Key Employees Part 1: Value

As part of your own exit strategy, you’re weighing the possibility of selling your business to one or more key employees. You’ve got a lot to consider when determining if this will be the best course of action for you and your business. It begins, though, with understanding what a key employee is and what you’ll need to do to build their value.

First, there isn’t one easy method for determining the value of a key employee. Business owners customarily use one of three methods to estimate the worth of an employee to their company.

  1. Multiple of Compensation: Annual compensation multiplied by a selected factor determined in part by the difficulty the business will have in replacing the employee. (This method needs to be adjusted to market salary if the employee is an owner that is being paid only a small salary which does not accurately reflect his or her value to the business.)
  2. Contribution to Profits: The company’s total excess profit is multiplied by the percentage of the company’s profit attributable to the key employee, then multiplied by the number of years needed to find and train a competent replacement.
  3. Cost of Replacement: The total of the direct, out-of-pocket costs involved in finding, hiring and training a replacement, as well as the estimated “loss of opportunity” costs.

Pre-Funding the Loss of a Key Employee

Most businesses do not have the necessary funds on hand to meet the unexpected costs related to the loss of a key employee. 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 will be available when death occurs.

If permanent type policies are used and the key employee becomes disabled or leaves, policy values can be available to the business in time of need. Additionally, the business may be able to continue the policy with a new key person as the insured.

How Does It Work?

‘Key Person Life Insurance’ is a simple concept for business owners to understand. The business applies for, pays premiums on, owns and is the beneficiary of a life insurance policy on the key person’s life.

These premiums are not income tax-deductible, but death benefits are received by the business income tax-free if the requirements under IRC 101(j) for employer-owned life insurance are met.

Life insurance is a logical solution to the uncertainty of loss of a key employee. Having a plan in place will help ensure the continued success of the business in difficult times.