The Biggest Manageable Risk Is the Least Talked About by Small Business Owners


The Biggest Manageable Risk Is the Least Talked About by Small Business Owners

We don’t always talk about what we should. “If you avoid difficult questions, you’re out of business already and just don’t know it – but your suppliers might already suspect.”

Talking about what would happen to your business if, an owner or key person suffered a serious illness or even died from a stroke, is not the usual topic of conversation around the BBQ with mates. But we do talk about what would happen if the shop burnt down, the computers were stolen or if the roof was ripped off by a storm and the warehouse flooded.

Small business owners are particularly exposed to one key manageable risk; the businesses reliance upon the owner or its key people and their ability to continue to do their job.

How to recognise a key person in your business.

When it comes to key people, there’s usually one in every business. But how do you recognise them and how do you measure the potential loss to your business if they suddenly stopped working?

If your business employs staff, you’re legally required to have compulsory worker’s compensation insurance to protect your employees from accidents in the workplace.

But when it comes to your key people, this is one manageable business risk that’s usually left unprotected; even though it can literally mean ‘the end of the business itself and the income it provides’.

Although the number of key people in a business will change from business to business, there will usually be at least one. A key person is usually someone whose skill, knowledge, experience or leadership significantly contributes to the financial success of a business directly or indirectly.

They are someone whose potential absence, because of serious illness (or even death), would have a significant impact on the businesses future profit. Whether that’s because customers and suppliers begin losing confidence in the businesses future or because the loss of expertise means the immediate loss of capacity, key people have a direct impact on the bottom line.

Key people might include:

  • A managing director or CEO.
  • A partner in a partnership.
  • A senior sales manager.
  • An employee with a particular skill, technical expertise or supplier connections.

Why don’t we talk about this more?

Some business owners take the ‘head in the sand approach’ saying, “If it’s important my accountant will tell me about it” while the accountant says, “If they have an important question, I’m sure they will ask me about it.”

And so, the circle of dis-ownership and avoidance of essential questions goes around and never really gets sorted, until the lawyers get involved later.

What happens if this risk is not managed and something happens?

This is when a business owner, (and usually their family) pays the full cost of not having that initial conversation about managing their key people risk.

The lawyers from the bank, the shareholders (or even the estate of a deceased non-executive Director) begin to look for ways to recover their losses. They will start searching for someone to sue alleging professional negligence and demanding compensation from:

  • the company Partners or Directors, for breaching their various fiduciary duties; and
  • the company Accountant or Business Adviser, for professional negligence in not proactively identifying a key business risk for their client, who employed them with this expectation.

Why is this important?

The overwhelming number of small business owners and directors have their personal assets on the line and at risk of forfeiture. It can even put at risk their ability to afford to retire in the future.

Case Study: How one business protected itself through a key person insurance strategy.

Anthony runs a small structural engineering firm, providing consulting services. Gary is a key employee of the business and responsible for generating about $200,000 of business revenue each year:

  • Anthony realises that Gary is critical to the immediate survival of his business.
  • He estimated it would take 12 months to find and train a suitable replacement if Gary became disabled or died.
  • Anthony estimated that if Gary were unable to work, the net profit of the business would fall by $200,000 per annum.

This would place the business, and Anthony, under significant financial pressure.

Anthony calculated the risk of the potential business loss as:

Annual fall in net profit                           $200,000

Cost to hire a replacement                      $25,000

Cost to train a replacement                    $25,000

Total business risk to be covered          $250,000

As most businesses don’t have an idle $250,000 available, Anthony’s company took out a life insurance policy on Gary’s health and life for $250,000 to protect itself from the risk of suddenly losing its key person, Gary.

If Gary dies or becomes disabled, the insurance policy payout could replace the fall in net business profit of $200,000 over the next 12 months and cover the cost of finding and training a replacement for Gary.

When it comes to understanding the tax position of this type of strategy, speak with your accountant first, but usually, the purpose of the insurance cover will determine whether the premiums are tax deductible and how the proceeds are taxed:

  • As a general rule, if the purpose of insurance is to protect the revenue of the business, through replacement of lost sales or provision for increased expenses, the premiums will be tax deductible, and the payout assessed as income.
  • A sample company document to record the purpose of this insurance strategy can be found here.

What happens if my key person is only temporarily off work?

The absence of a key person due to temporary disablement can place a business under the same significant stress that occurs in the event of a more serious disability or death:

  • A temporary disability is statistically more likely to occur than a permanent disability or death. Temporary disabilities for a key person could be from any cause, including a physical injury, early stage cancer or a minor heart attack.
  • When it comes to understanding the risk of having multiple key persons in a business you can see our table here.

Confidence in business comes from the financial strength, present and future of the business. So, next time you’re having that BBQ with mates, you be the one to ask, “Who contributes the most revenue and value to your business and what would happen if that stopped tomorrow?”

Don’t let missing a hard conversation force you to lose everything you’ve worked so hard for.

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