By Matthew Theal, CFP®
According to the Census Bureau’s annual survey, companies with 100 employees or fewer make up 98.2 percent of all businesses in the United States. This statistic makes sense, as small businesses are often referred to as the lifeblood of the American economy.
Because of their importance, small business owners have been studied for decades. These studies show that small business owners:
- Have a need for achievement
- Are greater risk takers
- Need to be in control
- Have a keen interest in growing wealth
- Have a tolerance for ambiguity
These traits are what make small business owners successful, but they can also be traits that lead to ruin. A successful business owner understands the risks they face and uses techniques to minimize their likelihood.
Risk Management Techniques
There are four main risk management techniques that small business owners can use:
- Risk minimization: Using strategies that reduce the likelihood of loss caused by a particular risk. An example would be wearing a helmet while riding a bicycle.
- Risk retention: When you know there is a risk, but you choose to ignore it. An example would be forgoing paying for eye insurance and opting to pay out of pocket instead.
- Risk avoidance: Avoiding a risky activity. For instance, you could choose not to drink and drive.
- Risk transfer: Having an entity that takes on the risk for you. An example would be if you purchase auto insurance or homeowner’s insurance.
For today’s article, we’ll focus on how business owners can manage their risk using the transfer technique.
Common Risks Faced by Business Owners
We have found that most business owners don’t understand the risks they face in the type of business entity they select. For instance, if you select the wrong business entity, your personal assets could be at risk. In fact, that is one of the main reasons to avoid a sole proprietorship. Instead, it may make sense to opt for a corporation (C, S, or LLC), which would offer protection of your personal assets if you are involved in a business lawsuit.
Tip: Talk with your accountant or financial advisor about selecting the proper business entity.
Business owners face other risks—let’s call them damage risks. These would include bodily injury, property damage, false advertising, and faulty products. An owner can pass these risks on to an insurance company via general liability insurance.
Tip: If you own a business and don’t have a general policy, find someone to sell you one!
Another risk pops up when an owner hires their first employee. Employees can sue for myriad reasons: injury on the job, victim of unfair hiring practices, sexual harassment, being overlooked for a promotion, and wrongful termination, among them. An owner can implement policies like workman’s compensation and an employment practices liability policy to transfer the risk to an insurance company.
Many business owners purchase protections against such risks sometime within their first few years of business. Some risks get ignored, though, and they are harder to insure against, especially given their complexity. They usually take serious planning by a person who specializes in working with business owners.
What will happen to your business if you, your partner, or one of your key employees passes away or becomes disabled?
To protect against death or disability, you will want to put a buy-sell agreement place.
A buy-sell agreement is a contract between the corporation shareholders and the corporation (business entity). The agreement lays out who purchases the shares of the company if an owner passes away. Think of this agreement as life insurance for your business.
The agreement lays out how closely held corporations will be sold by establishing a formula to value the company. This makes sure all parties can receive a fair price. It also protects shareholders, making sure that shares of the company don’t fall to inexperienced outsiders. It also ensures continuity between employees and management.
A buy-sell agreement is a complex document and beyond the scope of this article. For brevity’s sake, a contract can be structured in many ways. Typically, at least three outside parties will be involved: a consultant (like a financial advisor), a lawyer, and an insurance agent.
We have found that most business owners take care of the basic policies, like general liability and workman’s comp. But we have also found that 98% of small business owners don’t know what their business is worth.
This leads us to believe that 98% of small business owners don’t have a plan for when an accident strikes. You can’t put a buy-sell agreement in place unless you know what your company is worth and how it is valued.
What’s your business worth?