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Home : Planning Your Finances : For Your Business : Key Employee
Key Employee Insurance
The untimely death of a key employee or 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:
- A weakening of the company's credit rating.
- The financial cost (in time and dollars) to find, hire and train a replacement.
- The distraction of other employees, resulting in deadlines not met, deteriorating morale, or a higher level of personality conflicts.
- A need for cash to fulfill promises made to the deceased employee's spouse or family, such as salary continuation or deferred compensation.
- The inability to seize a business opportunity because cash reserves are being used to recruit and train the new employee.
- A loss of confidence among both suppliers and customers.
Additional problems (if key employee is an owner) might include:
- Disagreement between heirs and surviving business owners or key employees.
- Lack of cash to buy the interest of the deceased owner, requiring a sale of the business to an unknown "outside third party."
- Surviving owners may be forced to work with someone who is either not competent, or not motivated enough to make the business thrive.
- The business may have to be sold to pay estate taxes.
Valuing a Key Employee
Financing the Replacement of a Key Employee
Valuing a Key Employee
There's no easy formula for determining the value of a key employee. Over the years, business owners have frequently used three different methods to estimate the worth of an employee to their company.
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, 2x annual compensation) will depend on the type of business and the estimated difficulty in finding a qualified replacement.
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. 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 and the percentage is multiplied by total excess profit, to determine the dollar amount of excess profit from each employee. This sum is then multiplied by the number of years needed to find and train a competent replacement.
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.
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Financing the Replacement of a Key Employee
There are three methods commonly used to finance the replacement of a key employee:
Establish an Accumulation Fund
However, dollars kept in a savings account represent lost business opportunities.
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.
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 occurs. Although the premiums paid on the life insurance policy are not a deductible business expense, the proceeds at death are generally received income tax free by the company.* If permanent type policies are used, there will also be a cash value buildup, which can be available to the business in time of need.
For more information and help with your business planning needs, contact a
Transamerica representative.
*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 1998, the Taxpayer Relief Act of 1997 repealed the AMT for "small" corporations. In general, a small corporation is one which has generated average gross receipts of $5,000,000 or less for the three previous tax years.
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