Imagine a scenario where your business partner and fellow director has died.
Your business partner’s wealth, including their share of the business, passes down to their family. This poses significant potential risks to your company.
They could become involved in business decisions they know nothing about. They could also sell the shares without your consent to someone who knows nothing about your business or to a competitor. You will need to pay dividends to the new shareholders if you want to take them. If you do not take them because of this, your new business partner might take you to court.
This situation can also pose risks whoever inherits the shares. There is no guarantee they will receive the full market value of the shares if somebody else offers to buy them.
Either way, this is an unsustainable situation.
What is shareholder protection?
The first part of setting up shareholder protection is having appropriate legal frameworks and documents in place setting out what happens on the death of a shareholder These include the articles of association and cross option agreements. Having these in place on their own may lead directors to believe they are fully protected. But what if there is not enough money available to do this?
There is the option of going to a bank for a loan, but this is not always possible. The death of a shareholder can significantly disrupt a business. Banks know this and may not be willing to loan any money if they are concerned about getting it back.
This is where the second part of setting up business protection comes in. This is putting insurance in place to ensure the money is available to buy the shares of a deceased shareholder.
Although we are talking about the death of a shareholder, these arrangements can also cover the critical illness of a shareholder.
How does shareholder protection insurance work?
Simply put, Shareholder Protection Insurance is life insurance (It can include critical illness cover). However, implementing it within a business appropriately, and tax efficiently, can be complex. here are many factors to consider. These range from the basics how you are planning to purchase your cover, to the contents of the shareholder and cross option agreements. A valuation also needs to be placed upon the shares. This requires either having a formula or an agreed way of valuing them.
There are three ways to set up this insurance.
The first is using a ‘life of another’ policy. This is usually applicable where there are only two shareholders. Both take out a life insurance policy with the other as the beneficiary. If either dies the other gets the proceeds and uses it to buy the deceased’s shares from their next of kin.
Where there are more than two shareholders, a better option might be to set up own life policies held under a business trust. Each shareholder takes out insurance on their own life which the company pays for. The death benefits go into a business trust which is run by the shareholders. Upon the death of a shareholder, the lump sum goes into the trust and is used to buy the deceased’s shares.
The third option is a company shares purchase agreement. This is where the company takes out life insurance policies on all the directors and receives the proceeds upon one of their deaths. The company then buys the shares from the beneficiaries and cancels them. This is the most complicated option in many ways and is often unsuitable for companies less than five years old.