It is important for businesses to plan for the future and shareholders should think about what will happen to their shares in the event of their death.
At Nelsons, we advise clients on shareholder protection plans working in conjunction with our own Investment Management team.
Shareholder protection insurance is put in place to allow for surviving shareholders to acquire the shares of a deceased shareholder for value from the estate of a deceased shareholder. The surviving shareholders retain control and the estate enjoys the value of the shares. The document which sits alongside the insurance policy (and associated trust documents) to facilitate the arrangement is a cross option agreement.
Benefits of the arrangement are:
- The surviving shareholders/directors maintain control rather than risking involvement from an unqualified/inexperienced beneficiary.
- The business has a fail safe in order to pay for the shares taking the worry out of how it would finance the purchase of the shares.
- Tax exemptions.
- The beneficiaries are provided appropriate return in respect of the shares and the responsibility of the shares are returned.
How does a cross option agreement work?
There are two types of cross option arrangements:
- Buyback of shares by the Company (where the company itself is a party to the cross option agreement).
- Acquisition of shares by the surviving shareholders (where the individual shareholders are party to the cross option agreement).
In either case it is important to review a company’s existing constitutional documents to ensure the cross option agreement works alongside without the need for amendment. By way of example:
- Do the Articles of Association allow for the company to undertake a share buy back?
- Do the Articles of Association include pre-emption rights which need to be waived?
- Are there any existing Shareholder’s Agreements in place providing for what should happen to the shares in the event of the death of a shareholder?
Additionally, in the case of a buyback by the company itself there must be sufficient distributable reserves in the company at the time of the buyback (i.e. at the time the option is exercised and not just when the arrangement is entered into).
A cross option agreement includes both Put and Call Options. In order to maintain the Business Relief (from Inheritance Tax) the two options should run consecutively rather than concurrently such that the structure is usually as follows:
- The surviving shareholders/Company have the right to exercise the Call Option to compel the deceased shareholder’s estate to sell the deceased’s shares to them; and (if this Call Option is not exercised) then
- The deceased shareholder’s estate have the right to exercise the Put Option to compel the surviving shareholders/Company to acquire the shares from them (using the proceeds of the life policy).
Structuring a cross option in this way is not viewed as a binding contract for sale in the eyes of HMRC and this preserves the Business Relief. It is seen as a “right” to sell/buy and not an “obligation” which is a key distinction.
Components to a cross option agreement include the relevant life assurance policy which is used to pay for the deceased’s shares and trust deed which outlines that the proceeds from the policy are to be used to fund the purchase of the deceased’s shares thus protecting the insurance proceeds from the deceased’s estate.
The method of valuation of shares in the context of shareholder protection is key. Possible methods would be:
- Fixed value (linked directly to the sum assured)
- Fair/market value
- Valuation model (contained in the cross option agreement/articles of association)
Naturally each scenario brings with it different challenges; a fixed value seems most secure, however, the true value of the company may not be reflected on sale and beneficiaries can be left feeling underpaid.
The fair/market value seems a reasonable option, however, it should be considered that existing shareholders would be in a predicament if the life assurance policy doesn’t cover the value of the shares reflected in the market at that time. A fair value mechanism can also give rise to dispute between the parties when they disagree on what constitutes fair value.
A valuation model which has been specifically drawn up to take account of the sector and nature of the business gives certainty but again there is a risk the sum assured is insufficient.
Review, review, review!
The best advice is to keep the value of the company under review even on an informal basis very regularly to ensure the sum assured adequately reflects the current value of the company.
Shareholders entering into this arrangement should also ensure they have reviewed their personal documents. A cross option arrangement relies on the parties having appropriately drawn up Wills in place.
How can Nelsons help?
Alice Rees is a Partner at Nelsons, specialising in corporate services.
Our corporate services team combined with the wider specialisms and expertise within the firm, make us the perfect choice for any business looking to implement a shareholder protection plan or a cross option agreement.