Key Man Insurance

Derek Notman, CFP |

What founders and venture capital firms need to know about key man insurance.

So, after much deliberation you’ve done it.  You are a founder and have started a business – you have started to realize your dreams and make progress towards your goals.  Now you’re on the hunt for funding from Venture Capitalists.  VC’s need to know their investment is protected.  This is typically done by insuring their ‘Key Man (Person)’ with a properly structured life insurance policy.

Let's be clear, key man insurance is not just for men!  It is for the key founders & employees of a business, simple as that.

Yes, this may sound a bit boring, but it is a key point virtually all investors will expect as part of investing in you and your startup.  Thankfully, this is a straight forward process and there aren't too many hurdles to overcome.

As a Certified Financial Planner® with over thirteen years’ experience, I would like to help you understand the basics of getting key man insurance as part of your capital raising strategy.

Building this component into your pitch and financial models will show you are prepared as well and fully aware of the risks your potential investors are subjecting their capital to.

Key Man Insurance Concept

If this is new terminology to you, Key Man (Person) policies are a life insurance policy that pays out to the company should anything happen to the Key Man (Person) i.e. You.  This requirement by a Venture Capitalist is not unusual and all VC’s require Key Man insurance when investing.  After all, VC’s want a return on their investment while using effective risk management for it, a life insurance policy will ensure protection should something bad occur.

It would be the norm for founders seeking venture capital funding to reveal details about their operations, visions and their finances.  Founders may also find, in order for them to obtain Key Person insurance, they need to be open to having medical checks done as investors want a guarantee that their Key Man is of sound health and mind.  Remember, for Series A funding to be approved, Key Person insurance is life insurance on a company’s founder or founders, with the company as the beneficiary.

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Covering The Debts

You can’t blame Venture Capitalists for being mindful of their investments.  If a founder whose existence to the company’s future is vital, the last thing VCs would want is an unexpected death.  The investors and the company would be left to carry the debts as early-stage companies don’t usually have major cash reserves or revenue to draw on.

This is where the policy becomes so important.  The proceeds pay wind-down costs, including salaries, creditors and debts to vendors.  Whatever is left, will be distributed to stockholders, usually at pennies on the dollar.  If the company decides to proceed with the business, without its Key Person, the insurance money can be used to hire a replacement and/or fuel the operations of the company.

 

Usually when a company is raising its first round of financing, investors will request a company to purchase Key Person insurance coverage.  Venture Capitalists will request the insurance at the term sheet stage (A term sheet is a bullet-point document outlining the material terms and conditions of a business agreement. After a term sheet has been executed, it guides legal counsel in the preparation of a proposed final agreement) or as part of negotiating definitive investment documents.

Initially the demand for a policy can be somewhat daunting for a founder, however, this should be met with a positive attitude.  The investors consider the founders’ knowledge and skills to be vital to the company’s wellbeing and all they’re asking for is a back up plan should anything happen.  It is important to note that investors won’t require key person policies for every employee at the company.  Typically, the more founders or team members in a company, the less crucial any one founder is, yet it is quite normal for all the key players to be insured.

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How Do You Get Key Man Insurance?

The coverage is based on how much cash the company would need after the loss of the key person or to wind down operations and satisfy their financial obligations.

Obtaining a policy is not difficult.  You will be required to undergo some medial underwriting to make sure you can qualify for the insurance. 

The process is pretty simple and straight forward as follows:

  • Determine amount of coverage needed
  • Determine type of insurance
  • Once agreed upon complete an application
  • Once the application is submitted to the insurance company you will be required to do things like give a blood & urine sample, answer some medical history questions, get your height & weight verified and perhaps have an EKG completed.
  • Once all of this is completed, which can be done in a matter of days, it is all sent to the underwriters to review and hopefully approve which will then give you the exact cost of the insurance.

The costs associated with your underwriting are borne by the insurance company, not you or your company.

 

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Key Person Insurance as Executive Deferred Compensation

As the company grows and there are strong revenues and additional rounds of venture capital is common for the founders to start planning for their personal financial futures.  Sure, they usually have some equity in their company, but this is not a liquid asset and it may be some time before it can be converted to cash. 

Another potential use of key person insurance is to structure the policies in a way that allows for the founders to put additional money away for themselves while still protection the company.  This is typically done as a carve out benefit for the key persons of the company in addition to any other benefits they may have.

This can be a great way to save substantial amounts of money for the key players while also using it as a so called “golden handcuffs” to keep the key people with the company as long as possible.

Do I Keep The Policy?

Unless the key person leaves the company there usually is no reason to drop these policies while the company is growing.  If anything, the founders will be required to purchase additional insurance as the business grows.  This is standard practice and helps keep the business and investment from VC’s protected.

If the company is sold or shut down the key persons who have the insurance can even take the policies with them once they part from the company.  If they do this, they would be responsible for paying the premiums moving forward.

If the policies where also being used for deferred compensation there could be a variety of benefits for the key people to keep the policies after the company is sold.

In all likelihood, you won’t ever need the Key Person policy.  It’s mostly a hedge against the worst-case scenario and offers the venture capitalists reassurance.  They have after all taken a risk investing in you and they would like to be prepared for a worst-case scenario.

Where to get Key Man Insurance?

Although technically any life insurance agent can sell you a policy to meet the key man insurance requirement you will want to make sure you are working with someone who has experience in this area as it is a specialty.  You wouldn't go to McDonald's for a filet mignon would you?

Don't get your key man life insurance from a generalist, get it from an expert.

Thank you for reading!

Cheers,

Derek Notman