Most small businesses don’t last after the first generation of owners die. If you’re starting a family business, or if you have a partner and want the business to be able to continue after you or your partner die, purchasing life insurance can be extremely helpful.

For example, let’s say you and two partners own a business and each of you has a family. Now let’s say one of the partners dies unexpectedly, and the other two partners want to purchase the deceased partner’s interest in the business from his or her spouse. Having a life insurance policy on each partner worth the value of each partner’s share in the business will help surviving partners purchase the deceased partner’s share without undue financial hardship on the business or the surviving partners’ personal finances.

Here’s another example of how life insurance can be beneficial to small businesses. Let’s say your small business has a key employee who performs tasks that require unique training or experience. Now let’s say that employee dies. A life insurance policy on that employee can help provide your business with the money it needs to stay afloat if the employee dies and projects he or she were working on must be outsourced to other businesses and while you search for a replacement.

Prior to purchasing a life insurance policy on proprietors, partners or key employees, it is important to value the worth of your business.

Valuing your business

Business valuations are made based on the current value of cash flows the business is expected to have in the future. Regardless of what method you use to value your business, the basic premise remains your business’ ability to generate cash flow.

Two of the most commonly used business valuation models are the cash flow multiple method and the price earnings multiple method.

The Cash Flow Multiple Method works well for most small businesses and is nicknamed the Main Street approach. In the cash flow multiple method, a multiple is applied to the expected adjusted cash flow stream of a company. The multiple usually ranges between 3 and 6, and is usually determined by an evaluation of a company’s potential for risk and growth.

Historical cash flow data is usually the basis of calculating the business’ future cash flow stream. For example, if your business has had EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of about $1 million, and a multiple of 3 is applied, the business’ value would be $3 million.

The Price Earnings Multiple Method is better suited for larger businesses, such as publicly traded companies. In this method, the business valuation is determined by taking the net after tax profit of a business and applying a market driven factor as a multiplier. For example, a numerical value may be assigned to high growth rates, financial resources, strong market position, etc. As a result, most businesses using this method may have multiples of 10 or higher.

Once you have a good idea how much your business is worth, or is likely to be worth, you should purchase a life insurance policy for you and your partners eqivalent to each partners’ share of the value. For life insurance policies for valued employees, you and your financial advisor may want to use a policy based off the business’ value or another calculation regarding that employee’s contribution to the business.

The benefit of purchasing life insurance policies for partners is that it can head off the succession squabbles that often kill small businesses. By immediately having the wherewithal to buy out a partner’s share in the business, you can avoid costly court wrangles with heirs that can be harmful to your personal finances or to the ongoing operation of your business.

Even single proprietor businesses can benefit from a life insurance policy for the proprietor, as it can provide some financial cushion for your heirs as they learn how to run the business or allow heirs who are better suited to run the business to buy out the interest of other heirs.

Succession planning isn’t something you should put off, as the unexpected can happen at any time. To get a better idea of the options most appropriate for your company, contact a financial services professional and a life insurance agent or broker.