Key person 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 definitely need to consider key person insurance on those people.
Here's how key person insurance works: A company purchases a life insurance policy on its key employee(s), 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 can cause the immediate death of that company. The purpose of key person 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 person insurance gives the company some options other than immediate bankruptcy.
If the company is a sole proprietorship and employs just you and no other employees or has no other people who depend on it, then key person insurance isn't as necessary. You'll notice we didn't mention your family--don't confuse key person 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's the owner 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 person 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 person 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.