Ownership Protection

By Lee Davy, Director, Rebroke, www.rebroke.com/corporate, 01270 211311

The loss of a partner or shareholding director can cause problems to the day to day functions of the business although what happens to that persons share of the business can also cause problems. It is important to ensure that suitable protection and legal agreements are in place

Shareholder Protection

Is there a need for shareholder protection?

Every company has a Memorandum and Articles of Association. The Articles of Association set out the rules for the running of the Company's internal affairs. They will therefore deal with such issues as transferring and selling shares.

The Companies Act 1985 contains model articles called Table A and if adopted by the company it means that in the event of a shareholder becoming critically ill or dying the he could sell his shares, if fully paid, to an external third party even if this was against the wishes of the other shareholders. Although this is of no comfort to the other shareholders, it is also of little comfort to the critically ill or family of the deceased as they may encounter difficulties in obtaining a realistic price for the shares, or it could take months or even years to conclude a sale to a third party investor. Alternatively, the spouse of the deceased might decide to retain the shares and become involved in the business. This could be just as unwelcome for the other shareholders.

Not all companies adopt the model Table A provisions and many will have incorporated a "pre emption" clause which gives the other shareholders the first opportunity to buy the shares of the critically ill or deceased. This may not offer the protection intended though. For example, many shareholders have little surplus cash with their wealth primarily tied up in the business. Borrowing is an option, but is should be remembered that this would be done against the backdrop of a potentially traumatic time where the company has lost someone who is perhaps key to the business. Any lender would take this into account when arriving at its decision to lend.

The solution

A shareholder protection arrangement resolves these problems. It ensures that the proceeds are available when required on death and/or critical illness of a shareholder, to ensure a speedy conclusion to the succession problem. The shareholder or their family will quickly receive the true worth of their shares to alleviate these anxious times.

Arranging the plan

The most common method of arranging this protection is for each shareholder to take out an own life plan for the value of his shares. The plan is then written under business trust for their co-shareholders. The aim is that if one of the shareholders suffers a critical illness or dies , then the others will receive the funds from the trust to purchase the shareholding from the ill person or the deceased's personal representatives. If the shareholder had died then the personal representatives would then distribute the proceeds in accordance with the deceased's will or rules of intestacy.

To ensure that the arrangement will proceed as intended then some form of shareholder agreement or cross option agreement is required.

What is a cross option agreement

It gives the surviving shareholders the option to buy the shares of the deceased individual. Correspondingly, the personal representatives of the deceased also have an option to sell the shares. If either side wishes to exercise their option, the other party must comply. Options can only be exercised after death and their will be a specific option period usually three months. Partnership Protection
In a partnership the existence of a partnership agreement is vitally important:

• If there is no agreement in place then the Partnership Act 1890 will dictate what happens. If a partner dies then the partnership has to be wound up and their estate will usually require the partnership share to be paid out.
• If there is an agreement then it should dictate how the share is to be paid out to the estate of the deceased partner.

In either of these situations the need to find a large cash sum would come at a time when the business is also suffering the impact of losing a key partner.

The aim of partnership protection is to provide cover that enables:

• The remaining business owners to retain control of their business
• The estate of the deceased owner, or outgoing critically ill owner, gets fair value for their share of the business.
• The arrangement is set up in a tax efficient manner.

Normally an automatic accrual arrangement provides that upon the death of a partner their interest (value of goodwill) would pass automatically to the remaining partners. In this instance the deceased family receives no payment for that interest.

The solution is for each partner to maintain a life policy on their own life to the value of their share in the business.

The policy would be written in trust for the benefit of the partners family to avoid the policy proceeds forming part of their estate for inheritance tax and the delays that accompany the probate process.

Automatic accrual agreements normally cover the value of goodwill only and may make no allowance for the value of the partners capital account or any loan accounts that are outstanding. As these amounts may also be substantial it is important to consider additional protection so that these amounts can be repaid in the event of death.