No one likes to think about the “what ifs” in life and business but to do so is a necessary part of a comprehensive risk management plan. The good news? Proper insurance can protect your life and business from financial loss due to just about any hazard. With a proactive approach, risk can be mitigated and managed – even when unthinkable.
Key person insurance protects your company when the unthinkable happens. The untimely death of a company leader reverberates through an organization. Grief and the resulting vacuum is often too much for a company to survive.
Such a loss is so likely to crumble a company most investors require key person insurance on a term sheet. Investors want to know they are protected should an untimely death occur.
What is key person insurance?
Key person insurance is a life insurance policy that protects your company in case a key member dies. The recipient of a claim payment from a key person policy is the company or the investors. The policy allows a company the financial security to carry on operations after the loss of a leader. Key person insurance offers two main benefits to for companies:
- It provides cash flow. After the death of a key person, operations suffer, and cash flow can dry up. Key person insurance helps fill the cash flow gap.
- It promotes overall financial security. The security that a key person insurance policy delivers can help build investor confidence and show your company has a proactive risk management approach – a boon when courting investors.
Although one of the most appealing benefits of a key person policy is that it can help attract investors, there are other benefits as well. On the company level, key person insurance helps provide business continuity by assisting with some of the costs that come with the untimely death of a key member. On a more personal level, key person insurance serves to ease the concerns of your team as the company navigates the aftermath of a loss.
When should a company purchase key person insurance?
Not every company needs a key person insurance policy, but there are signals that your company should have this protection in place. If your company relies heavily on a handful of individuals for intellectual property, proprietary knowledge or even the administration and creation of company culture, key person insurance is critical.
Key person insurance is also useful during the founding stages. If you are in the earliest stages and seeking investors, key person insurance helps to lower the startup risk profile, making you more attractive to investors.
What are the alternatives to key person insurance?
Alternatives to key person insurance exist. However, they have some shortcomings when it comes to the singular needs of a company. Let’s look at a few alternatives to key person insurance and discuss what they’re missing.
Sinking fund: At its most basic, a sinking fund is a capital fund established by the company for future cash flow needs. It can be useful to help fund future projects or to repay a long term debt. However, when considered as a substitute to key person insurance the sinking fund falls short. A sinking fund takes time to fully establish. What if a critical person passes away before the fund is at its maximum?
Debt financing: Debt financing requires the company to raise capital by selling notes to investors. In return for lending the money, investors now become creditors, and a company is beholden to repayment terms. While “convertible notes” commonly used in venture financing mitigates the interest and repayment risk by converting the debt to equity upon maturity, it’s particularly difficult to raise a new round of notes after the loss of a key person.
Tapping into company cash flow: Using existing cash flow to cover the expense of losing a key person is risky. After the loss, cash flow may decrease as productivity dips and the organization struggles. Relying on cash flow to act as a band-aid to steer a company through the transition is a poor plan. It’s also particularly difficult for venture-backed companies who are often operating at a net burn rather than with net income.
The new alternative: contract protection insurance (“CPI”)
Contract protection insurance (“CPI”) is also known as “failure to survive” coverage. As opposed to debt financing and a sinking fund, contract protection insurance makes a nice alternative to key person insurance. In fact, contract protection insurance has some features that are uniquely beneficial to businesses and startups.
Contract protection insurance has evolved in the insurance marketplace over the past several decades to help businesses secure protection for its key players and financial obligations.
It has been used to satisfy loan obligations when securing lending, and in divorce decrees,ut the policy shines as a type of key person insurance particularly useful for venture-backed companies.
Contract protection insurance benefits
The beauty of contract protection insurance is its ease of use. Unlike standard key person insurance which requires extensive underwriting and medical testing, contract protection insurance has a short underwriting period. Most policies are issued with 24-48 hours after applying.
Contract protection insurance requires no diagnostics, medical testing, or toxicology screenings. There is no need to make doctor and lab appointments. The coverage is designed to move quickly when you must place coverage as a condition to close funding or have time-sensitive M&A deals on the table.
CPI additional benefits
A traditional key person policy covers only the death of a key member. But what is the member is permanently disabled? Traditionally, companies purchase a separate policy known as a permanent total disability insurance policy to protect them from this risk.
Contract protection insurance again offers simplicity. The disability risk is included in one policy, eliminating the need to carry two policies with distinct policy terms, conditions, effective dates, and billing. In short, contract protection insurance insures both for the risk of death and disability all in one package.
No one enjoys thinking about worst-case scenarios and insurance coverage – particularly life insurance. Still, business risk must be considered, and proper insurance put in place. The good news is that contract protection insurance makes protecting your business from a key person loss or disability simple and easy.