Robert Little, director of chartered financial planners Bob Little & Co, in Kirkleatham Business Park, Redcar, examines how business owners can safeguard their assets against unexpected events…
Very few business owners in the UK have either a Shareholder Protection Policy or Key Person Insurance in place, yet both types of cover are, in my view, essential.
Shareholder Protection is invaluable for businesses with more than one owner, while Key Person Insurance can provide peace of mind for businesses with more than one important member of staff, including owners and managers and any other people who contribute to the profitability of the business.
In this article I’m going to take a closer look at one of these policies, Shareholder Protection, but I would strongly urge all business to consider taking out both of them.
Who needs Shareholder Protection?
Shareholder Protection is vital for any limited company, partnership or Limited Liability Partnership (LLP) with more than one owner or partner. If you are the only owner of your business then you should not require Shareholder Protection but other types of business protection could still be important. While the policy is called “Shareholder” Protection it is available to partnerships and LLPs as well as limited companies. For these purposes I will use the term “shareholders” to refer to the owners of partnerships, LLPs and limited companies.
What does it do?
It provides a lump sum if one of the shareholders either dies or experiences a serious illness (such as a heart attack, stroke or cancer diagnosis). This lump sum is paid to the other shareholders who can use the money to buy the ill or deceased shareholder out of the company.
Why is it important?
It can help to ensure business continuity and can stop any disagreements between the ill or deceased shareholder’s family and the remaining shareholders.
Mr Jones and Mrs Adams are shareholders and directors of a limited company. Mr Jones owns 60% of the shares and Mrs Adams owns the other 40%. Each of them has a spouse and two children. Their accountant tells them the business is worth £1m.
Mr Jones passes away suddenly. His wife, Mrs Jones, inherits his share of the business, so she now owns 60% of the company shares. She has no interest in continuing to run the business and she would prefer to get rid of her shares. She asks Mrs Adams to buy her out. Mrs Jones speaks to the accountant and she is told the fair value of the shares is £600,000 (60% of £1m) so this is what she expects to receive from Mrs Adams.
Unfortunately, Mrs Adams doesn’t have £600,000 available. However, there is some money available in the company bank account. She asks the accountant about paying a lump sum out of the company bank account to help towards the share purchase. The accountant tells her that this is not possible – first of all, it would be treated as a dividend and would be subject to dividend tax, which would reduce the amount she could receive. Secondly, Mrs Jones (as a 60% shareholder) is entitled to 60% of any dividend payments. Both of these points mean the company would have to pay a dividend of far more than £600,000 for Mrs Adams to actually receive £600,000 and the company does not have this much money.
Mrs Adams then approaches a bank to ask about taking a personal loan of £600,000. Unfortunately, the bank views the company as too risky and is unwilling to lend £600,000 (after all, the majority shareholder has just passed away and this will leave a void in the business).
Mrs Adams tells Mrs Jones she will be unable to buy the shares. Mrs Jones looks for an alternative buyer and, eventually, a private investor agrees to buy the shares for £400,000 (a substantial discount to the fair value of £600,000). This private investor, a stranger, now owns 60% of the shares and has legal control over the company.
As an alternative to selling her inherited shares to the private investor at a discount, Mrs Jones could have held on to them. Had she done this there would be no obligation for her to do any work to help Mrs Adams with the running of the business. Mrs Jones, as the majority shareholder, would have control over the company, including the future dividend policy. She would have the power to appoint other directors even if this was against Mrs Adams’ wishes.
Without Shareholder Protection:
The family of the deceased was forced to sell shares in the family business to a stranger.
In the meantime there was a great deal of uncertainty for the family of the deceased and the remaining shareholder.
The family of the deceased received far less than the true value of the shares.
The remaining shareholder is left with a stranger as the majority shareholder in the company. This person is now legally in charge of the company, including the future dividend policy.
With Shareholder Protection:
Mrs Adams would have received a lump sum of £600,000 following Mr Jones’ death.
She would have used this money to buy Mrs Jones’ inherited shares.
Mrs Jones is left with the fair value of her late husband’s shares and has no more concerns about the business in the future. She remains in 100% control of the company without having to take out a loan.
Director, Bob Little & Co