Ronnie Martin demonstrates how small business protection can work in practice
According to the Small Business Service (the Government agency that champions small businesses), small businesses that employ less than 50 people, account for some 99% the current total (see figure one).
And of the 3.7 million businesses trading at the start of 2000 nearly 2.6 million are sole proprietors, partnerships and companies comprising only an employee director.
It is with the small business and partnership/director-owned firms that the real needs for business protection most clearly exist as larger firms and plcs should already have succession planning in place.
Our research shows that when small and medium-sized businesses were asked to prioritise the most important factors in running a successful business, 995 of firms placed 'people' at the top of the list. In fact 435 also felt that in the event of one of their key people dying, or being absent through long term illness their business was unlikely to survive for more than three months.
The research results confirm that businesses recognise the importance of their senior people, and also highlight the opportunities that exist to raise the profile of business protection insurance in the areas of life, critical illness and key person income protection.
Needs will vary for each business and while the product solutions are likely to have similar characteristics a 'one size fits all' approach is not appropriate. The role of the adviser is absolutely vital since a full understanding of differing business structures is important to allow the legal and taxation implications of any recommendations to be taken fully into account. Let us consider some of the protection issues around a fictional small to medium-sized business:
Clearhead Ltd is a successful design consultancy owned by three working directors: Brian Walker, (aged 55) Rupert Bell, (aged 45) and Julian Gordon, (aged 35). The original founder is Walker and the business has shown excellent growth and now employs an additional five staff. They have a number of high profile clients and their sales and marketing manager, Tina Bailey, (aged 38) who joined them from a competitor some time ago has excellent relationships with, and is the prime contact for, most of the principals in these firms. The company's payroll is approximately £350,000 per year and gross profits last year were £250,000.
The progress that has been made acquiring new clients in the North has resulted in plans to open an office in Manchester where Julian Gordon will be Northern director for Clearhead's professional design services.
A £250,000 loan has been arranged to support these expansion plans which include obtaining suitable office accommodation. The business plan is reviewed regularly and currently values the business at £1m and the ownership of the company is split with Walker holding a 50% share and Bell and Gordon 25% each. A pension plan already in place assumes retirement for all directors at age 60.
Worst case scenario
It is important to consider what would happen to a shareholder's interest in the business following the serious illness or death of a fellow director prior to retirement.
The Articles of Association should stipulate what happens, but usually the personal representatives and subsequently the beneficiaries will become entitled to their shareholding. Unless the deceased director owned a majority of the shares, the beneficiaries are likely to find ownership of the shares could bring very little benefit.
Sales of shareholdings to outsiders are likely to be restricted, if at all desired and a sale to the continuing shareholding directors is likely to be possible only through prior planning for funds to be available at the time they are needed. Additionally at a time of crisis it is inevitable that raising finance would prove to be very difficult. Banks and other lenders are unlikely to offer loans when there is instability in the business ' particularly if they have already advanced capital to the company.
Taking all the above information into account means a protection priority for this business should be directors' share protection. Directors' protection will provide cover that allows access to funds when needed and offers fair value to the remaining families/beneficiaries.
Walker, Bell, and Gordon each take out a policy on their own life for a sum assured that reflects the value of their interest in the business. Writing these policies under a flexible business trust will ensure the proceeds are payable to the surviving co-directors. Additionally it is important to support the arrangement with a share protection agreement to ensure tax efficiency.
A cross option (or double option) agreement provides details of the share purchase in the event of death and how the purchase can be made. This cross option agreement can cover the arrangements for all three directors in one document. It simply gives the surviving directors an option to buy the deceased director's shares and the personal representatives of the deceased have a matching option to sell to the surviving directors. As a result, since a cross option agreement is not a binding contract for sale, this preserves Business Property Relief for Inheritance Tax purposes.
Clearhead therefore arranges shareholder protection ' life with critical illness (own occupation) to age 60 for the following sums, written in cross option agreements (see table one).
Since premiums reflect the age and sum assured of each director the amounts do not reflect the benefits each might receive in the event of a claim. Assuming the directors wish to address this issue and distribute the costs fairly this can be achieved through apportioning premiums according to each director's stake in the business.
As Walker owns 50% of the business and Bell and Gordon own 25% each, on Walker's death Bell and Gordon will each receive 50% of Walker's sum assured. Likewise on Bell's death Walker would receive two-thirds of Bell's sum assured while Gordon would receive one third. The same proportions would apply on Gordon's death with Walker receiving two thirds and Bell one third. To equalise the costs in proportion to the benefits they are likely to receive means Walker would be responsible for £1,482.24 of the total annual premium for this protection, Bell would be responsible for £2,648.64 and Gordon £2,838.72 (providers have sales aids that expand on this approach to equalisation).
Key person cover
Another priority protection requirement for Clearhead would be key person cover on the life of their sales and marketing manager, Tina Bailey. With the valuable connections she has with clients, the loss of her services through either death or serious illness would inevitably impact on Clearhead's bottom line. Additionally she was recruited from a competitor and should the need to replace her arise then this would obviously involve additional expenditure in the form of recruitment costs as well as the time spent training a new individual. On top of that, settling in time that would be required for the new recruit to become effective.
The amount of cover required should directly reflect Tina's value to the business. This is simply expressed as the 'loss of profits' that could result through her absence. The figure for a sum assured can be calculated in several ways. One directly relates her specific contribution to total profits. The formula to do this is: Key person's salary/total payroll x gross profit x business recovery period.
The business recovery period in years is the estimated time it would take for the organisation to return to the trading position it enjoyed prior to the death or critical illness of the key employee.
For Clearhead to protect the life of Tina Bailey the calculation would be: 50,000/350,000 x £250,000 x 5 = £178,571 rounded up to a sum assured of £180,000. Term cover for five years payable on Tina's death, or on suffering a critical illness, or total permanent disability would cost £36.96 per month. As the benefits are designed to cover loss of profits and are for a short period the premiums are likely to be eligible for tax relief. This requires confirmation by Clearhead's local tax inspector and draft letters to the Inland Revenue are available from providers.
The company has arranged a loan to fund its northern expansion plans. As this project depends on Julian Gordon's professional expertise it is prudent (if not insisted upon by the lender) to arrange key person loan cover for the advance of £250,000. A decreasing term policy for life and critical illness benefits in the name of Clearhead on Julian's life will cost £43 per month over a 15-year term of the loan.
This addresses the immediate needs of this small to medium-sized business. The arrangements must be reviewed regularly to ensure the cover remains relevant to business protection needs.
Ronnie Martin is director (protection) at Legal & General
