The US is built on small business, and for good reason. Owner/managers get control over their destinies, gain the freedom to create, and have the chance for significant upside if the business is sold. Often, small businesses have partners, multiple owner operators who share the responsibilities of management – in the trials, and tribulations, that go along with that duty.
Life happens. And so does death. But what happens to the small business if one of these partners, a critical part for making the engine run, passes away? There is no way to compensate for the emotional devastation, but we’re not here to discuss hiring family therapists. The owner/operator now departed has an estate, and with it (hopefully) heirs. Those heirs are generally entitled to the partner’s share of the business. Unfortunately, those heirs may attempt to assert their rights beyond ownership, inserting themselves into an organization that they do not understand. It’s not always bad, but it can be – disruption to the business from getting them up to speed on what is going on, dealing with the immediate injection of diverging ideas, and sometimes demands to generate a liquidity event so the heirs can go do something else. This issue can be avoided if the business has a plan.
There are two ways in particular a small, thriving business can protect itself in the event one owner/operator dies. The first is to make sure resources are available to find and train a suitable replacement; the second is to ensure that heirs to the deceased partner’s estate are compensated in accordance with the deceased’s wishes. And both of these needs depend on the value of the individual partner’s contribution to the firm, and the value of the firm itself.
Life insurance is one of the most cost effective ways of providing protection to the business to serve both aforementioned needs, but policy choices must be evaluated separately based on those needs. In other words, the cost of bringing in a replacement partner should be evaluated separate and apart from what heirs to the deceased partner’s estate should be entitled to. In the first case, you should probably consider the following:
- How distinct is the industry? Can a new partner be readily found, or is this search going to require turning over a lot of small stones? Is hiring a headhunter a must, or is Craigslist good enough?
- How much would a new entrant require in terms of base pay? Are the closely held business’s present partners getting base compensation that is above or below the industry standard?
- Is the new partner going to receive significant equity? Are they going to have to buy that equity, or is it going to be granted and vest over time?
You are replacing a key person in the organization – insurance to fund the costs of that replacement is generally called “key man insurance.” The actual plan you put in place can be an informal one – decide what it is going to cost to replace each partner, and buy life insurance with a benefit relatively equal to that cost.
The other side of the business continuity plan, that which compensates the deceased’s estate, works a little differently. The partners have to to determine what the total value of the business is, and then determine individual value to them based on their respective ownership interests. The owners must have an understanding where they will exchange that value in cash for the benefit of their estate should they die. This arrangement, which also needs to be flexible enough to account for increases in the value of the business, is called a “buy-sell agreement.” It takes a bit more legal wrangling (and it can technically be crafted within an business operating agreement or bylaws), but simpler factors need to be taken into account:
- How much is the business worth financially, now?
- How much will the business be worth in the future (i.e. at the time of death)?
- How much of the business does each partner own?
Alas, it’s number tumbling time, so things get complex once again.
I’ve been hard pressed to find a small business that can afford a five or six figure price tag for a full blown valuation with a licensed CPA’s lengthy disclaimers and signature attached. Further, a lot of valuation work requires “comps” – financial transactions such as buyouts from which earnings or revenue multiples can be derived. Small businesses are most often private, and transaction data can be very hard to find. Under these circumstances, doing a back-of-the-envelope valuation can work, as long as the business owners are given enough options with which to make a decision on.
My own valuation work here focuses on two issues – several methodologies and providing ranges of multiples. For example, providing valuation calculations using both multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) and revenue often provides some good hints as to what the business might be worth. If comparative multiples (from those private buyout transactions) can be found to buttress those analyses, all the better. Further, some industries might be traditionally valued based on one or the other method. If the business is in newer, high growth industry, revenue might be considered more important than profit; a long-standing business in a mature industry might be the opposite.
You can get creative too. I’ve gone as far as to make up my own valuation methods, including one where we calculated the individual financial benefit the partners receive from their contribution to the firm, and backing into the valuation based on expected years of future service with the company. The bottom line is coming to an accord on what the value of the business is and/or will be, and getting those figures documented in the buy-sell agreement. Last but not least is purchasing life insurance policies for each owner/operator that reflect those numbers.
A small business continuity plan need not be complicated. It can be constructed in just two parts, coverage for key personnel and a buy-sell agreement. Piece of mind is what the business and it’s owner/operators are after, and that comfort can be attained with a little elbow grease and some reasonable monthly premium payments. And it can wind up much better than the alternative – having the body short a limb and/or having a prosthetic in place that’ll never function quite like the real thing.
Editor’s note: The author is not a licensed insurance producer. He’d rather crunch the numbers and leave the insurance pitch to someone else. Further, this post is not intended to represent or replace sound legal advice. The author is not licensed to practice law in any of the 50 states or Katmandu, and didn’t even go to law school for that matter. However, if you are looking for a second opinion, or need someone to observe and opine on the operation, feel free to email or call.