Reducing Key-Person Risk with Life Insurance for SBA-Backed Loans
It’s a common belief that all U.S. Small Business Administration (SBA)-backed loans require a collateral assignment of life insurance policies for business owners, managers or other key personnel who have significant responsibility for running business operations. In this scenario, a life-insurance death-benefit policy is assigned to a lender as a part of the required collateral for an SBA-backed loan.
In fact, while many SBA loans are at least partially secured with these policies, it’s not a requirement for all SBA-backed loans.
Instead, the SBA requires that lenders evaluate whether a business’s viability is tied to an individual or individuals, and if so, how that factors into the overall risks associated with a loan. With this assessment, any required or recommended loan protections can be put into place, including life-insurance death-benefit assignments.
The 504 Company has put together a summary overview of the SBA’s key-person risk considerations, including some examples of situations in which the assignment of life insurance is required or likely warranted. Keep in mind that although the assignment of a life-insurance benefit may not be necessary, it’s always considered a prudent lending practice.
Overview of key-person risk considerations
Although the SBA doesn’t explicitly require all SBA-backed loans to include the collateral assignment of key-person life insurance to reduce loan risks, there are certain situations in which it’s required or warranted.
In particular, if the death of an owner or key operational member would cause significant risk to the repayment of the business loan, life insurance will likely be required. Examples of these scenarios include:
- When an owner is the principal of a sole proprietorship or single-member LLC or when a business is primarily dependent on one owner’s active participation
- When the business is owned or managed by people who work in professional fields in which licenses are required to perform key duties
- When individuals in ownership or management positions have rare and particular skills, experiences or talents that can’t be taught or transferred to successive owners or managers
Keep in mind that the amounts and types of other collateral available to repay a loan (such as real estate and equipment) are also factored in. In these cases, if the other pledged collateral sufficiently covers the amount of the loan, then life insurance may not be required, even for key personnel.
Additional key-person risk assessment
The SBA leaves it up to lenders to perform key-person risks assessments, including evaluations of how the loss of a particular person (or people) could potentially put a business and its related debt at risk.
One reliable way to find the information needed for informed evaluations is by reviewing bylaws, operating agreements or buy-sell agreements. These important documents indicate ways that a business has already considered (and likely addressed) key-person risks, which could reduce or eliminate the need for a lender to require life insurance to secure a loan.
If and when available, these documents could shed light on key considerations, such as the:
- Type of business entity
- Number of business owners, who they are and the roles they play in day-to-day operations
- Value of the business
- Anticipated funding of a buyout
Additionally, and when relevant to a business, lenders should consider:
- How shareholder interests are transferred or sold
- How the value of shares is determined for the transfer
- How the transfer of shares will be financed
- Whether or not the successor owner(s) have the managerial and industry experience to operate the business in the absence of the key person(s)
However, since many small businesses don’t have sufficiently detailed bylaws, operational agreements or buy-sell agreements in place, the collateral assignment of a life insurance policy on a key owner or manager can often provide the risk reduction a lender needs, or that the SBA may require, to approve a loan.
Contact The 504 Company for more information
As a leading SBA lending partner in New York, New Jersey and Pennsylvania, The 504 Company partners with lenders who want to strengthen relationships with their clients and help them grow their businesses. We’ve helped hundreds of businesses and lenders successfully navigate application and approval processes and we have the information and experience that you and your small business clients need.
Refer to our “Frequently Asked Questions” about life insurance as collateral for SBA-backed loans and contact us today to learn more about how we can help you, your lending institution and your small business clients.