This week's article is directed towards small business owners, and specifically around protection for the business asset. There's a saying that a "business is the length and breadth of the shadow cast by the business owner," and we feel this is completely true. We also feel that most business owners don't understand the inherent risks in their businesses, namely the risks around themselves and their key people. What happens to the continuity of the business if something happens to the business owner or a key person? As with any business, we feel it is a prudent strategy to try to reduce risk where possible.
The risks inherent in a small business can be classified into three categories: Debt risks, key person risk, and ownership risk.
This occurs when a life event, either death or disability happens to a business owner and the value of the business drops, leaving an existing debt position exposed. This is further compounded by most business owners giving personal guarantees to lenders for finance needed in the business. For example, if a Mum and Dad business is worth $700,000 as a going concern, and there's a $300,000 business debt, the risk to that business being able to continue in the event of death or disability is extremely high.
Key Person Risk:
This occurs when the success of a business is closely reliant on a small number of people. If something happens to one of those people, there is an inevitable drop in the profitability of the business. For example, if a business is being run by a managing director who knows the ins and outs of the business extremely well, the cost to the business can be huge if something happens to that person and the business is forced to find a replacement, and then train that replacement into the role. The cost is far greater than the outgoing salary expense.
Let's assume the business is being run through a partnership model, and there are two partners involved. Let's also assume each partner has a spouse who isn't involved in the business. In this case, if one of the partners died suddenly or was disabled, the remaining partner is then in business with that person's spouse. This is not always the desired outcome! The continuity of the business and the provision for two families is then completely at stake.
For all of these risks, we'd suggest a strategic amount of life and disability insurance is the best course of action, and a prudent measure to take. The business can fund the premiums and in many cases these can be tax deductible, making them even more worthwhile. As with any insurance, there is a cost to having the policies in place but there's also a cost to not having them, which is always much more severe.