Key Person Insurance

There is no easy method for determining the value of a key person. As a business owner, you might use one of three customary methods to estimate the worth of an employee in your company.

• Multiple of Compensation — The first method involves annual compensation multiplied by a selected factor determined in part by the difficulty the business will have in replacing the employee. (This method does not work well if the employee is an owner who is being paid only a small salary that does not accurately reflect his or her value to the business.)

• Contribution to Profits — In the second method, the company's total excess profit is multiplied by the percentage of the company's profit attributable to the key person, which is then multiplied by the number of years needed to find and train a competent replacement.

• Cost of Replacement — The third 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.

Most businesses do not have the necessary funds on hand to meet the unexpected costs related to the loss of a key person. There are three methods commonly used to finance the potential loss of a key person.

• Sinking Fund — Money can simply be accumulated in a savings vehicle. However, dollars accumulated for potential losses can also represent lost business opportunities.
• Borrowing — This option assumes that the loss of a key person or owner/key person does not seriously damage the company's ability to borrow money. If money is borrowed, it also must be repaid with interest.
• Life Insurance — Many business owners choose life insurance to protect themselves against the loss of a key person. You may find this option to be the most appealing because the insurance premiums are small compared to the lump sum that would have to be quickly available when a death occurs.