What it means
A privately held business faces a specific problem that a listed company does not: if an owner dies, their shares pass to family members who may have no interest in the business and no ability to run it. The surviving owners usually want to buy those shares, but rarely have several hundred thousand dollars sitting idle.
Insurance turns an unfunded promise into cash on the day it is needed. The cover normally sits alongside a buy-sell agreement, a contract setting out who must buy, who must sell and at what price.
Without the agreement the insurance money arrives with no obligation attached; without the insurance the agreement creates a duty to pay that nobody can meet. The two documents are designed to be read together.
There are two common structures. Under a cross-purchase arrangement each owner buys a policy on every other owner and receives the proceeds personally to fund the purchase.
Under an entity purchase, sometimes called a stock redemption, the company itself owns the policies and uses the proceeds to buy back the departing owner's shares. Key person cover is the related variant that protects against losing someone vital who is not necessarily an owner, such as a lead engineer or the salesperson holding the major accounts.
Here the company is both owner and beneficiary, and the payout covers recruitment costs, lost profit and the reassurance lenders often demand. Banks quite frequently require key person cover as a loan condition.
The main practical challenge is keeping the numbers current. A business valued at $3,000,000 when the policies were written may be worth $7,000,000 five years later, leaving the cover badly short.
A regular valuation review, usually annual or every second year, is the discipline that keeps the arrangement useful.
In practice
Real-world examples.
Example
Two equal partners in a surveying practice value the firm at $4,000,000 and each take out $2,000,000 of cover on the other. When one dies, the survivor uses the proceeds to buy the estate's half and continues as sole owner without borrowing.
Example
A specialist manufacturer insures its lead design engineer for $1,500,000 as key person cover. The payout is intended to fund an eighteen-month search, a recruitment premium and the profit lost while a replacement is brought up to speed.
Example
A four-owner logistics business worth $5,000,000 uses an entity purchase structure, with the company holding a $1,250,000 policy on each owner. The company redeems the departing owner's quarter share directly, leaving the remaining three with proportionally larger stakes.
Formula
Calculation
Cover required per owner = agreed business value x that owner's ownership percentage. Under a cross-purchase structure, the number of policies needed = n x (n - 1), where n is the number of owners.
Three owners hold equal thirds of a business valued at $6,000,000, so each share is worth $6,000,000 / 3 = $2,000,000. Under a cross-purchase arrangement each of the other two owners must be able to fund half of that, meaning a policy of $2,000,000 / 2 = $1,000,000 on each of the other two.
The number of policies is 3 x 2 = 6. At an annual premium of $2,400 per $1,000,000 of cover, each owner pays 2 x $2,400 = $4,800 a year and the group pays 6 x $2,400 = $14,400 in total. If one owner dies, the two survivors each collect $1,000,000 and together pay the estate $2,000,000 for the shares.Case study
Seen in the real world.
Ridgeway Fabrication is a fictional metalwork business owned equally by two founders and valued at $3,600,000, giving each a $1,800,000 stake. Early on the founders signed a buy-sell agreement but left it unfunded, assuming the business could borrow if the worst happened.
Their accountant pointed out that a bank would be unlikely to lend $1,800,000 to a company that had just lost half its management. The founders instead bought $1,800,000 of cover on each other at roughly $3,000 each per year, a combined $6,000, and set an annual valuation review into the agreement.
Four years later one founder died unexpectedly. In this illustrative scenario the survivor received $1,800,000 within weeks, paid the estate the agreed price, and kept the workforce and the main customer contract intact. The family received a clean cash settlement rather than a minority stake in a business they could not influence.
Watch out
Common mistakes.
- Buying the insurance but never signing a buy-sell agreement, leaving the proceeds legally unattached to any obligation to transfer shares.
- Setting the cover at the original business value and never revisiting it, so a growing company ends up insured for a fraction of what a share is now worth.
- Confusing key person cover with owner buyout cover, when the first replaces lost earnings and the second funds a change of ownership.
Questions
People also ask.
Who owns the policy under each structure?
In a cross-purchase the individual owners hold policies on each other; in an entity purchase the company holds policies on all the owners.
Is the payout taxable?
Life insurance proceeds are commonly received free of income tax, though the structure affects the cost basis of shares and can have estate tax consequences, so specific advice matters.
How many policies does a cross-purchase need?
The count is n x (n - 1), so two owners need 2, three need 6 and five need 20, which is why larger groups often prefer an entity purchase or a trust arrangement.
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