Cross Option Agreements & Shareholder Protection Explained
Building up a successful business requires a huge amount of hard work and dedication. As a result, you’ll undoubtedly want to ensure the fruits of your labour can be enjoyed by future generations and that your company will be protected should something ever happen to you.
Shareholder protection and cross option agreements are two incredibly important business succession planning tools, designed to ensure the smooth operation of a company in the event of unexpected changes — such as the death or incapacitation of an owner or director.
Negotiating and drafting these key items requires meticulous planning and a consensus from all parties involved, so securing advice from experienced and commercially-focused solicitors is crucial. With this in mind, we’ve created this article to outline the important aspects of cross option agreements and shareholder protection, so you can make an informed decision about how to protect your business. Read on to find out more.
What Happens When a Shareholder Dies?
What happens when a shareholder dies depends on the provisions they made during their lifetime. If shareholder protection or cross option agreements exist in the company’s articles of association, these take precedence. If not, the shares pass to the beneficiaries outlined in the deceased’s will. Should none of these exist, the assets get divided according to the rules of intestacy.
Ensuring the necessary arrangements are in place is vital for reducing the likelihood of a dispute between the deceased’s family and surviving shareholders, or amongst the shareholders themselves. To read more about this matter, read our blog on the subject — What Happens Following the Death of a Shareholder.
What is Shareholder Protection?
Shareholder protection is an insurance policy that provides a lump sum in the event of somebody within the business becoming critically ill, incapacitated, or passing away. This money is designed to purchase the shares owned by the deceased or incapacitated individual, their family, or beneficiaries. Each shareholder takes out their own policy which is then held in a trust.
The aim of shareholder protection is to ensure that all shares remain within the business, instead of potentially being distributed in a way that could cause instability further down the line. It also provides families with a fair valuation for the percentage of the business they own.
What is a Cross Option Agreement?
A cross option agreement is a legal document that can be written into a shareholder protection policy. It sets out the different courses of action shareholders can take should one of them die or become incapacitated, by determining how the funds obtained from the insurance contract should be spent.
There are three main types of cross option agreements, which are:
- Single Option Agreement: Also known as a “call option”, this mechanism compels the deceased or incapacitated individual’s family to sell their stake of the business to the remaining shareholders.
- Double Option Agreement: In this scenario, the family or estate of a shareholder can force the sale of shares back into the business. Also referred to as a “put option”, the agreement outlines how these shares will be distributed and who will pay what amount to purchase them.
- Share Buyback: Involves the company itself purchasing the stake of the business, rather than the remaining shareholders.
Regardless of which option is chosen, the purpose of a cross option agreement remains the same, to ensure shares are returned to the business and remaining shareholders with as little disruption as possible. The funding for this purchase is usually taken from an insurance policy.
Cross Option Agreements Points to Consider
In order for cross option agreements to work, it’s important to review the company’s constitutional documentation (such as the articles of association) to ensure there are no clauses that may need to be waived. An example of this is pre-emption rights, which are designed to grant first refusal to purchase new shares to existing shareholders.
When it comes to share buybacks, the company must have sufficient distributable reserves available to fund the transaction. This is the case both at the time of the buyback and when the arrangement was first set up. Otherwise, the purchase will not be able to take place.
Finally, all parties involved in cross option agreements and shareholder protection policies should regularly review these arrangements to ensure they’re fit for purpose at all times. For example, continual valuation is recommended so that the true worth of each share can be realised.
The Benefits of Shareholder Protection & Cross Option Agreements
There are several advantages that cross option agreements and shareholder protection offer business owners should they die or become incapacitated. These range from reducing the likelihood of conflict between interested parties, and the potential for limiting inheritance tax liability.
The main benefits provided by these mechanisms are:
Business Continuity
The death or incapacitation of a shareholder can lead to uncertainty about the company’s future. Cross option agreements and shareholder protection provide a clear pathway towards a swift resolution, removing any doubts about succession and enabling the business to function normally.
Preventing Disputes
A lack of preparation when it comes to estate management could see individuals who have no interest or corporate acumen inherit shares in the business. This could lead to disagreements between interested parties about how the company should operate. Alternatively, there could be disquiet amongst remaining shareholders about control over the stake in question.
By clearly defining what should happen should a shareholder become incapacitated or die, everyone will be on the same page and the chance of conflict is significantly reduced.
Tax Efficiencies
If a cross option agreement contains both put and call options, HMRC will not view it as a binding contract for sale — and should see it as a right to buy or sell shares rather than an obligation. This preserves any Business Relief the company may have, which can then be used to reduce Inheritance Tax liability.
Writing shareholder protection policies and cross option agreements into a business trust can also reduce the tax liability incurred when making a claim, ensuring more money remains within the company.
Fair Valuation
Nobody wants to be short changed when it comes to the value of their stake. Having these mechanisms in place means that remaining shareholders won’t be paying over the odds when making a purchase, while families can be confident they are receiving exactly how much the shares are worth.
Peace of Mind
The sudden death or incapacitation of a shareholder will undoubtedly be a difficult time for all involved. Having comprehensive cross option agreements and shareholder protection policies in place removes any uncertainties and additional stress — providing peace of mind that the future of the business is secured.
Comprehensive Advice with Cross Option Agreements & Shareholder Protection
If you’re a business owner wanting to continue your corporate legacy, it’s important to obtain targeted and trustworthy legal advice to ensure your wishes will be carried out. This is where Thursfields excels.
Our specialist private client team has a great deal of experience with setting up comprehensive business succession planning and wealth protection strategies, as well as assisting with reducing your tax liabilities. We know that no two situations are the same, which is why we’ll work with you to understand your unique circumstances and goals, before devising a tailored solution to achieve your desired results.
As a full service law firm, we can not only assist with setting up cross option agreements and shareholder protection policies, but we’re also able to help you ensure important company policies such as articles of association are fit for purpose. On top of this, our solicitors are experienced litigators who will vigorously defend your interests when it comes to disputes between shareholders or disagreements over inheritance. Whatever you require, you can rely on us. Get in touch today.
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