Sometimes I get questions asking for some magic on my part. Or sometimes they ask me to solve a mystery and indulge my sense of fun at the same time. This question made me smile:
Q: Hi Richard. I’ve asked around, but I can’t get consistent answers to this question. So maybe it’s a gray area. Or is there a magical formula to calculate the required/desired appropriate life insurance?
A: Merlin the Magician from the King Arthur stories.is one of my favorite mythical figures. Merlin was a great magician and his feats are the stuff of legends. After all, he built Stonehenge. I’m no magician like Merlin was. And I haven’t got a magic wand. But I can conjure up some magic. Here’s the magic formula for determining the minimum amount of life insurance to require:
Step One. Start with the appraised value of your collateral.
Step Two. Determine the liquidation value. Most CDCs use 75% of the market value of the real estate, or 50% of the equipment value.
Step Three. Subtract the amount of the Third-Party loan from the liquidation value.
Step Four. Subtract the Net Debenture amount from the difference in Step three. Yes, Net Debenture, not the Gross Debenture.
Step Five. Require life insurance in the amount of the difference determined in Step Four.
Did you see what happened when you followed these steps? Dark clouds gathered. You determined the amount of your 504 loan that, in the event of liquidation, was not secured. It’s a grim thought, but if the principal of your borrower dies, the business might close. If it closes, you will have to collect from your second source of repayment: The Collateral. And because you want your money back quickly, you’ll sell the collateral at liquidation value. And if you do that, you won’t be fully paid. The Assignment of life insurance, properly acknowledged by the life insurance company, protects you from that risk.
Here’s a caveat: The amount you came up with is a justified, solid foundation, but it’s not fixed in stone. Your loan policy may require more life insurance. So might your principal’s spouse. But now that you know the magic formula, you should be able to justify the amount of life insurance you required if SBA ever asks.
Presto! Change-O!! Now you know the magic formula for determining the amount of life insurance to require!!!
Associate, CDC/504 Program