Protecting your business from loss of key employees

Managing Director of PIB Employee Benefits, David Skinner, considers the repercussions of losing key individuals from a business and how that risk can be addressed.

Due to the time and resources spent running their business, many organisations underestimate the importance of protecting the company in the event of the ill health or death of key personnel. In Legal & General’s 6th Edition “State of the Nation”, most business owners stated that the repercussions of losing a key individual could have a catastrophic effect on the financial viability of their organisation. Despite this, over half have not yet addressed the issue. A statistic which is even more concerning however, is that 52% of those surveyed suggested that their business would collapse entirely within 12 months of an event of this nature.

An injection of capital if a key person dies or becomes critically ill can help ensure that recruitment costs are covered, debt is repaid, and any shares are purchased from the deceased’s estate.

The results of the survey identified a wide protection gap. Of the 5.7m private sector businesses surveyed:

• 18% have key person protection
• 99% have identified at least one key individual that should be protected
• 40% have no continuity plan should they lose a key person
• 50% have no formal agreement for the transfer of shares on death
• Only 15% of family members would be skilled enough to work in the business if shares were inherited
• 20% use an insurance policy to cover debt
• 28% were not aware that Directors loan accounts need to be repaid on death
• £176,000 is the average debt level

There are three main areas of focus for Business Protection cover, however they are interlinked and often the solution may require a combination of products.

Business Loan Cover

The death or critical illness of a person that has guaranteed a loan can be particularly damaging to a business or the personal finances of the owner. In the worst-case scenario, business loan cover provides a fund from which a company can repay a commercial mortgage, overdraft or loan. This removes the requirement for any personal guarantees and can prevent undue pressure from creditors trying to recoup their funds.

A subset of loan cover is directors loan accounts cover. The average directors loan account at the time of the survey stood at £169,000.  The study discovered that a large percentage of the companies surveyed were unaware that a director’s loan account is legally required to be repaid on death. This can place further pressure on a business at a difficult time. Director’s loan cover can ensure that on the death of a director, the company can repay the loan account in full, easing the financial burden on the company.

Key Person Cover

A Key Person is any person whose loss to the business through death or diagnosis of a critical illness would have an adverse effect on the finances of that business, such as:  

• Loss of revenue and profit
• Cost of covering recruitment, either temporary or permanent
• Loss of client and supplier confidence
• Rebuilding client base confidence

An injection of capital into a company during a period of adjustment will assist the business in replacing lost revenue, fund an appropriate replacement, and remove financial pressure giving them the time and space to make the right decisions for their business. It also provides the business with a positive message to give to their suppliers, clients and creditors. This can help to alleviate pressure from third parties, such as competitors trying to unsettle client relationships following the uncertainty caused by the death of a key person. The company can reassure their customers and suppliers that the business will continue as normal, having had the foresight to purchase Key Person cover to financially protect the business.

Of the businesses surveyed, 52% said that they would not survive 12 months. Others said that the business would probably survive, but they would struggle to find a replacement person. The remaining organisations simply stated that there would be a period of financial uncertainty.

When asked what they thought the cost of purchasing Key Person cover would be, 80% of those surveyed estimated higher than the actual cost, with the overall average being more than three times the actual cost.

Share or Ownership Protection

The death of a business owner can lead to financial uncertainty within a business, however, share protection ensures that control of the company remains with the surviving shareholders. In the event of the death of a business owner where there is no agreement, the deceased’s shares would usually pass to their family members. This can result in the surviving shareholders losing control of the business, sometimes entirely. The family may also want to become involved but are often ill equipped to add value to the business or could even sell the shareholding to a competitor.

With guidance to properly construct an appropriate arrangement, organisations can mitigate the risks and ensure that the deceased’s family receive full value for the deceased’s shares whilst the surviving shareholders maintain control of the company.

This is an area which is generally poorly advised on in the UK. A large proportion of arrangements in place have at least one element which is incorrect and could cause problems if a claim arose, e.g.

• Articles of Association contradict the shareholders agreement
• Business valuation method is not stated 
• Business valuation is out of date, therefore the insurance amounts are too low/high
• No trusts or incorrect trusts used
• Non-payment of P11D taxation
• No cross option agreements 
• Changes to ownership not being addressed e.g., spouses have taken some shares for tax purposes 
• No equalisation of premium has been calculated

It is imperative that to ensure business is not disrupted business owners work with their insurance adviser, their accountant, and their solicitors to source the right solution. The four involved parties work together to ensure that any shareholder arrangement is appropriate:

• The accountants need to correctly value the business 
• Solicitors are required to ensure that the legal documents are evident and correct.  Cross option agreements, shareholders agreement, trust documents, Articles of Association checked etc.
• The insurance adviser needs to source and put on risk appropriate life/critical illness provision as well as completing the necessary equalisation of premium exercise (if required)
• The business itself needs to realise that such an arrangement is fluid and needs to keep abreast of changes in company valuation and shareholder changes to ensure that the agreement remains appropriate. It is very easy for the levels of cover to fall behind company valuation if it is not looked at regularly or when there is an event e.g., a business purchase or the securing of a new large client.

Summary

The advent of Covid 19 has put a greater focus on the health of the nation. It is more important than ever to take a step back and look at the risks associated with the loss or illness of key personnel and shareholders.

It is important to note that 73% of the businesses that took out cover only did so following advice from a professional.

Source: ‘Business protection, State of the nation’s SMEs report. Sixth Edition’, Legal & General, 28th August 2019