Case Study: Shareholder Protection
Examining the potential issues faced by a small business without shareholder protection.
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What Can Go Wrong When a Shareholder Dies
This hypothetical case study examines the potential issues faced by a small business when a shareholder dies. The company has two equal shareholders who play an important role in the success of the business. But, there is no shareholder protection insurance in place.
Company: Example Limited
Shareholders: Sam (50%) and Jordan (50%)
Company Valuation: Circa £250k
Shareholder Protection: None
Disclaimer: This case study is a hypothetical scenario created for illustrative purposes only. It does not constitute advice. For specific advice tailored to your business needs, please consult with a qualified financial advisor or insurance consultant.
Company Formation
Sam and Jordan set up Example Limited as equal shareholders, both serving as directors. After a year of hard work, the company begins to turn a respectable profit and they pay out the first dividend.
As the company grows, Sam and Jordan draw a basic salary, make pension contributions, and claim expenses. However, they also earn a significant portion of their financial rewards through dividends.
Terminal Illness
Sadly, after five years of steady growth, Jordan is diagnosed with a terminal illness. This situation poses a significant challenge for the company.
With Jordan unable to work, Sam takes on a much larger workload. He is working 70-hour weeks to keep the business running and to reassure Jordan’s clients. Both Sam and Jordan have skills that are hard to replace, and the company relies heavily on their input.
Inheriting Sleeping Partners
After a short illness, Jordan passes away. As a result, Jordan’s family inherits 50% of Example Limited’s ordinary shares. They now have equal voting rights with Sam.
Sam wants to do what is best for Jordan’s family, but not at the expense of the company. The Shareholder Agreement doesn’t include a clause that requires Jordan’s family to sell their shares to Sam. There is only a standard pre-emption clause. Jordan’s family become sleeping partners and do not participate in the company’s operations.
Even though Sam is now handling all the work, Jordan’s family, as 50% shareholders, still have a legal right to receive dividends.
Employee Costs
Sam finds someone qualified to take on Jordan’s work. But, the cost of salary, national insurance, and the employee benefits package needed to attract the right candidate is high. Hiring the new staff member will reduce the company’s profits. This would significantly reduce dividend payments in the short term, meaning Sam’s income also decreases. Hiring an employee to replace Jordan just isn’t financially viable.
Fair Value Share Offer
Sam would buy the shares from Jordan’s family at the right price. But, the bank won’t lend the business the money to buy back the shares.
Instead, Sam secures personal financing (an offer in principle to remortgage his family home) and makes an offer to Jordan’s family.
The offer is based on a fair value for the shares, considering the company has lost Jordan’s input. However, Jordan’s family refuses, falsely believing that they are worth much more. This is unrealistic, because the company is so dependent on Sam’s skills and future profits are likely to be lower without Jordan. As a result, tensions begin to rise.
Business Distraction
Jordan’s family remain sleeping partners and do not contribute to the company’s operations. But, they start taking a greater interest in Example Limited. Sam finds this intrusive and a drain on his precious time, as he has to deal with their daily calls and questions.
Loss of Control
Sam attempts to rebalance the distribution of compensation. He proposes an increase in the basic salary of the company’s directors (now just Sam). However, any change to directors’ pay at Example Limited requires the agreement of all shareholders. This means that even though Jordan’s family are not directors themselves, they can still block Sam’s proposed salary increase.
Following advice they find online, Jordan’s family argues that a salary increase would further erode any dividends. They even consider litigation, claiming that certain expenses Sam is claiming unfairly prejudice them.
Sam can’t just leave and start a new business due to clauses in the shareholder agreement, which would likely lead to litigation.
Company Closure
After a difficult 12 months, Sam reaches his limit. He gives three months’ notice of his intention to leave the company, having been offered full-time employment elsewhere. He also offers Jordan’s family his shares at the same fair value he previously offered to purchase their shares. Unsurprisingly, they pass up the opportunity to take full control of the company.
Eventually, the company’s assets are sold at a distressed price to a competitor. The company is then put into Members’ Voluntary Liquidation. Both parties have failed to realise the maximum value of the company’s shares, wasting many years of hard work and effort.
How could Shareholder Protection Insurance have helped?
- Upon Jordan’s diagnosis of terminal illness, the shareholder protection policy could have enabled either the company or Sam (depending on how the policy was created) to make a claim.
- The right insurance policy would have paid out the necessary funds to enable the purchase of Jordan’s shares using a pre-agreed valuation.
- 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.
- 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.
- Neither Sam or the business would have had to borrow money to purchase the shares.
- Jordan and his family would 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 minimised and that there was a pre-agreed valuation.
