Another kind of sustainability
Most business people tend to think of sustainability as something to do with recycling and a smaller environmental footprint. But some small businesses discover they are no longer sustainable after a sudden change involving a key individual.
According to entrepreneur.com, “The death of a key person in a small company can cause the immediate death of that company.”
Key person insurance is a life insurance policy a company takes out on the life of a key owner or key employees. The company pays the premiums and is the beneficiary.
Philip Streng, an Edward Jones financial advisor, is now working with a Grand Rapids technology company to set up key person life insurance on one individual at that company, which has more than 20 employees.
If something happened to that key person, he said, “the business could very well go south,” even though at least one of the partners “is very capable.”
“The key person is really the relationship person, who has brought in and sustained most of the business,” said Streng, and the insurance benefit may be enough to help the company regain its momentum if that person is lost suddenly.
Sustainability also can be threatened by other unforeseen events involving key people at the company who own stock in it. Those include disability, divorce, or termination from the company.
The divorce of a key person, for example, could mean that an ex-spouse ends up owning some of that person’s stock. Or, a key person who owns stock in the company could quit or be fired and go to work for a rival firm.
Young said a buy-sell agreement should include a mechanism for buying back that stock.
“If you do have a plan to buy out a key shareholder, part of that plan does need to be: How you are going to pay for it?” said Young. “A cash reserve or sinking fund is one way and it may be an expensive way. Life insurance may be a way. Payments over time is another way.”
Some planners “are bigger on the use of insurance to fund buyouts than others,” said Young. “Insurance is not essential to have a buy-out, although it can be convenient. But obviously it costs money in premiums.”
“As a practical matter, I find a lot of companies, notwithstanding their best intentions, don’t operate with a reserve of cash sitting around,” said Young. “That’s just too expensive — at least, for most of the companies that I see. They’d rather spend the money on new equipment or a new facility … or pay down their debt.”
“The reality is, most companies operate with some amount of debt, and it’s usually better to pay the debt down and perhaps hope that if there is a need for that cash, they can continue to borrow money when the time comes. But it’s expensive to hold cash, while you are paying interest on debt to the bank, too,” said Young.
Streng said much of the life insurance used in the buy-sell agreements he is familiar with are term policies, but he said the recession demonstrated to him recently that companies might also want to consider cash value life insurance.
One of his client companies had cash value life insurance policies on key people at the company. They were “great business owners,” he said, who had never missed a payment to their banks on their loans, but the major decline in real estate values meant a drop in debt-to-equity ratios across the land.
“The banks wanted to call in some of their loans,” he said, but his clients “couldn’t get financing anyplace else. So they borrowed on their life insurance policies the cash value they’d accumulated over 20, 25 years.”
Many small business owners, according to Streng, seem to have all their eggs in one basket —which is the business itself.
Streng said it is “very, very challenging” to get a small business owner to “take time out, take a few minutes and think about diversifying” the company’s investments.
Some readily do so, he said, but many others have told him, ‘you know, I’ll worry about that later,” when there is more cash available.
Sometimes they just say, ‘I’m so busy right now. I don’t have time,’ he added.
Key aspects of preparing a buy-sell agreement are involvement by the company’s CPA and attorney, said Streng.
At what point does he believe financial sustainability planning is necessary for a small business?
Streng said it is his opinion that a combination of revenue and the number of employees should trigger the planning. As far as revenue goes, “start talking about sustainability at or close to the point when the company’s revenues are in the black.”
“I think when you have two or more employees, that’s the time to talk sustainability because there are people relying on that business being around tomorrow.”
“Whether it’s the owner or the employees, people are relying on it. Let’s talk about what you can do,” he said.
And listen to that CPA, added Streng. Part of financial planning is “keeping a proper debt-to-equity ratio. Boy, if there’s one thing a lot of business owners learned over the past five years, it’s not leveraging themselves.”
More information on small business sustainability is available from the Family Business Alliance at GVSU, on whose board Young sits. Visit gvsu.edu/fba.