Shareholder protection planning is probably one of only a few number of times when a business owners professional advisers will all come together to advise their respective client. Drawing on many years of experience, being active in this area of advice will not only deliver desirable outcomes for the shareholders and their families, it will help you build professional connections with IFAs, Accountants, and Solicitors.
So, does Shareholder protection, as the name suggests, only look after the interests of the shareholders of a business? In reality, this type of protection and succession planning protects a multitude of different parties’ interests from shareholders, their dependents, to employees of the business and their families.
Firstly, it protects the shareholders. It ensures the affected shareholder (on death or suffering a serious illness) receives a fair payment for their shares, and the remaining shareholders have the option and funds to purchase the shares. This avoids the affected shareholder’s family having to be involved in the future running of the business, which the remaining shareholders usually prefer.
Secondly, it protects the shareholders families as they benefit from the market value of the shareholding or a specified cash payment rather than be at the mercy of the remaining shareholder’s offer. Furthermore, they do not need to be involved in a business that they may have no experience of running.
Thirdly, it protects the employees by ensuring continuality of the business with the remaining owners and management structure. There should be no need to raise debt and put extra strain on the business and thus avoids the need for the business to be sold, whereby jobs could be at risk.
Finally, it protects the business and means that the business does not need to be sold on the market to competitors, or when the business is vulnerable in terms of negotiation for a low value, or for asset stripping purposes.
What is needed and Why?
So we know the benefits from this type of succession planning but what is actually needed and why?
On the death of a shareholder, shares generally pass to spouse or other beneficiaries via their will and so as a professional adviser you must ensure that your client has an up to date will that reflects their current wishes.
The beneficiaries (of the shares) want cash and the surviving shareholders want the shares and ultimate control of the business. This exchange of shares for cash payment will need to be done legally and so a shareholder agreement must be drawn up by a solicitor. A shareholder agreement should ideally be established with the business from outset, but from experience, many private limited companies are formed and start trading without any consideration to having an agreement or the repercussions of not doing so.
However, the surviving shareholders may not be able to afford to buy the shares, or their bank may be unwilling to lend to the business, and particularly if the deceased shareholder is key person to the business and generating income. As such, a suitable protection policy should be put in place to pay out on death and/or suffering a serious illness such as cancer or heart attack. Otherwise, the beneficiaries may have to sell to a third party and they may not receive full market value.
The different ways of valuing a business.
But how do you value any business and therefore decide on the level of cover needed? This is not a defined science albeit that there are some general guidelines. I find that asking the business owners their opinion is the starting point to gauge their expectations. This provides a good opportunity to discover any existing protection, their own dependents needs, and gauge if any shortfall will happen even with any proposed shareholder protection. Next get their accountant involved to discuss possible valuations, which could be an independent valuation or based on either Price Earnings Ratio, Net Asset Value, or a multiple of net profits. It is important to remember that every business and sector is different and so insurers are prepared to go beyond standard variables with a valid business reason.
The different methods of shareholder protection are:
Company buyback method whereby the company repurchases the shares from the deceased shareholders. The company insures each shareholder and benefits from the claim proceeds on death or diagnosis of a serious illness. Once the company has repurchased the shares it then cancels them thereby increasing the value of the remaining shareholder’s shares proportionately. This is the most complex method and certain conditions must be adhered to.
Life of another method whereby each shareholder takes out a policy on the other shareholder so that they receive the benefit on the death or serious illness of the insured person. This gives the remaining shareholder the funds to purchase the deceased or serious ill shareholder’s shares. Due to the nature of this type of arrangement then it only really works for a two shareholder or partner business, and becomes more complex beyond this number of shareholders.
Own policy written in flexible business trust method for the benefit of surviving shareholders, and which offers flexibility on the number of, and without specifying shareholders, both now and in the future.
Each of these routes has different advantages and disadvantages, including minimum time that shares have been owned, complexity, tax reliefs and tax costs, and so it is essential that independent financial advice is sort to advise what method is the most suitable for any respective business now and in the future.
Equally important is the need to involve other business advisers such as Accountants and Solicitors for their profession input, and thereby building an ongoing and mutually beneficial relationship for all.