Thousands of people become entrepreneurs and start a business every year. In fact, there have been about 400,000 startups annually for the last decade, according to the Small Business Administration.1
Of course, a good number of businesses, nearly as many as are created, fail each year, too. That’s a testament to the challenges businesses face and the resources it takes to maintain operations on a profitable basis year in and year out.
Life insurance and disability income insurance can be tools that help handle some of those challenges.
“Most of my business-owner clients would argue that the most profitable dollar spent for them is one put into their business,” said J. Todd Gentry, a financial professional with Synergy Wealth Solutions in Chesterfield, Missouri. “Is that hard to argue? Well, at the same time, almost all of my clients who are retired business owners or aging business owners lament they did not do more to plan for the future that is now.”
Here are three ways life insurance and disability income insurance can help you as an entrepreneur.
Protect your family
A business takes investment and seed money to get going. Many entrepreneurs put up their own assets as collateral for business loans. Sometimes, those assets are central to family members as well. A second mortgage on a home, for instance. Or a loan against a 401(k) account.
All that is well and good if things go as expected and you and your business thrive. But what happens if you get too ill or injured to manage the business? Or worse, you pass away? Such events could have negative implications for the home your family lives in or the retirement funds your spouse was counting on. That’s why life insurance for business owners is so important. (Life insurance calculator)
“A person who is a sole proprietor tends to invest everything back into their business, which can have no value if that person is no longer able to run that business,” said Douglas Collins, a financial planner with Fortis Lux Financial in New York City. “That’s why any entrepreneur needs life insurance and disability income insurance. So much of his or her net worth and cash flow is correlated to their business value. And losing that can be disastrous for a family depending on that value.”
Help your partners
Starting a business is sometimes a joint effort. It’s not uncommon for entrepreneurs to form partnerships, with each person bringing different talents and resources to the enterprise.
In that respect, partners rely on one another. So, if something happens to one — be it illness, injury, or death — it will have a negative impact on the others.
“In the near term, if you have business partners, protect each other and your families,” said Gentry. “At the very least, having a simple buy and sell agreement funded with term insurance is a must, but many business partners do not seem to have one in place.“
A buy and sell agreement is a contract that lays out how a partner’s share of a business should be handled in the event he or she passes away. Typically, the agreement provides for the remaining partner or partners to buy out the deceased partner’s share.
The death benefit from the life insurance policy can help fund the sale. The amount and type of life insurance necessary can vary, depending on circumstances. (Learn more: Funding a buy-sell agreement)
“What’s needed depends on the structure of the business, the number of people involved, and how mature the business is,” said Collins. “These tend to be more dynamic cases.”
The agreement should also lay out a course of action if a partner is too ill or injured to work. (Disability calculator)
“Disability is too often overlooked in buy and sell agreement planning, yet the likelihood of disability is far greater than the likelihood of early death,” said John Ocwieja, a family business specialist with The Hoopis Group in Chicago.
Indeed, 1-in-4 of today’s 20-year-olds will find themselves unable to work at some point during their career because of an illness or injury, according to the Social Security Administration.2
Source of capital
Certain types of permanent insurance, like whole life insurance, build cash value over time. This cash value can be used at any time and for any purpose. While there can be downsides for doing so, some business owners find this a convenient source of funds to bridge unforeseen financial stress in their operations.3
“That aspect, the cash value, is valuable for businesses,” said Jackie Dorsey, a financial professional with Coastal Wealth, a MassMutual firm in Tampa, Florida. “Obviously, protection is important, but the cash value is a key component.”
Even if entrepreneurs or business partners are starting out with term insurance — typically the least expensive life insurance option but without a cash value component — many such policies can be converted at a later time. (Related: 4 times term insurance is the answer)
“Term insurance is a tool that lays groundwork for when that business is thriving and the convertibility of that term insurance can be leveraged into deferred-compensation strategies and other wealth accumulation strategies,” said Gentry.
Insurance beyond the owner
Beyond the entrepreneur and partners, financial professionals suggest getting life and disability insurance for critical employees as well. This is commonly called key man insurance.
“Key person insurance to protect the business is also important,” said Gentry. “It can be used to pull that key employee even closer, and protect you and your business from recruiting and turnover issues, especially in those key employee ranks.”
In such business life insurance programs, the employer takes out a life insurance policy on a key employee. The policy is owned by the business and the death benefit would be paid to the business to help offset the costs likely to arise from the loss of a critical player.
Life insurance can also be used an employment incentive. The business arranges the purchase of a policy for the employee. The employee is the owner of the policy, and gets to determine the beneficiaries and have access to cash value within the policy. The employer covers the cost of the policy by periodically giving the employee a bonus big enough to pay the policy premiums. It can be structured in a number of different ways, depending on what makes the most sense for the company and the key employee. (Learn more: Life insurance as an executive bonus )
In the end, life insurance and disability income insurance can serve as versatile tools for business owners and entrepreneurs. In particular, life insurance for business owners can offer protection for family and partners. Life insurance can also provide a useful financial option over time and be used as a benefit to attract and retain top talent. A financial professional can help examine what may be appropriate for a particular entrepreneur’s enterprise.
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This article was originally published September 2019. It has been updated.
1 Small Business Administration, “Frequently Asked Questions about Small Business,” August 2018.
2 Social Security Administration, Fact Sheet, Disability.
3 Tapping into the cash value of a life insurance policy reduces its value and death benefit and increases the chance the policy will lapse. And if a policy lapses with an outstanding loan in excess of the cost basis, it may result in a tax bill if the policy terminates before the death of the insured.