Small businesses that bloom usually succeed by filling a niche that no one else can, offering unique skills, personal service or a killer product. But they also often depend on the know-how of one or a few irreplaceable people. If tragedy strikes them, it can take down the whole firm.

Enter key-person insurance — life insurance in which the beneficiary is the covered person’s business. Also called key-man insurance, it may be the best-kept secret to ensuring a company’s longevity or a successful exit for partners after the death of a top executive. Though small companies need it most, they’re the least likely to carry it. A 2007 survey by the National Association of Insurance Commissioners showed that only 22 percent did. “We tend to insure all of the assets of the company but forget the key assets, which are the employees,” says Gary Pevey, president of Wealth Design Group in Sacramento.

Key-person insurance offers breathing room at a time of pain and disruption. The beneficiary business can use the payout to cover outstanding loans and buy out the heirs of the deceased so that employees and the surviving family aren’t forced into a working relationship neither side wants. It can also cover the cost of finding the key person’s replacement — that may mean luring a star player away from another firm by bumping up their salary or offering a signing bonus, Pevey says. And if staying open isn’t possible, the benefit can cover the cost of shutting down.

If you’re seeking a loan or venture capital, you may have no choice about getting coverage. Wells Fargo’s David Kaneda says that, though each loan is different, his bank normally requires companies that don’t have collateral to buy key-person insurance with the bank named as the beneficiary. Bonding companies also might want to see it, Pevey says.

You need key-person insurance for any employee who can’t easily be replaced. Stephen Bender, CEO and president of Warren G. Bender Co., says his firm spends hundreds of thousands of dollars over a period of years to train, brand and “culturalize” its leaders. To cover that investment, the company insures all of its managers and the C-level executives.

How much coverage does a company need? It depends. Startups may want $250,000 on key people, and more established companies might want $1 million to $3 million, says Brian Souders, founder of Finish Line Insurance Services in Sacramento. Agents use various strategies to come up with a number; one is to make the benefit three times the covered person’s salary. Another is to estimate an employee’s actual replacement cost, taking into account how long it would take to find and train a new person, says Dean Forman, president of GFBB Benefits in Roseville.

In most cases, premiums won’t drive up your overhead costs too much. Pevey estimates that a 10-year term policy on a healthy 40 year old that provides $1 million in coverage would run about $500 a year.

The alternative is a cash-value policy, which has no set end point and grows as you pay premiums. It will generally run you three times more than a term policy, according to David Hill, owner of Sacramento’s SGC Financial and Insurance Services. You can borrow against a cash-value policy or draw on it as an emergency reserve. You also can use it to create “golden handcuffs” for essential employees by offering to turn it over to them if they stay with the company until retirement and meet performance goals, says Rita Gibson of Rita Gibson Insurance and Investment Services.

Generally, the longer you think you’ll hold the policy, the better off you’ll be with a cash-value plan. You can also buy a term policy that offers the option of conversion to a cash-value plan. Often, newer companies opt for term insurance and more-established ones for cash plans, Pevey says.

What if you’ve got a key person who’s uninsurable because they’re older or in poor health? The best you can probably do is self-insure by creating a special investment account, says Fred Hymans of ING Financial Partners. Or, if the employee has an existing life insurance policy they qualified for when they were younger, you can look into splitting the benefit of that policy between the employee’s family and the company by paying an increased premium, he says. 

But a company can lose a top performer to a disability too, and that’s harder to cover with insurance. In California, key person disability policies are much more expensive and harder to find than their life insurance counterparts, says Souders. Even when you do find them, “the products that are out there aren’t very good,” he says. According to Forman, a few regular disability plans allow companies to pay for a key-person disability rider.

None of that should stop you from preparing for the worst. Hill says it’s understandable that most startups and small firms neglect key-person insurance because they’re focused on turning out great products. But not tending to the company’s financial infrastructure could create a mess down the road: “If you have integrity about your responsibilities to [those who are left behind],” he says, “you want to make sure your finances are cleaned up.”