The best subtitle for this article would probably be, “New Horizons in Financial Underwriting!” But first, let’s take a short break to capture a parent-child moment in a typical American home:
Father: “Son, I want you to be good at school today.”
Son: “I’ll be good if you give me five dollars.”
Father: “That’s ridiculous! When I was your age I was good for nothing!”
All humor from the Father’s unintended meaning notwithstanding, the vignette illustrates an accepted and common truth within a family unit, i.e. certain things are expected from the kids in the household for which they do not receive cash compensation.
And when allowances are paid in return for completion of chores and acceptance of other responsibilities, the amount of money most often does not represent even the minimum wage available for similar tasks out in the marketplace. But at least the parents understand that their seemingly underpaid offspring are well reimbursed by such things as a roof over their heads, medical care, free Wi-Fi and afternoon snacks.
Most carriers start with ten times salary, but also consider other elements in the employee’s overall package, e.g. the cost of health insurance, retirement plan contributions, club memberships and afternoon snacks.
But another component of pay that most carriers will consider is any equity interest in the company. Most acknowledge that the employee is taking less traditional compensation in return for some ownership.
Valuing that element of “pay” for purposes of its inclusion in the “10x formula” is a little more elusive and beyond the scope of our talk today. The same should apply in family businesses where the second generation is working for less, knowing that someday they will own the business. If there was no future hope of ownership they would go elsewhere for more money.
Underwriter hesitancy comes from comparing a key person need with a different financial justification involving future ownership – insuring against anticipated estate tax liability. Carriers, generally, will not allow a second generation to build an anticipated inheritance into their net worth calculation when purchasing coverage to pay estate taxes – because it might never happen.
This is not a bad argument given that the hope for ownership is not creating a present financial need.
1) The son or daughter is taking less than he or she is worth, 2) the business is getting services at a current lower rate, and 3) it would cost more than what is presently being paid to hire a replacement who isn’t motivated by possible future ownership.
The fact that the inheritance may never occur is not a contingency that affects the very real (and very measurable) need for more coverage than ten times compensation would suggest. This should be a consideration in the financial underwriting process.
Call us regarding any key person cases that we can help you place for your client. If the circumstances for justification are of a Sweat Equity on the Come nature, we will help you blaze a trail in the exciting world of financial underwriting. And who knows, as a result – Maybe someday your name will be in lights/ Saying Johnny B. Goode tonight.
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