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Shareholder Protection Insurance Guide

Certainty for business stakeholders.

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What is shareholder protection?

Shareholder Protection Insurance is a type of life insurance that mitigates many of the potential negative outcomes that can arise in a small or medium-sized business should one of the company’s shareholders die or become terminally or critically ill.

Policies are usually designed to make a lump sum financial payout (either to the remaining shareholders or the company itself) to ensure that the necessary funds are available to purchase the shares owned by the terminally or critically ill shareholder, or, in the event of death, the deceased shareholder’s estate. The policy will be structured together with a legally binding agreement (a ‘Cross Option Agreement’) that obligates each party to buy or sell the shares and determines how the shares will be valued.

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Why consider Shareholder Protection?

For the uninitiated business owner, it isn’t surprising to wonder, “Why do I need shareholder protection if I already have a shareholder’s agreement?”

A shareholder’s agreement is a broad and fundamental document that is often created during a company’s formation, although it is not a legal requirement. Outlining the rights and obligations of the shareholders together with the necessary clauses to determine how the shares are managed, it will also stipulate the specific business matters that require shareholder approval.

Most often, when shareholders of small, medium, and start-up businesses are discussing the shareholder’s agreement, they are likely to focus on provisions that relate to matters such as voting rights, conflict of interest, non-compete, and non-solicitation. These clauses aim to protect the shareholders and the company by restricting shareholders from working for competitors, starting a competitive company, or poaching staff for a new venture.

There is also likely to be clear stipulations on what happens if one shareholder wishes to sell their shares, such as pre-emption clauses, which give shareholders first refusal on any sale of shares, and Tag-Along and Drag-Along rights, which cover the scenarios of what happens to minority shareholdings if a majority sale is being negotiated.

The shareholder agreement may even go to the extent of including a provision that addresses the death or incapacity of a shareholder who can no longer perform their role in the business. After a period of time (e.g., 90 days), the clause could require the other shareholders to purchase the incapacitated shareholder’s shares at “fair market value”. It may even go a little further to grant each shareholder the right to obtain life insurance on the other shareholders for the sole purpose of acquiring a deceased shareholder’s shares.

However, one of the many potential issues that this does not solve is, “Where do the remaining shareholders obtain those funds from?”

The company valuation may be a lot higher than expected, and the remaining shareholders are required to find a substantial sum that burdens the individuals or company with a level of financial risk that they are not comfortable to shoulder. Even if the debt burden is manageable, it is far from a foregone conclusion that a bank will lend to facilitate the purchase of the shares. The timing, too, could also be very inappropriate, since the deceased or incapacitated shareholder’s absence may be causing additional business issues and even a loss of revenue.

Altogether, even the most precise, up-to-date, and comprehensive shareholder agreement isn’t going to solve the issue of paying for the affected shareholding. Nor will it provide the same level of certainty that shareholder protection insurance can.

What are the benefits of shareholder protection insurance?

In the unfortunate event that one of the shareholders named on the insurance policy dies or is diagnosed with a terminal illness (or a critical illness if this option is part of the policy), the three main benefits of holding a shareholder protection policy are:

Cost – The cost to acquire the affected member’s shares of the company is covered by the policy. The remaining shareholders will not have to find the capital or raise finance to acquire the affected shares.

Control – Ensures that the control and direction of the business remain with the remaining shareholders and prevents the company’s shares from being obtained by a third party.

Certainty – Creates financial and operational certainty for the business by greatly reducing the risk of business disruption and many undesirable scenarios. Additionally, since the company’s valuation method is agreed upon, it also creates certainty for shareholders; in the event of their own death, terminal or critical illness, they can rely upon their shareholding being purchased for a pre-agreed, definable sum.

Together, these three benefits greatly assist with business continuity planning, risk management, and, to some degree, the succession planning of the business.

What risks does shareholder protection insurance help mitigate?

There are countless different scenarios and risk factors that shareholder protection insurance helps to mitigate. Primarily, shareholder protection insurance eliminates the risk of company shares falling into the hands of a third party. While a shareholder agreement may have specific clauses that seek to prevent this too, since a shareholder protection policy is intended to payout the required funds to acquire the shares, it also eliminates the risk that the remaining shareholders are unable to raise finances or face higher bids coming from outsiders. Additionally, since

These mainly stem from a loss of control and the subsequent issues this can cause.

Even a minority shareholding in a small or medium-sized business that is bequeathed to a third party can easily cause severe disruption and even have the potential to force the company’s closure. Ensuring the issued shares of a company remain in the ownership of the existing shareholders helps to decrease or eliminate the risk of:

  • Unwanted input from outsiders
  • Change of business direction
  • Misuse or incompetent use of voting rights attached to shares
  • Unbalanced or unfair remuneration
  • Delays caused by the probate process
  • Potential threats of litigation
  • Business distractions and legal costs caused by the above

Shareholder protection policies and tax

There are three main ways that a shareholder protection policy can be set up: Life of Another, Own Life, and Company policies. Each has different characteristics and important tax implications that should be discussed and understood with the company’s accountant to ensure the most suitable policy is chosen. The information below should not be considered tax advice.

Executive in Boardroom Icon to represent Shareholder Protection

Life of Another

This is the simplest type of shareholder protection and is paid for personally by each shareholder. It has a very straightforward structure, with each shareholder taking out a policy on the life or lives of the other shareholders. In the event that another shareholder dies, the remaining shareholder(s) will receive a tax-free cash lump sum payment to purchase the affected shares.

As this type of protection requires each shareholder to have a policy on the life of every other shareholder, it is most suitable for small businesses with just two or perhaps three shareholders.

Tax: Since the insurance premium is paid for by the individual and not the company, there is no benefit in kind for tax purposes or tax considerations for the company.

Businessman and Shield Icon to represent Individual shareholder protection

Own Life

This type of policy is more complex in its structure, requiring the creation of a business trust. It is far more suitable for companies with four or more shareholders and where shareholders may change more frequently, since adding or removing shareholders is relatively straightforward.

As the name suggests, each shareholder takes out a policy on their own life, which is written into trust with the company being the beneficiary. Should any of the shareholders die, the policy pays out to the business trust, which is used to acquire the affected shares.

Tax: Own Life policies are generally paid for by the company, and premiums are likely to be deductible against corporation tax. However, the premiums are normally seen as a benefit in kind, meaning shareholders are likely to be required to pay tax on the premiums.

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Company

More straightforward in structure than an Own Life policy, here it is the company that takes out and pays for the shareholder protection insurance on the lives of each individual shareholder. This structure does not require the creation of a business trust.

Should a shareholder then die or become terminally ill, the policy pays out the necessary lump sum directly to the company, enabling the company itself to buy back the affected shares. Rather than redistributing the purchased shares, the shares are then simply cancelled.

Tax: The lump sum is not likely to be subject to corporation tax, and equally, the premiums are unlikely to be eligible to be offset against corporation tax. HMRC generally does not look upon this as a benefit received by the shareholder.

There are, however, some related complexities that require consideration before taking a company policy. These are broadly related to the length of time the shares have already been owned, capital gains tax, and any significant creditors the company may have.

Cross Option Agreement

When setting up any shareholder protection policy, it is crucial that the policy is not in conflict with either an existing shareholder agreement or the company’s articles of association.

Once this has been established, if required, a ‘Cross Option Agreement’ can be put in place. This is a simple agreement that creates the necessary obligations so that the remaining shareholders have the option to acquire the affected shares, and the affected shareholders have the option to insist that the remaining shareholders make a compulsory purchase.

Premium equalisation

It is essential to take into account any differences between shareholders, such as age and health issues.

Importantly, this could result in older shareholders having to pay more for a lower level of protection.

Equalisation is well worth considering because it ensures that HMRC does not view the policy as a ‘gift’ to younger employees or those with a smaller share in the business. Usefully, equalisation means that the cost of insurance is divided equally between shareholders.

How much does shareholder protection cost?

Annual premiums are determined by many factors which include but are not necessarily limited to:

  1. Company valuation – The overall amount of cover required directly correlates to the valuation of the company. The higher the value of the company, the higher the insurance premiums.
  2. Company industry – The market sector in which the company operates can influence the risk and, therefore, the premiums.
  3. Shareholders – Just as with a standard life insurance policy, there are many personal factors that contribute to the cost of the premiums. These can include: Age, Occupation, Lifestyle, Smoking status, and Medical history.
  4. Critical Illness Cover – Policies that do not cover Critical Illness are likely to be significantly cheaper than policies which offer extended protection. This is because it is far more likely that a shareholder protection policy will pay out during the term of the policy.
  5. Policy Type – Whether the policy is set up as an Own Life, Life of Another, or Company Policy will contribute towards the overall cost of the premium(s).
  6. Term of Policy – Whether the policy is set up for 5 or 10 years will also likely affect the overall annual premium.

Valuing the shares for the purpose of the policy

One of the advantages of setting up a shareholder protection policy is that it requires the shareholders to agree on both the valuation method to be applied when calculating the value of the business and any additional formula as to how much each group or class of shares is worth. Minority holdings are often considered to be less valuable than a majority stake since the majority stake is likely to carry with it much more control. Equally, if there are multiple classes of shares paying different dividends or carrying different rights, each class will need a separate valuation.

The value of the shares will determine how much cover is required and contribute towards the cost of the policy’s premiums.

Valuing a business can be an extremely complex task with multiple methods that can be applied and various factors that require consideration. Accountants are often best placed to advise on the most suitable valuation method for any business.

Shareholder Protection Insurance Quotes

Acquiring a quote and advising on the most suitable shareholder protection policy requires the insurance consultant handling the enquiry to possess a high degree of commercial acumen.

Black Lion’s in-house business protection specialist has over 25 years of experience in this field of insurance and a demonstrable level of knowledge, helping many businesses protect themselves against future disasters.

Shareholder Protection Case Study

Small business with just two shareholders.

Company: Example Limited
Shareholders: Sam (50%) and Jordan (50%)
Company Valuation: Circa £150k
Shareholder Protection: None

Sam and Jordan jointly set up Example Limited as equal shareholders and are both directors. After 12 months of long days and late nights, the company starts to turn a respectable profit and pays the shareholders its maiden dividend.

As the company grows, Sam and Jordan pay themselves a basic salary, make pension contributions, and claim expenses, although a sizeable percentage of their financial reward comes in the way of dividends.

Unfortunately, after 5 years of steady growth, Jordan is diagnosed with a terminal illness. It’s a devastating blow to the company, Sam, Jordan, and Jordan’s family.

With Jordan unable to work, Sam is having to manage a much larger workload and is back to working 70 hours a week in order to keep the business running and reassuring Jordan’s clients. Jordan’s skills, like Sam’s, are hard to replace, and the company relies heavily upon them.

After a short, traumatic illness, Jordan sadly passes away just a few months after the original diagnosis. This means that Jordan’s family inherits 50% of Example Limited’s ordinary shares and now have equal voting rights to Sam.

Sam wants to do what is best for Jordan’s family, although not to the detriment of the company. There is no clause in the Shareholder Agreement that forces Jordan’s family to sell their shares to Sam and only a standard pre-emption clause. Jordan’s family have become sleeping partners.

As 50% shareholders, Jordan’s family are, of course, legally entitled to continue receiving dividends from Example Limited even though it is Sam who is still shouldering the massive void left by Jordan.

Sam is able to find someone suitably qualified to take on Jordan’s work, although the cost of salary, national insurance contributions, and additional benefits package needed to attract the right candidate is high and eats into the company’s profits. This subsequently means that dividend payments are going to be far less in the short term, and so Sam stands to earn less money, at least in the short-term.

At the right price, Sam would be prepared to buy the shares from Jordan’s family, although the bank will not lend the business the money to buy back the shares. Sam secures some personal finance (an offer in principle to remortgage the family home) and makes Jordan’s family an offer based on what he has been advised is a fair value for the shares, given that the company has lost Jordan’s input. Jordan’s family refuse Sam’s offer, believing the shares to be worth much more based on conflicting advice given by an accountant friend who suggests that their shares are worth 3 – 5 times last year’s profits. However, this is an unrealistic valuation given how highly dependent the company is on Sam’s skills and input and how having recently lost Jordan, future profits are likely to be less. Inevitably, despite relations begin to become strained.

Jordan’s family, while still sleeping partners and not contributing to the running of the company, start taking a greater interest in Example Limited. Sam finds this to be intrusive as well as another drain on his precious time and an unwanted distraction with daily calls and questions.

In a move to rebalance the overall distribution of compensation, Sam looks to increase the basic salary of the company directors (which is now just Sam). However, any change to directors’ pay at Example Limited is a matter that requires all the shareholders to agree. This means that even though Jordan’s family are not directors themselves, they are still able to block Sam’s proposed increase in basic salary. Based on advice they received via the internet, they argue that it will further erode any dividends and that they may even have to look at litigation to resolve the issue that Sam has been claiming certain expenses that they believe unfairly prejudice them.

Sam can’t just leave and set up a new business since the non-compete and restrictive covenant clauses in the shareholder agreement forbid this and would bring about litigation.

After a hellish 12 months, Sam has had enough and provides 3 months’ notice of his intention to leave the company, having been offered full-time employment elsewhere. Sam offers up his 50% shareholding of Example Limited to Jordan’s family at the same fair value price he had offered to purchase their holding, although unsurprisingly they pass up on the opportunity to take full control of the company.

Eventually, the company is sold at a distressed price to a competitor. Both parties have failed to realise the maximum value of Example Limited’s shares, with many years of hard work and effort going to waste.

How would Shareholder Protection Insurance have helped?

  1. Upon Jordan’s diagnosis of terminal illness, the shareholder protection policy would have enabled either the company or Sam (depending on how the policy was created) to make a claim.
  2. The insurance policy would have paid out the necessary funds to enable the purchase of Jordan’s shares using a pre-agreed valuation.
  3. The company would have benefited from not having the additional distractions that may have otherwise been brought about and can focus on growing the business.
  4. Because Sam would be receiving 100% of Example Limited’s dividends in future, the hiring of the necessary staff to replace Jordan is ultimately made more affordable and helped assure the company’s continued growth.
  5. Neither Sam or the business had to borrow money to purchase the shares.
  6. Jordan and his family benefited from a pre-agreed valuation and prompt payment for the shares.

In addition to the above, in the time before the diagnosis of terminal illness, the business, the shareholder, and their families would have had the peace of mind that, should the worst happen, any disruption to the business would be minimized and that there was a pre-agreed valuation.

Frequently asked questions on Shareholder Protection Insurance.

When would a company not require shareholder protection?

There are many instances where shareholder protection isn’t a suitable business insurance. The most obvious example would be a company that has just one shareholder. Because there are no other shareholders to consider, whether the company has 1 or 1 million employees, the company and shareholder are likely to achieve a better level of protection and business continuity from taking out Key Person Insurance.

However, even in a company where there is only one active shareholder but a small number of ‘silent partners’ there are still countless negative scenarios that can be avoided with Shareholder Protection. For example, one of the silent partners dies with a 20% shareholding. Without adequate protections in place, those shares could be inherited by an inexperienced and poorly-qualified individual with grand ideas of where the business should go. Worse still, that shareholder could now be the kingmaker in many crucial decisions. Shareholder Insurance helps to ensure that overall control of the company remains in stable hands.

Some may argue that family businesses have far less need for Shareholder Protection, and there is some argument that this would be the case for a husband and wife business but perhaps less so for a larger, multi-generation business.

The size of the business is also something to consider. Larger companies with many shareholders may have less need for Shareholder Protection especially if the shares are distributed relatively evenly. Then there are tiny micro-cap companies that have low valuations. As an indication, the smallest shareholder protection insurance policy Black Lion Insurance have ever assisted was for a company with a valuation (at the time) of just £75,000 with 2 active shareholders.

When does a shareholder protection insurance policy pay out?

Typically, all shareholder protection insurance policies will pay out should one of the shareholders named on the policy die or be diagnosed with a terminal illness and have a life expectancy of less than 12 months. The time taken for the insurance provider to transfer the necessary funds in order to facilitate the purchase of shares is normally between 30 and 90 days after a successful claim or a time-frame which relates to the date of the transfer of the shares.
Most policies include the option to increase the circumstances under which a claim can be made by adding additional critical illness cover. This would then enable a claim to be made should one of the shareholders named on the policy be diagnosed with or suffer from one of a number of conditions. The list of conditions covered is different for each insurer, although generally is likely to include:

  • heart attack
  • stroke
  • cancer
  • Parkinson’s disease
  • Alzheimer’s disease
  • multiple sclerosis
  • brain tumor
  • kidney or liver failure
  • heart conditions and cardiovascular diseases such as coronary artery disease
  • major heart surgeries or organ transplants
  • blindness, deafness, loss of speech

What’s best for small businesses, shareholder protection or key person insurance?

While it is often the case in many small businesses that the individuals most crucial to the ongoing success of the company are also shareholders, this is not something that should be assumed. It also should not be assumed that if an individual is covered by a shareholder protection policy, they do not require a separate key person insurance policy. Indeed, there are many scenarios where high levels of business continuity and risk management can only be achieved by an individual being covered by both policies.

In the scenario of a limited company where there is just one shareholder director who is ultimately responsible for the day-to-day operations then it is very likely that Key Person Insurance may provide a greater amount of business protection. This is because a Key Person policy would pay a sum of money to the company which can be used to hire consultants or find a replacement for the Director. This is likely to provide a greater level of business continuity and succession planning if the business is one that could still be run in the permanent absence the one shareholder director. If the company has employees that are also integral to the company’s success, key person policies should also be considered for these non-shareholders.

However, if the limited company’s main purpose is for contracting the services of the one shareholder director and has no other employees, it may be that an Executive Income Protection policy provides a more comprehensive level of protection.