Q: What is key man insurance, and does my new business need it?
A: When you're just starting out, you've got a lot on your plate, and it seems like you spend all your time working on the urgent stuff--trying to get your product or service ready, hiring people, figuring out how to increase sales, paying the bills and so on. It's hard to find the time to consider something that isn't really urgent but that can be incredibly important, such as insurance--specifically, "key man" insurance.
Key man insurance is simply life insurance on the key person in a business. In a small business, this is usually the owner, the founders or perhaps a key employee or two. These are the people who are crucial to a business--the ones whose absence would sink the company. You need key man insurance on those people!
Here's how key man insurance works: A company purchases a life insurance policy on the key employee, pays the premiums and is the beneficiary of the policy. If that person unexpectedly dies, the company receives the insurance payoff. The reason this coverage is important is because the death of a key person in a small company often causes the immediate death of that company. The purpose of key man insurance is to help the company survive the blow of losing the person who makes the business work. The company can use the insurance proceeds for expenses until it can find a replacement person, or, if necessary, pay off debts, distribute money to investors, pay severance to employees and close the business down in an orderly manner. In a tragic situation, key man insurance gives the company some options other than immediate bankruptcy.
If the company is just you and doesn't have any employees or other people who depend on it, then key man insurance isn't as necessary. You'll notice that I didn't mention your family--don't confuse key man insurance with personal life insurance. If you have a spouse and/or children who depend on your income, then you should have personal life insurance for that purpose.
How do you determine who needs this insurance? Look at your business and think about who is irreplaceable in the short term. In many small businesses it is the founder who holds the company together--he may keep the books, manage the employees, handle the key customers and so on. If that person is gone, the business pretty much stops.
How much key man insurance do you need? That depends on your business, but in general you should get as much as you can afford. Shop around and get rates from several different agents; most life insurance agents will sell you a key man policy. Be sure to ask for term insurance--many agents will push whole or variable life, which have much higher premiums and commissions but are unnecessary for a key man policy. Ask for quotes on $100,000, $250,000, $500,000, $750,000 and $1 million and compare the costs of each. Then think of how much money your business would need to survive until it could replace the key person, come up to speed and get the business back on its feet. Buy a policy that fits into your budget and will address your short-term cash needs in case of tragedy.
Let me share an example from my own personal experience. My brother-in-law started a golf vacation business in the winter of 1997. Tommy worked many long hours for almost three years, and it looked like all his hard work was paying off. Then one night he was killed in a car wreck. He was 35 years old. As my wife and I tried to deal with the magnitude of that loss, we also had Tucker Golf's employees, vendors and customers to think of. No one planned for this to happen. But it did happen, and we had to pick up the pieces. Tommy did not have key man insurance, and the company struggled for almost two years before it recently got back on solid footing. While key man insurance wouldn't have brought Tommy back, it would have taken a major worry away from his grieving family and employees.
Most people, particularly when they're young, don't plan on dying suddenly. If you are working to start or grow a small business, you've got plenty on your mind, and chances are you haven't thought much about key man insurance. But take it from my experience: By the time you need it, it is too late to do anything about it. Call an insurance agent today, figure out how much key man insurance your company needs and buy it!
Keith Lowe is an experienced entrepreneur who is a founder and investor in companies in several industries. Lowe also mentors new entrepreneurs; serves as past chairman of the board for Biztech, a nonprofit high-tech business incubator; and is a co-founder and officer for the Alabama Information Technology Association.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.