How Life Insurance for Small Business Owners Works

Life Insurance is never the most exciting topic of conversation, but it is a crucial tool in helping protect your family if the worst should happen. Life insurance becomes more confusing when you add being a small business owner to the mix. Life Insurance for small business owners usually results in more complexity, more options, and more people calling you to try and sell that nice, large insurance policy.

This blog is going to cover the basics of life insurance and how life insurance for small business owners differs from a regular W-2 worker looking to insure their family.

On this blog, we are going to cover:

1. How to find the right amount of life insurance as a small business owner
2. How you adjust the amount of life insurance to include the value of your small business
3. Other types of life insurance you may encounter as a small business owner

‍What is the right amount of life insurance for a small business owner?

Life insurance is the simplest financial product in the world. You pay a company, and if you die, your family receives a benefit. However, it is an easily misunderstood and often oversold tool that results in two reactions for most small business owners:

1. They either don’t have it because they think it’s a scam or that they don’t need it.
2. They buy an arbitrary like $1,000,000 because it sounds like a lot of money.

At its very core, life insurance is just math. It is a math equation that solves for how much money you will need today to provide for your family if your income stops.

Rather than focusing on how much insurance you need, it’s better for small business owners to focus on what problems they want solved:

1. How much do I need to provide for my family on a yearly basis?
2. Do I replace my full income or do I cover a certain amount of expenses?
3. How many years do I need to provide said income?
4. Will my spouse continue working or go back to work?
5. If so, how much will they earn?
6. Do I want to include their earnings in your calculations?
7. Do I want to pay off any debts?

By starting with the right questions, you can back into how much life insurance you need.

While I have my own planning software, my favorite DIY tool to solve for how much life insurance a small business owner will need is Life Happens. LifeHappens is website that helps you convert your answers into an amount of life insurance.

Turn Your Answers Into a Number with Life Happens

For our blog today, let’s use a business owner earning $250,000 per year. If you use Life Happens, and answer the questions I posed above, you can run your own scenarios. I have 3 different variations of life insurance needs for this small business owner:

1. Fully replacing income for 20 years
2. Fully replacing income for 10 years
3. Partially replacing income for 20 years

As you can see, by solving for what the business owner actually needs, you wind up with a number that is tied to your actual financial circumstances. While having some insurance is better than having no insurance, choosing an arbitrary number may result in you leaving your family shortchanged. I would encourage anyone reading this blog to answer the questions and calculate how much life insurance you would need under various scenarios.

Want to learn more about another risk? Check our Disability Deep Dive.

How does a small business owner include the business in their life insurance calculations?

After you’ve determined how much you will need today to replace your income, the next step is determining how much your assets are worth. In some cases, the assets you own today can completely offset the need for life insurance, as they can produce the income that your family needs. A basic formula looks like this:

For most small business owners, their business is usually the largest asset they have and is typically valued at a multiple of earnings. However, the death of a business owner can result in a significant change in both the earnings and valuation of the business at the time your family needs to sell the business most.

Let’s look at a few scenarios:

1. Self Employed Graphic Designer – runs a solo shop and does it all.
2. 10-Person Engineering Firm – owner and founder is an engineer, and has a small, yet effective group of employees. Mainly does managerial duties but has developed key customer relationships.
3. 30 Personal Sales Organization – owner and founder who makes strategic decisions but does not maintain customer relationships anymore.

Does it make sense that each of these small businesses would be valued the same way?

I would say not. I would contend that the families of business owners 1 and 2 would most likely find themselves with less than they would have otherwise expected from a sale based on the income the business produced.

The Graphic Designer’s business has no terminal value. The family may be able to sell their list of clients, but that income stream will stop now that the graphic designer has stopped producing work. There was probably minimal business value even if the designer had tried to sell the business while living.

The 10-Person Engineering Firm will most likely retain some value but the owner is the key person holding the entire firm together through both managerial duties and client relations. I would argue a firm like this would retain some value but would not retain the full value of their business in a rushed sale made by the family.

Finally, the sales organization would retain the most value of the three businesses. At that size, there should be more than one layer of management which will allow the company to continue functioning and retain the most immediate value for the family. There is also most likely a key employee who can keep the lights on.

How would this look from a comparison standpoint?

I don’t believe this is likely, but let’s assume that all four businesses made $250,000 per year and were valued at $1,000,000. Furthermore, the business owner wanted to fully replace all income for 20 years as in table 1.

Based on the assumed discounts for each company, you can see that the difference in sales price of the business post-death results in a large difference in insurance needed.

The second question that small business owners considering life insurance need to ask is:

• What will my business be worth if I pass away unexpectedly?

To help answer that question, here are a few questions to consider:

1. Will my family be involved in the business after I pass? If so, do they even need to sell?
2. Who will manage the business?
3. Will there be a decline in sales?
4. Will we need to hire more people, reducing earnings, if I pass?
5. Is there a buyer in place if I pass?

Until you know the answer to these questions, it’s impossible to answer how you should include your business in your life insurance calculations. If, like the graphic designer, there is no one who can do your job and pick up the slack after you pass, it is probable that you should reduce or exclude the value of your business in your considerations.

How does a small business owner's life insurance change if they have partners?

Until now, we have focused on the mechanics of how to find the right amount of insurance to protect your family if you were to pass. However, there are two other types of life insurance for small business owners that I would like to briefly discuss.

The first is buy-sell insurance.

Buy-sell insurance refers to insurance that funds a buy-sell agreement between partners. Typically, these agreements require that the deceased’s family sell their shares to the remaining partner at an agreed upon valuation. There are several funding mechanisms – insurance, an installment note, cash, or a bank loan to name a few. Buy-sell insurance is designed to do two things:

1. Fund the buyout of your family’s shares and ensure they are paid.
2. Prevent either partner from having to go into business with the remaining family.

In the examples above, we discussed how depending on your business, your family may not receive the full value of your business if you pass. However, the buy-sell agreement will require that your partner use the insurance proceeds to purchase your family’s shares, ensuring your family receives full value.

Here’s how it works:

Essentially, the buy-sell agreement replaces the value of the business for your family with life insurance, assuming the insurance is equal to the business value.

It’s important to note that buy-sell insurance does not affect how much your family will need in the event of your death. Buy-sell insurance simply reduces how much personal insurance you may need and ensures the family realizes the business value in a sale to a partner.

Loan Insurance for Small Business Owners

The third and final form of life insurance for small business owners that I wanted to discuss today is loan insurance, or loan guarantee insurance.

Many lenders, and SBA loans in particular, will require life insurance for small business owners who are taking out a loan. These lenders understand that for the first few years there is most likely no value to the business if the business owner passes away and they will need to recoup their loan.

To complete these agreements, a business owner buys a life insurance policy that they own. They then “assign” the benefits of the loan to the bank. If the business owners passes away, the loan balance goes to the bank with the excess going to your family.

The important part to note is that this insurance will most likely not cover your family’s full needs. The main benefit to your family is that it will prevent the bank from seizing your family’s assets to pay off the loan.

Summary

From term insurance to whole life, there are more types and kinds of life insurance out there than any one person can understand. However, at its very core life insurance is math. If something happens to you, what do you want to leave behind for your family? Once you solve that problem, the rest falls into place. While Life Insurance for Small Business Owners is more complicated than life insurance for the average person, it is a problem that can be solved much more easily once you define what you'd like to accomplish.

Ironclad Wealth Management can help. As part of our full planning process we will help you answer those questions and determine which method is best for you. Ironclad Wealth Management is a financial & tax planning firm that focuses on working with small business owners with 1-25 employees to help them reach their financial goals. If you’d like help reviewing your life insurance in the context of a full financial plan, reach out below to schedule a no-cost introductory call.

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