Business owners, for all the business challenges you may not have control over the loss of a key person is one you can plan for.
What’s the concern? If for some reason, you or any one of your key employees were to leave the business, things just wouldn’t be the same and the business wouldn’t do as well and perhaps fail.
Have you ever seen this happen?
A business is doing well–profits are good, employees are happy. There are a couple of people that are central to the business’ success. These key people usually include the owners and may also include non- owner employees. Then one of the key people leaves.
The business just isn’t the same. From the outside it may manifest itself by poorer service, less inventive solutions, unhappy employees and unhappy clients because someone they had relied on is no longer available. From the inside you see customers departing, fewer new clients, lines of credit drying up or becoming more expensive, employees leaving.
I’ve seen this happen–a number of times in many different businesses:
- A non-owner key person left the business and went to a competitor because the benefits and opportunities were better.
- A non-owner key person opened their own business – they saw no ownership opportunities in the business they had been working in.
- A non-owner died.
- An owner became disabled and was unable to continue to work.
- An owner died.
There were different outcomes in each of these cases. In some cases, the business was able to survive and in certain cases even thrive. In a couple of these situations, the outcomes were troubling; the businesses struggled and did not survive.
In each of these cases, different outcomes occurred because the businesses had prepared differently.
How to prevent the departure of a key person
When a key person chooses to leave it may be because of dissatisfaction, better benefits, more opportunity. What can you do?
- Weigh the cost of losing the person. Lost customers, costly recruiting, time-consuming training or time to get up and running with a new person and the impact on other employees. If these costs are not acceptable, your next steps are to consider what may keep the key person in place.
- Review your benefits. Make sure your benefits are competitive. Make sure your basic benefits, cash compensation and special key person benefits are competitive and appropriately reward the key person. Special key person benefits, often called executive benefits may be provided selectively to your key people. There are many variations, including bonus plans split dollar or salary continuation plans each providing different current and future tax results, cash flow requirements, vesting and benefits.
- Consider non-compete agreements when the individual is first hired.
Ultimately, it may be that you are unable to keep the key person in place. If so, do you have sufficient funds in place to act as a financial cushion to give your business time to recover from the key person’s departure?
What happens when a key person dies or become disabled?
What about a situation where you or a non owner key person leaves due to circumstances beyond their control? This usually involves the death or disability of the key person.
A number of years ago a friend of mine bought into a business with two of his friends. Each of the three owners made their own special contribution to the success of the business. They did some planning which included setting up a buy sell arrangement that set out the terms of a buyout if one of the owners became disabled or died.
About four years after they started the business, one of the owners became ill and passed away just a few months later. The family was taken care of because of the buy-sell–it provided for the terms of the buyout, there had been insurance funding to help the co-owners complete the buyout.
Everyone thought they were set–but over the next year the business suffered financially. Having lost their co-owners’ special skills they lost business opportunities, suffered from cash flow strain and lost customer confidence.
They borrowed money to try to carry them over–but the bank terms weren’t particularly favorable with a relatively high interest rate and short payback period. At the same time they were trying to recruit someone to fill their deceased partner’s shoes–this became an expensive proposition as they couldn’t find anyone to buy in at acceptable terms. So they hired someone new–between salary, anticipated bonuses and benefits–this added to an already stretched cash flow–the business was looking at a stark future.
The importance of having key person insurance
The loss of a key person through death is often sudden, emotionally wrenching and challenging for the business and people in many ways. But it doesn’t have to create an immediate financial crisis if the business has plans to create a financial cushion following the death or disability of the key person.
Most often, businesses do this by using Key Person Life Insurance. It’s simply life insurance that the business will own on the life of a key person. It’s designed to deliver funds to the business when it needs them most. Because the policy is a business asset, its cash value (if any) will show as an asset on the business’ balance sheet. The death benefit may be paid to the business on an income tax free basis. (Sorry to talk technical with you for a moment–there are some simple hoops to jump through when the policy is being applied for to qualify the policy death benefit for income tax free treatment–be sure to speak with you planner about these steps. For the techies reading this blog post, I’m talking about IRC Section 101(j)).
For my friends, if they had received these funds, they may have avoided having to go to the bank, creating new debt and cash flow strain for the business. The funds could also have helped with recruitment costs for the new employee.
For all the business challenges we may not have control over, the loss of a key person is one you can plan for. Whether it’s providing special benefit packages to reward and retain your key people or implementing an insurance program to assure a financial cushion should a key person die or become disabled–the loss of a key person may become a manageable concern.