What is key person risk?
Key person risk occurs when a business or business unit becomes heavily reliant on a key individual(s). Although this risk is typically found in small to medium enterprises (SMEs), it occurs in companies of all scales.
The most notable examples of key person risk occur in some of the world’s largest companies. The late Steve Jobs or Sir Richard Branson are two prominent modern era key people. Most businesses of similar scale to Apple and Virgin have processes and frameworks in place that are well structured to delineate risk away from any one individual.
At Apple, Steve Jobs was a visionary and key driver of innovation. It is nearly impossible to formulate a process or business model which consistently delivers innovation. Apple, even as one of the world’s most valuable companies was, and probably still is, reliant upon a select few innovators.
At Virgin, Sir Richard Branson is the emblematic heart and soul of Virgin. The company’s values are an extension of his ethos. Virgin’s brand value is inexorably linked to its founder’s personal goodwill.
Fortunately for large scale corporates, although key person risk can be nominally substantial, companies are well capitalised to weather the loss. The same cannot always be said for SMEs.
Do you have key people?
If you own, manage or work within a SME, you’ll likely be able to narrow in on a select few people who are enormously important to your business’ viability.
Now imagine if you suddenly lost one of these person’s employment services. This can quickly place the SME into financial distress. Without sufficient cash flow or business protocols it might even force a fire sale of business assets and/or be a catalyst for the loss of further staff.
Admittedly, most people within a business are replaceable. However, when you work with or for someone whose knowledge, relationships and experience are entirely unique to your SME, as a business manager, it is your responsibility to appropriately address this risk.
Mitigate key person risk first
As managers, we prefer to avoid key person risk occurring. We achieve this by building robust business models, where no one individual is the sole holder of important intellectual capital, knowledge or relationships.
Through common processes, defining roles, automating workflows and responsibilities and cross skilling senior managers, you can create a business model that has the rigour to withstand the loss of almost any one individual.
In some circumstances, even with risk mitigation planning, there are some employees who remain vital to a business. These are your ‘rainmakers’, founding partners, innovation centres or long term key relationship holders. In this instance, no amount of business model rigour will diffuse key person risk and the business will have to explore external avenues for risk management.
Hedge risk that cannot be mitigated
When mitigating risk through business management doesn’t work, to ensure the viability of the SME, you need explore alternate methods of managing the key person financial risk.
A cost effective tool to manage financial risk is through the placement of a ‘key person insurance’ policy. Insuring an individual might sound like an unusual solution, but is actually quite a common strategy for protecting companies from financial distress.
Key person insurance provides a lump sum benefit in the event a key employee or business owner ceases to work due to premature death or total and permanent disability (TPD).
To implement a key person insurance strategy like this, the SME takes out and owns a life and TPD insurance policy on the life of the key person. The policy should have a sum insured that aligns to the key person’s value to the business.
If the policy is triggered, the insurance proceeds provide a pool of capital that can be used to;
- Extinguish debt;
- Recruit replacement employment;
- Offset revenue shortfall;
- Offset loss of goodwill;
- Provide liquid capital to assist funding professionals to initiate business sale; or
- Any combination of the above.
There are tax implications associated with both the funding, ownership and benefit payment of a key person insurance policy. Additionally there are complexities in insurance product design and contract structuring. It is important you seek financial advice when implementing a key person insurance risk management plan for your business.
Although key person insurance mitigates much of the financial risk, it cannot offset the cultural and emotional impact on a SME of losing a key person. No amount of money can achieve this. But by having a well-structured key person risk management plan, SME managers are well resourced to navigate the business back into safer waters.
About the Author:
Matt Vickers CFP® is Principal Adviser at Snowgum Financial Services