More on Life Insurance
More on Life Insurance
What startup founders need to know about purchasing key person insurance.
Updated October 29, 2020
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Congratulations! You have a great product, a viable business plan, and your KPI’s are ready to pitch on Sand Hill Road. But if you’re a startup founder seeking funding from venture capitalists and angel investors, you might be missing an important requirement on your potential investor’s term sheet: key person insurance.
Key person insurance (also called “key man” or “key employee” insurance) is a life insurance policy that is owned and paid for by a business, which also serves as the policy’s beneficiary. It ensures that a business can continue to operate even if a central person to the business — usually the founder, owner, or CEO — dies.
During business planning, startups often skip over buying life insurance. But key person insurance, and other products like buy-sell agreements, are essential to mitigate risks that could damage or bankrupt a new business. It can be complicated for startups to purchase key person insurance because they usually haven't made any profits or revenues yet, but it's worth the time and extra effort. Working with a licensed insurance agent from the beginning can help you get the protection you need for your business.
Startups need key person insurance to protect the businesses from financial losses if a co-founder or executive dies
Buy-sell agreements, cross-purchase agreements, and entity purchase plans are products we recommend in addition to key person insurance policies
Applying for life insurance as a startup vs. an established business can be more complicated because it’s harder for life insurers to evaluate financial viability
Key person insurance is a life insurance policy taken out on a crucial member of a business. The business is the beneficiary and pays the premiums.
Any type of policy that can be used for an individual can also be structured as key man life insurance. The two most common types of life insurance are term life and whole life insurance. Key person policies involving whole life insurance are sometimes called split-dollar life insurance.
With an individual life insurance policy, the policyholder is typically the person who pays the premiums and is insured, and they can select their beneficiary. For key person insurance, the business or company is the policyholder, pays the premiums, and is the beneficiary if the employee insured dies while the policy is in force.
Key person insurance pays a death benefit to a business if the founder of the company — or any other key player — dies so it can continue operations. The death benefit can be used to help absorb losses in revenue the company may face and provide cash to help the search, recruitment, and onboarding of a new executive.
Key person insurance does not replace a personal life insurance policy, as none of the money from key person insurance would go towards family members. If you have key person insurance through your business, we recommend also having a personal life insurance policy.
Hypothetical example for a startup co-founder named Sarah:
|Key person insurance||Personal life insurance|
|Beneficiary||The business||Sarah’s family and dependents|
|Who pays premiums?||The business||Sarah|
|Is the benefit taxed?||No||No|
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Even though many investors require key person insurance, it can be difficult for startups to purchase it because they don’t always have the revenue yet to prove financial justification. But buying key man insurance is similar to buying an individual policy, with one main exception: financial underwriting.
If you’re seeking key person insurance for an employee, an insurance company needs to know more about your startup’s overall financial situation. They’ll look at your company’s losses year over year, gains, tax statements, and other aspects to determine the fitness of your business. In the same way that individual health is important to determine life expectancy and premium rates, a business’s “health” and estimated longevity helps determine key person insurance rates.
Because of this, some life insurance companies simply won’t offer key person insurance to startups. But several insurers are more open to working with startups, especially when presented with a narrative that explains that the business is growing and has a clear path to viability.
A Policygenius agent can recommend an insurer that is open to the changing trends in business and willing to write coverage for startups. We can also help you organize your application so it's optimal for approval.
After you choose an insurance company, applying for key person insurance is identical to applying for a personal policy (although you’ll need to provide more documents about your business). The person to be insured will need to answer questions on the application and undergo a medical exam. That information, along with other records, will be reviewed during underwriting and the insured will be assigned a health class, which will determine rates. The insured and the policy owner will both sign the policy, and the policy owner will pay the premiums.
Key person insurance works best in tandem with additional business life insurance products, such as buy-sell agreements. An agent can help you structure your plan correctly, which can be complicated. We recommend having a solid plan in place and talking to an agent before applying for life insurance.
Buy-sell agreements are necessary for companies with shared business ownership. Similar to a will or prenuptial agreement, a buy-sell agreement determines what happens if someone leaves the business (or dies). It lays out the prices and terms under which the remaining business partners can buy the deceased (or exiting) partner’s shares of the business.
It’s common for companies to organize a cross-purchase agreement, which allows partners to buy life insurance policies on one another as part of the buy-sell. In this situation, if one founder dies, the co-founder gets the death benefit from the policy, which can be used to buy the deceased’s company shares, as outlined in the agreement.
A third option is to set up an entity purchase plan, which allows a business to have life insurance policies on each owner or co-founder. If an insured employee dies, the company can purchase its shares using the death benefit.
Startups, in particular, need to plan and budget for life insurance products for their business’s top executives. Every business, large and small, can be crushed by the loss of an important employee. Startups are even more vulnerable to those risks because co-founders or owners are more difficult to replace either because of their expertise or personal networks. In many cases, potential investors are interested in a particular startup because they believe in a founder’s unique vision. So while a death benefit can’t replace the next Jack Dorsey or Anne Wojcicki, it can help the next big startup stay afloat in case anything unexpected happens.
Talk to an agent before you get your business up and running so you have financial protection from day one.
Anyone who is integral to the business’s operations, and whose absence would cause revenue loss, can be considered a key person. Typically, that includes any co-owners, founders, and executive members like CEOs and CFOs.
Because key person insurance functions like an individual life insurance policy, any type of life insurance – including term, whole, or another permanent insurance product – can be used. Most key man insurance policies are term or whole life insurance.
The tax-free lump sum from a key person policy can be used for any expenses the business has. Some common expenses include recruiting costs, client retention, loan payments, or buying out partner shares from the deceased.
Rebecca Shoenthal is a life insurance editor at Policygenius in New York City, specializing in buying life insurance and the ins and outs of life insurance ownership. She's edited business books by the country’s top academics, politicians, journalists, thought leaders and CEOs, including venture capitalist John Doerr’s Measure What Matters, entrepreneur Scott Belsky's The Messy Middle, NYU Stern professor Scott Galloway's The Four, and technologist John Maeda's How to Speak Machine.
Rebecca has a B.A. in Media and Journalism from the University of North Carolina at Chapel Hill.