Reasons Why You Need A Shareholder Agreement

When businesses are set up initially, it is often done in a fuzzy haze of optimism, blind faith, and self-belief.  However, further down the line, a healthy dose of realism needs to be injected into the heady mix.  In this article, we explore what happens if one of the owners dies, and how to protect against unwanted consequences.  We are going to be talking about what is commonly known as Shareholder Protection in the case of Limited Companies, or Partnership Protection in the case of Partnerships.

What I have seen over the years is both how much additional shareholders and partners can add to the value of the business when it all goes well.  And how badly things can go when the parties either fall out or die.

Shareholder or Partnership Protection is basically a life assurance policy that is paid by the business and which pays out a lump sum on death – it can also be extended to the diagnosis of a critical illness, although we will leave that one for another day.

Importantly, the life cover is placed in Trust to the other shareholders or partners.  This means that on death the life cover pays out immediately, avoiding Probate, to the other shareholders or partners – not the family of the deceased.  This is because the second part of the planning revolves around a Cross Option Agreement – an agreement that, if one of the shareholders or partners dies, the proceeds of the life cover are used to purchase the deceased’s holding from their estate, neatly tying everything up.

This way, the remaining shareholders do not end up in business with the spouse or family of the deceased, a situation that I have seen, and which rarely works well.  The deceased’s spouse or family end up with a large cash sum that recompenses them for the shares, and which then allows them to carry on with life and grieving, rather than having to be involved with a business that they may have no interest or aptitude for.

It also means that a minority shareholder is not effectively side-lined from the business with no recompense or opportunity to have a say in that business.

You will have noticed that it is called an Option Agreement – there are also Buy/Sell Agreements out there.  However, these can then give rise to Inheritance Tax bills because of their prescriptive nature.  I have described Cross Options Agreements as rather like having your arm up your back when asked whether you would like to sell the shares or not – you may choose not to, but the effects are not going to be pleasant.  Having an option rather than a definitive requirement to sell avoids the problem of Inheritance Tax.

Assessing the value of the business at outset is vital, to make sure that everyone is happy with the valuation.  Importantly, this value needs to be re-calculated every year or two to make sure that someone is not short-changed in the event of death.  There are also usually mechanisms in place that requires an independent valuation on death, and a facility to repay any under-valuation over a set period of time so that it does not cause the business any cash flow problems.

It is important to understand that the life assurance premiums are classified as a Benefit in Kind – on the person’s own policy, even though they will not benefit from it directly.  If there are Directors or partners of greatly differing ages or health, then this can mean very different premiums and therefore tax bills.  Often, there is an agreement between Directors or Partners to pay those that have a higher tax bill more as a balancing payment to make it fair.

So, although there is no legal requirement to have a shareholders’ agreement in place, we would strongly recommend that any business considers them very seriously.  It protects from any possible disputes at a time when there are far more important things to think about, and litigation always costs.

If you would like to see how Shareholder or Partnership Protection could help your business, or even want a review of your existing arrangements, then please contact us and one of our Wealth Strategists would be pleased to discuss your option with you.