Risk is part and parcel of running a successful business. Some business owners thrive on risk-taking, while others hope to take a more conservative approach to risk. As owners approach their business exits, it’s important for advisors to clarify four facts about business risk:
- Many business risks are unavoidable.
- Many types of risk are insurable.
- As owners near their exits, the impact of a risk event increases.
- Few owners have taken adequate measures to minimize the occurrence or consequences of a risk event.
In this article, we’ll look at two categories of business risk: insurable and uninsurable. Advisors must identify these kinds of risks for business owners because most owners can’t identify them themselves. Unless owners know the risks they’re facing and how to avoid or mitigate them, they will struggle to plan for the future of their businesses successfully.
Most businesses rely on standard insurance policies to protect them against a long list of liability claims for bodily injury and property damage. These claims can arise out of any of the following:
- Operations, ongoing and completed
- Personal injury liability
These are simply the most common types of risks. It would be naive to assume that this list covers all insurable risks. Often, owners must prepare themselves for risks that are just as common but not as commonly insured. Risk events that are insurable but may not be covered in standard policies include:
- Sexual harassment
- Data breaches: These events are occurring more frequently and can lead to serious losses in terms of finances, customers, and reputation.
- Fraud and embezzlement
- Environmental impairment
- Death or permanent incapacitation of the owner or a key employee
The purpose of this article is not to describe the ins and outs of every risk. Instead, we will focus on two risks that demand special attention because of the critical role they play in Exit Planning: the death/incapacitation of owners and the death/incapacitation of key employees.
The Death/Incapacitation of an Owner
Every Exit Planning Advisor must help owners understand the threat that their untimely death or permanent incapacitation poses to the very continuation of the business. Exit Planning Advisors must then minimize that risk.
If the success of a business depends on the owner and that owner dies, the business will not continue successfully after the owner’s death. The stop-gap recommendation—one that Exit Planning Advisors commonly make for solely owned businesses—is to create a Stay Bonus Plan. A Stay Bonus uses financial rewards to motivate important employees to remain with the business after an owner dies and until the business can be transferred or liquidated. The purpose is to insulate the owner’s estate from a huge financial hit.
The permanent solution, however, is to develop a management team that can continue the business—with minimal interruption to cash flow—without the owner. That’s the definition of a business with transferable value.
An additional and often overlooked consequence of an owner’s death or incapacitation is the financial instability that arises from the loss of the owner’s personal guarantees. Businesses with debt or bonding requirements often require an owner’s personal guarantee, secured by a personal residence or other collateral. Without those guarantees, the business typically can’t continue, even if capable management is in place. To address this risk, Exit Planning Advisors recommend that owners acquire life insurance in amounts sufficient to satisfy their banks and bonding companies.
The Death/Incapacitation of a Key Employee
The death or incapacitation of a key employee can be agonizing for owners. Key employees typically take on more responsibilities as owners approach their exits. When key employees die, it forces the owner to either find a replacement or take the reins again, which can delay their exits.
A simple and appropriate recommendation is for owners to purchase key-person insurance. An additional and longer-term recommendation is to develop other managers who can step into the shoes of the departed key employee. Again, the existence of a management team contributes to transferable value.
How the Exit Planning Advisor Contributes
What can advisors—specifically, Exit Planning Advisors—do to ensure that business owners are properly insured? We suggest that advisors recruit the appropriate professionals to deal with specific planning and execution recommendations. For example, an Advisor Team with a top-notch casualty firm can review the specific business risks to both the owner and business, and provide recommendations about how to approach those risks. The Exit Planning Advisor coordinates and facilitates the actions of all of these advisors.
Proper planning and action can help owners mitigate or avoid many uninsurable business risks. Examples of uninsurable risks include:
- Operational: Events that arise from inadequate or failed internal processes, human or system error, or external events.
- Reputation harm
- Regulatory defense and penalties (although cybersecurity insurance is increasingly available for many events in this category)
- Intellectual property (IP)
In this category, we’ve risks that may be insurable, but the high cost and limited scope of doing so may make insuring against them impractical for many businesses.
Under the category of IP, there are four types of protection. Three of these protections (patents, trademarks, and copyrights) require owners to submit the appropriate filings and registrations to achieve them. The main challenge is to determine whether that owner has protectable ideas or creations. Many businesses do, and securing a timely trademark can protect those ideas or creations.
The fourth type of IP is trade secrets. These include customer lists, pricing policies, and processes or systems developed by the company. We strongly encourage advisors to ask owners about any information, processes, or tools they use that give their companies an advantage in the marketplace. Once identified, advisors should ask how each process or system is protected. If there is no protection in place, advisors must suggest that owners meet with an intellectual property attorney. Generally, businesses restrict access to confidential information and use nondisclosure agreements, post-employment restrictive covenants, and other security practices to maintain trade secrets.
How the Exit Planning Advisor Contributes
Exit Planning Advisors help owners mitigate and prevent uninsurable risks in three ways.
- They make business owners aware of the threat that uninsurable risks pose to the business and the owner’s Exit Plans.
- They suggest that owners develop proper internal business practices, often with the assistance of another professional advisor, such as a risk management consultant. This review usually encompasses internal processes such as contract review, employment processes, and branding protection.
- They bring in appropriate expert advisors, such as business attorneys to review the legality of a company’s transactions with customers, employees and governing authorities (e.g., the IRS); and the company’s CPA to ensure that the proper financial controls are in place. In short, Exit Planning Advisors initiate a mini-due-diligence project.
- An advisor’s suggestion to review business risks—and the consequences of inaction—can be the difference between an owner’s successful exit and no exit at all.
- Advisors should recruit an experienced property and casualty firm to review their clients’ existing business insurance and ensure proper coverage: the right amount of coverage for the right risks.
- Advisors should ask a business attorney, CPA, and risk management consultant to conduct informal due diligence on a client’s company to uncover potential liabilities and minimize uninsurable risks.
- Advisors must quantify how an owner or key employee’s death or incapacitation affects the company. For example, advisors should show owners how a death or injury can create a shortfall in managing the company or disrupt the financial strength of the enterprise.