First-time entrepreneurs need to think about how they will exit the company or manage without one of the principal players. Lorna Bourke on why key man insurance should be part of a business plan.
It is perhaps inevitable that when starting up a business few first-time entrepreneurs have their minds fixed on the finish - in particular, on how they will exit the company or manage the death or defection of one of the principal shareholders. Yet, as many of their forebears will testify, how you structure a company to deal with such events can be every bit as important as the initial business plan.
'A business plan should cover points like exit routes,' confirms Lee Dudak of accountants Clark Whitehill. 'For example, are you going to sell to a trade buyer, float on the alternative investment market, or go for a full public company quote?' The exit route is important if one of the main aims of starting the business is to make substantial capital gains. For those confident of achieving this goal, potential liabilities can be minimised from the outset. 'Despite recent tax changes, there is still scope for avoiding some capital gains tax by putting 49% of the business offshore,' says Dudak.
Another equally important area during the early years, though one just as often overlooked, is key man insurance. 'A lot of businesses don't have a policy, but it could be disastrous if a key person dies,' explains Dudak. As the name suggests, key man insurance provides a lump sum on the death of a 'key person' - usually, one of the founder shareholders who brings in the bulk of the business or is the creative linchpin in a team.
It can be used for several purposes - most commonly to cover any loss of profits and the higher cost of employing a key specialist. The latter can be significant; entrepreneurs who are also shareholders in their business often work for much less than the salary they could command as an employee. 'Key man insurance is bought by small and medium-sized companies,' explains independent adviser Alan Frei of Williams Allan. Cover of £250,000 for five years for someone who will turn 40 at their next birthday costs around £300 a year. For a 50-year-old the premium jumps to around £750 a year.
'I would never allow a company to buy key man insurance for more than a five-year term,' says Frei. 'If the business plan is on target they should not be "key men" after five years - although by then they may have several employees whom they need to cover.' As a rule, he says, 'you only need to renew key man insurance on an individual in those companies where the business plan has not been fulfilled and the next generation of managers is not yet in place.' A shareholder agreement can also be critical. 'It is important as it covers what happens if one partner dies or wants to leave the business,' says Dudak. 'It should include provisions for retirement, death and a mechanism for valuing shares. People don't realise that a minority stake in a private company is worth very little except to the remaining shareholders or partners in the business. The shareholder agreement should contain a formula for valuing shares, less a percentage if it is a minority stake.' A common strategy is to have a 'put and call' option on the shares. The remaining shareholders make an offer for the shares of the departing minority shareholder and he has the option to sell them at that price or buy their stake at the same price. This forces the remaining partners to offer a realistic price.
Of course, in the first throes of a start-up there seems little time to deal with such issues. Besides, many will seem too distant to merit current attention. But that doesn't mean that you won't pay for the oversight in the longer term - with interest.