When a company shareholder dies or becomes terminally ill, the impact on both the business and remaining directors can be profound.
It's typical for a Limited company's Articles of Association or an LLP agreement to stipulate what happens to the deceased owner's share of the business. Usually it will state that the shareholding should be left to the shareholder' dependents or beneficiaries.
But this can have serious consequences for the surviving shareholders.
For example, whilst the beneficiaries may have no interest in the company, their control of a significant stake could potentially disrupt or delay the other owner's ability to make business decisions.
And even if the family members are happy to be sleeping partners, seeking their agreement for an eventual business sale or exit could be made more difficult.
In the worst case scenario, a competitor could end up buying the stake from the family members, before mounting a full takeover bid.
And of course, the deceased's family may want to sell their inherited shareholding quickly. But without a readily available buyer, they could struggle to receive a fair price.
That's where shareholder protection insurance comes in.
Read on to find out how it works, what the tax implications are, and how it can benefit surviving business partners and the deceased's family alike.
What is shareholder protection insurance?
A share protection agreement is a legally binding contract drawn up between the owners of a small business about what happens to an owner's stake should he or she pass away
Upon a shareholder's death, the agreement gives remaining shareholders the right to purchase the deceased's stake from his or her beneficiaries.
Shareholder protection cover is an insurance policy that provides the surviving owners with the financial means to buy the shares from the family members at open market or fair value.
How does shareholder protection work?
Shareholder protection insurance works like this:
- Each shareholder takes out a life insurance policy. Either with or without critical illness cover.
- Each life insurance policy must be written into trust at the outset for the benefit of the other owners.
- One shareholder protection agreement is drawn up to cover all the owners. Typically a cross-option agreement. See below.
- The trustees keep the shareholder agreement and life insurance policies.
- Upon a shareholder's death, the trustees claim on the deceased's policy
- The insurance company pays the lump sum to the business
- The business purchases the shares from the beneficiaries at the agreed price.
How a cross-option agreement works
A cross-option agreement forms the basis of the shareholder protection agreement. It describes how shares will be sold to the remaining shareholders should one of the parties die, become terminally ill or if chosen for the policy, critically ill.
A cross option is a double-option agreement, which means both parties have the right to exercise their option to buy or sell respectively.
The deceased's beneficiaries have the option to sell their inherited shareholding to the remaining limited company shareholders, who are then obliged to buy them.
Similarly, the remaining shareholders have the right to buy the deceased partners shareholding, and the estate beneficiaries are obliged to sell them.
Either way, the agreement is only activated if one of the parties triggers the purchase or sale after a shareholder's death or terminal illness. A critical illness, if added to the policy could also allow a party to trigger it.
What happens if neither party triggers the cross-option shareholder agreement?
In the unlikely event neither party exercises their option, the deceased party's shareholding would remain with the estate beneficiaries.
A single option agreement is typically used where critical illness cover is added to the shareholder protection insurance policy.
It then comes into play if one of the shareholder's becomes critically ill and is either unable to continue working in the business, or no longer wants to.
In such circumstances, it allows for the affected shareholder to force the sale of their shares to the remaining shareholders on the agreed terms.
Unlike the double option, this is a one-way agreement which can only be initiated by the seller, not the buyer.