Research published last year by a major UK insurer suggested that businesses are massively underinsured against a number of risks. While it is tempting to think “they would say that wouldn’t they?” some of the statistics highlighted by the research are interesting. For example, the research found that although nearly half of business owners thought that if they died their shares would be acquired by the other shareholders, most of the companies surveyed had no insurance to meet the cost of doing that and one third of the respondents had not reviewed their articles of association since incorporation to check whether the transfer process would work in the way in which they intended.
The important point which this raises is that business owners should not only think about what they want to happen to the shares of a shareholder who dies but also about whether the necessary steps have been taken to ensure that this can happen. If there is conflict between the rights set out in a shareholders agreement, articles of association or a shareholder’s will, this may mean that the transfers cannot take place as planned. This can cause delay and cost and, in the worst case mean that the shares cannot be transferred as intended. This is particularly the case where a shareholder dies intestate and the articles and shareholders agreement are silent on the subject.
Each business and family will have its own unique circumstances, but a few general points to consider are as follows.
- Protection of family ownership: It is common for articles of association of a family business to contain a restriction on the transfer of shares to non-family members. The exact way in which this works will vary and needs to be tied in with provisions in other documents (such as the individual’s wills).
- Cross options: the transfer of shares can be managed by including “cross options” in the company’s articles which provide that if a shareholder dies his shares are automatically offered to one or more of the other shareholders, who have a first right to buy them. In this way, the ownership of all of the shares is kept within the existing circle of owners and the deceased shareholders’ beneficiaries receive value for their shares. Where cross options are used;
- care needs to be taken to ensure that the transfer procedure is genuinely an option to acquire the shares (rather than a contractual obligation to acquire the shares) as a binding contract could jeopardise business property relief on the shares and trigger a significant charge to inheritance tax.
- it is important to consider how a purchase by the remaining shareholders would be funded, because the arrangement may not be implemented if none of them can afford to buy the shares. A common approach is for the other shareholders to take out insurance to meet this cost. If insurance is used it needs to be reviewed periodically to ensure that the amount insured reflects the current value of the shares, and that the beneficiaries of policy are the right people. It may also be important to consider, from an accounting and tax perspective who pays the premium (the company or the shareholders) any consequences of this.
- Consistency: whether or not there are cross option arrangements in the articles, it is important to check that the provisions of the articles of association are consistent with other documents, so that for example, shares are not left to someone in a will only to find that the transfer is prohibited by the terms of the articles.
- Other events: shareholders may also want to think about arrangements in the event of a shareholder being critically ill or becoming bankrupt and forfeiting his shares as part of bankruptcy proceedings. In the case of illness it may not be appropriate for the shareholder to be required to sell their shares but there may need to be practical arrangements to ensure that the control of the business can be maintained effectively (for example it may be helpful to have powers of attorney in the event that a shareholder is unable to act for a period of time).
- Continuity: owners need to think about business continuity generally. The 2013 research found that nearly half of business owners thought that their business would be unable to survive the death or critical illness of a key individual. Even if there is insurance to allow the other shareholders to acquire the shares, it is important to consider whether the business is adequately prepared to survive the upheaval that would follow an unexpected death or illness. One answer may be using key person insurance to help the company financially over any transitional period but there are practical steps which can be taken too. For example, ensuring that the company has a properly developed board which can share responsibility, ensuring business contacts are shared and that there is a plan to deal with business interruption.
- Providing liquidity: one way to avoid tensions which can de-rail a family business is to ensure that family shareholders who want to realise the value of some or all of their shares have a way to do so. This can be achieved in different ways (either with the company buying the shares or other shareholders acquiring them) but it is important to have a mechanism which is fair and transparent and (as before) to ensure this fits in with other share transfer provisions. It is far easier to agree such a mechanism (including particularly the approach to valuation) in advance than to try to do so when relationships are more fraught.
It’s not a pleasant subject to think about, but advance planning of this sort can ensure the survival of the business and that beneficiaries receive the value which they deserve. It can also mean that current shareholders can sleep more easily at night.