By Ronald P. Perilstein, CLU
One man in a thousand, Solomon says,
Will stick more close than a brother.
And it’s worth while seeking him half your days
If you find him before the other.
—from The Thousandth Man by Rudyard Kipling
In every successful small-to-medium business, there are a handful of men and women who rate the honor of the Thousandth Man–the truly committed men and women, the ones who hold keys to the company’s success. These gifted managers skillfully guide the business through operations, sales or financial decisions. They possess the technical minds whose innovative ideas lead to market edges. They are the relationship builders who guarantee client and supplier commitment.
The loss of their practical experience, their expertise, their leadership skill is likely to have such a fundamental effect on the business that economic loss is certain. That’s the downside risk of having great people—the continual peril of losing them. Why would a business take precautions against fire, natural disasters, theft and vandalism, yet neglect the risk of losing the knowledge and experience of the people who made it successful?
The Economic Value of the Thousandth Man
Most business owners will claim to have contemplated the loss of key people and even taken steps to indemnify the company. But it is rare that the real cost of the loss has been accurately measured, so the company remains at risk. The cost attributable to the loss of such key employees through disability or death can be difficult to quantify since so many components of the business are likely to be affected. It goes far beyond a job function. Companies must consider the loss of
• Sales revenues.
• Client goodwill.
• Market share.
• Proprietary knowledge and systems.
• Production capacity.
• Credit standing with lending sources and suppliers.
• Time and money to recruit and develop replacements.
• Cash flow.
Life and disability insurance protection can provide funds to meet debt obligations, offset lost sales and cover the expenses of recruiting, hiring and developing replacement personnel. They are essential components of any risk management plan for any business.
Determining the amount of insurance coverage is not a precise science. Some advisors favor using salary as the starting point, but the fact that the range runs from 2x to 10x annual salary shows that the calculation is largely a comfort-level guess. The mid-point ends up being most typical, so it is hardly a sophisticated approach.
Replacement cost calculation offers a more rational basis. This begins with the search fees and other costs associated with bringing a new person onboard, such as a moving allowance. Salary is still the primary consideration. But the lost key person might turn out to have been a bargain from a salary perspective—a leftover from older salary structures—with perks and bonuses making up the real value. Or, a new person might come at a much higher base price tag, since performance-based incentives, which became habitual with the previous employee, can seem like a high risk to someone new on the job.
Also, the company might consider whether the key person’s function can really be handled by one replacement. If the key person wore many hats, the company could be better served by splitting the roles and hiring two less experienced people. Another important measure should be a calculation of the impact to sales and profits of the loss of the key person. If client relationships are jeopardized by the loss, there may be costs to rebuilding them. The same with relationships with suppliers and credit sources.
When the Thousandth Man is Numero Uno
All of these factors are multiplied when the Thousandth Man is the owner of the business. Typically, though, the owners of small-to-medium companies rarely consider to measure their own loss. They see what happens when they are gone for the day or the week, and their solution is to never be gone again. But not all absences are a matter of choice.
Some owners die while they are still active in their businesses. A greater percentage become disabled in a way which forces them to withdraw from active participation. The rest eventually do retire. The withdrawal of the owner is not a contingency but a certainty. The only uncertainty is when it will happen. At that time, some form of ownership and/or management transfer must take place. No matter when or how it happens, that transfer must be designed so it does not cripple the business.
The role of the continuity plan is to separate the life of the business from the life of its owners, to anticipate possible future events in the life of the business, and to guarantee that it will continue to exist in a manner that meets the owners’ goals.
An owner looking ahead to scaling back direct involvement in anticipation of retirement is likely to form a mental picture in which the business draws upon his expertise and influence in return for consulting fees of some kind. If the owner considers the possibility of a disabling condition, he or she probably expects that the business will continue to pay a salary for a number of years. And if he or she contemplates the eventuality of death, there is probably a mental picture of family members receiving cash for the business interest so that their income will not be dependent upon the decisions of surviving partners.
Surviving partners naturally have their own agendas and mental pictures. Typically, they do not want inexperienced, non-active members of their partner’s family to be involved in the operations of the company. Of additional concern is the effect the loss of the owner could have on credit and bonding capacities.
The owners may actually share these personal scenarios and come to consensus on alternate futures. But until a plan is drafted that makes these desires contractual, there is no guarantee the desired future will ever come to fruition. From experience, there is a better guarantee that it never will.
The Business Will
The most common business continuity tool is a funded buy-sell agreement, sometimes referred to as a business will. The buy-sell agreement is inexpensive to draft and less complicated than other ways of transferring ownership and management of a closely held corporation. It can be responsive to changing circumstances, since alteration is possible with the consent of all parties.
The agreement is a legal contract restricting the right to dispose of a business interest to specified parties according to specified terms. It typically requires the sale of a business interest at a predetermined price or by a predetermined formula, triggered by death, disability, retirement, withdrawal from the business, or involuntary transfer of one of the owners.
For the family of a retired, disabled, or deceased shareholder, the agreement provides an orderly transfer of ownership and continuity of management, freeing it from business worries and assuring a fair price. If it is funded with life insurance, the agreement generates liquidity for the payment of the debts, expenses and taxes of the estate. The family will not be dependent on the business and its remaining owners.
With the agreement, remaining owners are assured that the stock will not fall into the hands of anyone not connected to the company or without an appropriate interest in running it. It may comfort the potential fears on the part of creditors or bonding companies. The agreement may also provide a method for withdrawing funds from a family corporation other than as dividends.
In short, the buy-sell agreement controls the disposition of all stock in the corporation in the event of a spectrum of contingencies. An effective buy-sell agreement should protect all parties from disadvantage by including all essential provisions key to the success of the arrangement. These provisions include, but are not limited to the following.
• A statement of purpose of the agreement, outlining the intentions of the parties and objectives for the smooth transfer of the business interest.
• The promise to purchase/sell, identifying the purchasers and sellers of the interest and the percentages or shares to be purchased, as applicable.
• A valuation provision that establishes an agreed-upon price with provisions for re-evaluation at predetermined times, a formula for valuing the business at the triggering event, or procedures for selecting and using outside appraisers.
• For life insurance funded agreements, instructions for the purchase of the life insurance and requirements for keeping the policy in force.
• For disability funded insurance funded agreements, a definition of disability that reflects the provisions of the policy itself and outlines the circumstances under which, and at what point, the buy-sell will be activated.
• For installment purchases, the terms and conditions of the payment plan.
The terms of the buy-sell should specify how the purchasing party will pay for the business interest. Broadly, options include cash payments from savings, borrowing, installment sale, disability insurance proceeds, or life insurance proceeds.
Planned saving can be impractical since triggering events are likely to occur with little or no notice, and complete funding cannot be assured. Borrowing can be equally impractical since much of the lender’s security depends on the stability of the company, which may be threatened by the shareholder’s withdrawal.
Installment sales by themselves can place a burden on both parties to the transfer. The payments will drain current earnings as well as forcing the departing owner or heirs to rely upon the future success of the business, over which they no longer have management control.
Installment sales are often included among the provisions of buy-sell agreements to provide for payment beyond insurance funding solutions. This may be done as a two-pronged payment plan or as a fail-safe mechanism, should insurance be allowed to lapse or if increases in the value of the business overtake the amount of the insurance policy proceeds. Typically, in an installment plan the estate of the deceased takes a note from the corporation or remaining co-owners.
The heirs may actually feel very comfortable with this arrangement, since it provides an income stream for them. But, as an unfunded obligation of a corporation or its owners personally, installment payment plans must be carefully analyzed and periodically reviewed.
The potential mistake of this kind of clause in the buy-sell agreement is no different in concept from the common mistake of credit card debt. The business cannot simply expect that future revenues will be able to support the installment agreement. In some cases—particularly in businesses with narrow profit margins—the increased sales needed to generate cash for the payments can far exceed any reasonable revenue expectation or historical model. Even more sobering is the fact that, since the installment payment is not deductible, revenue calculations must reflect after-tax dollars.
Given these potential problems, the combination of disability and life insurance typically proves to be the least costly of these options. The most significant advantage is that complete financing is guaranteed from the beginning. A lump sum payment to the deceased stockholder’s estate is generally feasible only if life insurance proceeds are available to fund the payment.
Furthermore, life insurance proceeds are received by the beneficiaries free from income tax, except for the corporate AMT. Cash values in the policy can also be utilized for a buyout of a retiring or disabled partner and allow the withdrawing partner to keep the policy. However, the trade-off for the tax free proceeds is that the insurance policy premiums are not tax deductible.
Life insurance funding avoids bank and bonding company problems. The credit position of the firm is not affected by a deceased shareholder’s stock in the firm, and the selling shareholder does not need to depend on the credit-worthiness of the company for an extended period.
On the disadvantage side, insurability may be a problem or, due to age differences among shareholders, premiums may not be equitable. This can usually be addressed with appropriate compensation measures.
In summary, how much is the company’s Thousandth Man worth? Measured by his or her potential loss the Thousandth Man can be worth as much as the company, and only key person coverage and a funded buy-sell agreement will secure its value.
Ronald P. Perilstein, CLU, is president of The Arjay Group, Inc., a member firm of the PartnersFinancial national network, located in Narberth, Pa.