When buying life insurance as a business owner, a business valuation is essential in determining the appropriate coverage amount and the structure of the policy. A valuation is used to:

1. Assess insurance needs: A comprehensive business valuation helps identify the true worth of the business, taking into account assets, liabilities, cash flow, and potential future earnings. This assessment is crucial in determining the amount of life insurance coverage required. If the business owner were to pass away unexpectedly, the insurance payout should be sufficient to cover outstanding debts and financial obligations.
2. Fund buy-sell agreements: In businesses with multiple owners or partners, a buy-sell agreement is often established to ensure a smooth transfer of ownership in case of an owner's death. The business valuation determines the value of each owner's share, which becomes the basis for structuring the buy-sell agreement. Life insurance can then be used as a funding mechanism for the agreement. Depending on the structure of the buy-sell arrangement, the policy can be owned by the business or by a co-owner of the insured. In cases of a sole proprietorship, the policy could also be owned by a key employee or family member that the owner wishes to take over the business. In the event of an owner’s death, the insurance proceeds are used to buy out their business shares, providing liquidity for the buyout and ensuring the business's continuity.
3. Determine key person insurance: In some cases, a business relies heavily on the expertise and skills of a key employee. The business valuation can help assess the financial impact of losing that key person; and insurance can be purchased to provide financial protection to the business in case of the key person's death. 

Business valuations and life insurance premiums

A business valuation can significantly impact the premium of a life insurance policy for business owners.

The valuation of a business is closely tied to a policy’s coverage amount. A comprehensive business valuation helps determine the appropriate amount of life insurance needed to adequately protect the business and the owners’ interests. 

If, for example, the valuation shows that the business has substantial value, and the owner's death could result in significant financial losses, the insurance coverage required will be higher, leading to a higher premium.

Addressing changes in business valuation

Business valuations can change over time as businesses evolve and grow. Should the value of a business increase substantially following the purchase of a life insurance policy, the policyholder has several options: 

Policy riders: Many life insurance policies offer riders that can be added to an existing policy to increase coverage without purchasing a new policy. For example, a policyholder may be able to add a "guaranteed insurability rider," which allows him or her to increase the coverage amount without the need for further underwriting.

Policy replacement: In some cases, such as with a term life policy, replacing an existing policy with a new one that reflects the updated business valuation might be most appropriate. A policyholder would have to purchase a new policy with higher coverage and better terms based on the current value of the business'. A new policy would require new underwriting, so the insured’s health profile at the time of replacement would have to be considered.  

Supplemental policies: If a current policy is insufficient to cover the increased business value, the business or policyholder can purchase additional life insurance policies to bridge the gap. As with a policy replacement, an additional policy would also require new underwriting.  

When purchasing a life insurance policy for a business, an applicant may elect to start with a higher valuation based on the projected growth of the business. For example, a business currently valued at $1 million with expected growth of $1 million over the next five years may be insured at $2 million to alleviate the need of future policy adjustments.

Types of business valuations

There are two main types of business valuations: informal and formal. An informal valuation provides a reasonable estimate of the value of the business for the purposes of obtaining insurance, but may not be admissible in some contexts, such as in court proceedings. 

The business owner or his or her may conduct an informal valuation on their own by using a third-party software program, some life insurance carriers also provide an informal valuation service for free. An advisor can help serve as a liaison between the client and the carrier to ensure all the relevant information is received. 

A carrier will typically need the following to conduct an informal valuation:

• Tax returns from the last three years
• Profit and loss statements
• Revenue reports
• Asset inventory

The alternative is a formal business valuation conducted by a third party firms following a structured and comprehensive process to determine the business's fair market value. A fact finder will review:

• Company financial statements
• Revenue trends, profitability, cash flow patterns, and key financial ratios
• Industry analysis like the growth landscape and industry trends

A formal business valuation report will be prepared, documenting the entire valuation process, the methodology used, the data analyzed, the findings, and the conclusion on the business's value. These reports typically hold up under legal scrutiny during court proceedings. However, a formal valuation is more time intensive and can cost anywhere from five to twenty thousand dollars or more.

Business valuation methodology

There are several different methods used to determine the value of a business. The choice of valuation method depends on a number of factors, including the type of business, industry, financial performance, and the purpose of the valuation. Some common business valuation methods include:

Fixed-price: As the name suggests, this type of valuation sets a predetermined dollar amount for the business's value or the ownership interest in a buy-sell agreement. The parties agree based on their individual estimates, appraisals, or specific formulas. This is the most straightforward method to value a business, but  may not be suitable for more complex businesses.

Book value: This method determines a company's worth based on its accounting records and financial statements. The book value represents the value of the company's assets minus its liabilities reported on its balance sheet. This approach is relatively simple and provides a basic estimate of the business's net worth. However, it may not accurately reflect the true market value of the business, especially for companies with significant intangible assets.

Discounted earnings: The discounted earnings business valuation is an income approach method based on projected future earnings. It involves estimating future cash flows, discounting them to present value using a discount rate that reflects the time value of money and risk, and potentially adding a terminal value to account for ongoing business worth. While effective for businesses with a history of stable earnings, it may not suit businesses with unpredictable earnings. 

Capitalization of earnings: The capitalization of earnings involves projecting future earnings and applying a capitalization rate, representing the expected return on investment, to determine the business's value. This approach is suitable for stable, mature companies with predictable earnings, but may not be ideal for businesses with fluctuating earnings or high growth potential. 

Appraisal method: This is the formal valuation conducted by a third party to determine a company's fair market value. Here, certified appraisers use various techniques to assess the business's worth based on factors like future earnings, market comparisons, and asset value. The final valuation report provides a comprehensive assessment that can be used for mergers, acquisitions, and financial reporting in addition to applying for life insurance. 

Candidates for a business valuation

In general, people who meet the following criteria are good candidates for a business valuation:

Established and growing businesses: Businesses with a track record of stable earnings and growth potential are ideal candidates for a business valuation. The valuation can help determine the company's fair market value and guide strategic decisions related to growth and expansion.

Businesses with multiple owners or partners: Companies with multiple owners or partners may require a business valuation to establish a buy-sell agreement and ensure a smooth ownership transition in the event of an owner's death or departure.

Business planning for key persons: Companies that heavily rely on the expertise of a key person may consider business valuations to plan for key person insurance or to ensure the business's continuity in the absence of that individual.

Business owners without current policies or buy-sell agreements: Business owners who don’t currently have coverage or buy-sell agreements in place would greatly benefit from a business valuation to help establish future business goals and succession plans.

It's important to note that while the above characteristics may make an individual an ideal candidate for a business valuation, every business is unique, and individual circumstances will ultimately dictate whether a valuation is necessary or beneficial. Understanding a person’s specific needs, business structure, and financial goals will help determine if a business valuation is essential to their overall financial and insurance planning. 

Case study

Greg is a 50-year-old sole owner of a successful manufacturing company, and he wants to ensure a smooth transfer of his ownership share to his son upon his death. To achieve this, he is considering a life insurance policy his son will own. This will provide the necessary funds for his son to buy out his share and maintain the business's continuity.

Greg wants to obtain a business valuation to accurately assess the value of his ownership share in the manufacturing company. The valuation will help determine the appropriate amount of life insurance coverage required to fund the buyout.

Greg meets with an experienced advisor who specializes in business planning. During the consultation, they discuss his goal of passing on his ownership share to his son and the importance of a well-structured buyout arrangement.

Based on the advisor's recommendation, Greg engages a qualified business valuation expert to formally evaluate his ownership share in the manufacturing company. The expert requests financial statements, ownership documents, and other relevant information about the business.

The expert presents Greg with a detailed valuation report outlining the methodology used and the final conclusion on the value of his ownership share. Greg’s advisor reviews the valuation report and helps him determine the appropriate amount of life insurance coverage needed to fund the buyout by his son.

With the business valuation report and life insurance coverage in place, Greg can rest assured that his son will have the necessary funds to buy out his ownership share in the manufacturing company upon his passing. The business valuation not only ensures a smooth transition of ownership but also secures his son's inheritance and the business's continued success.