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KEY PERSON INSURANCE
This policy determines what happens if a key person dies. Such a life insurance policy specifies the corporation as the beneficiary if the key person dies. Though the premium payments are not tax deductible, if the policy is activated, the distribution to the corporation is tax free.
The distribution helps a company navigate a transition, such as finding a replacement and paying the salary. Also, the insurance can compensate for the potential reduction in revenues due to the departure. The rule of thumb is that coverage should be at least five times the salary of the key person. The amounts tend to range from $1 million to $10 million and is usually for a term of two to 10 years.
To illustrate, when Martha Stewart Living Omni-media filed to go public in July 2000, the prospectus filed with the SEC had a risk factor titled "The loss of the services of Martha Stewart or other key employees would materially adversely affect our business." Because Martha Stewart is the personification of most of the company's brands and also a highly active senior executive officer, two steps were necessary to protect the company. First, Martha signed a five-year employment agreement. And second, the company purchased a key person life insurance policy with a minimum amount of $10 million.
From a buyer's perspective, the existence of such a policy (or policies) may prove invaluable. For example, deals often go on for several months before they're finalized. What happens if the principal dies during that period? Also, there are other critical, perhaps even indispensable, people other than the founder -- perhaps the chief technology officer, operations vice president, or even a key project manager. The disability or death of key persons could spell disaster for a potential sale. But with a key person policy in effect, the deal could probably survive, and negotiations won't have to begin from scratch.
