at death are received income tax free by the company1.

 

If permanent type policies are used there will also be a cash value build up, which can be available for the business in time of need, regardless of the firm's credit worthiness.  

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1 However, proceeds are included in "adjusted current earnings" to the extent that they exceed the policy's tax basis, for purposes of the Corporate Alternative Minimum Tax.  Beginning in 1996, the Taxpayer Relief Act of 1997 repealed the AMT for "small" corporations.  In general, a small corporation is one which has had average gross receipts of $5,000,000 or less for the three previous tax years.

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