A shareholders’ agreement is as much about planning for future misfortunate events as it is about control of the business today.
Events such as death, incapacity, bankruptcy or insolvency can change ownership, and in doing so, the balance of control of the business. In the case of a small team of founders, decision making about important issues to the business could be passed to someone else such as a carer acting under a lasting power of attorney, an inexperienced beneficiary under a last will and testament or an institutional creditor such as a bank. The new person is unlikely to have the same knowledge and experience, time commitment, shared vision, or personality as the old one.
Moreover, since shares are a personal asset, other shareholders have very little control over the person to whom they could be passed.
The other person to consider in such situations is he or she who inherits or is compensated by the shares. He or she is unlikely to prefer ownership of the company over cash: a creditor will want the debt repaid; and a beneficiary probably will find it more difficult to see the potential upside in holding onto the shares until the whole company is bought out as opposed to having cash in hand now. But shares in a private limited company are not easy to sell.
The solution to these issues is to use a cross-option agreement. The terms can be placed within the shareholders’ agreement or in separate document.
A cross-option agreement grants legal rights to the remaining shareholders to oblige the new shareholder (and perhaps other shareholders such as his or her immediate family members) to sell (known as a call option), and to the new shareholder to oblige the remaining ones to purchase (known as a put option). Importantly, neither side has an obligation to buy or sell unless the other side exercises their option.
A cross-option agreement is therefore a mechanism for the remaining shareholders to prevent a loss of control to an outside party, and one for the person who gains the shares to liquidate the shareholding.
Liquidity to enable an option to be exercised
Shareholders are unlikely to be able to fund the purchase of shares at short notice. So in order to make exercising the option a viable decision, insurance policies are taken out at the same time as the cross-option agreement is entered into, to the proportional value of the business for each shareholder (and adjusted from time to time). When an event occurs, the policy ensures that the money is available for the shares to be bought.
Who takes out the policy can vary. The company may take out the policy in favour of itself, or the shareholders may agree to take out a personal life policy in favour of the others.
If the company has the policy, it buys back the shares, leaving the remaining owners with the same number of shares, but a greater proportional ownership.
If a shareholder has the policy, then the policy pays for the others to buy the shares in proportion to their current holdings. The shareholders own more shares and have the greater proportional ownership.
There are tax implications either way, so which method minimises tax depends on the particular circumstances of the company and the owners. Where shareholders take out an individual life policy, the policy is usually written into a discretionary trust.
There are certain matters to consider in respect of putting cross-options in place.
The first is how the business should be valued at transfer. There are many ways of valuing a company, none of which are likely to produce a figure that all shareholders think completely fair to themselves personally. The values of intellectual property and of future earnings potentials in particular are very subjective.
The second is that there should be an obligation for shareholders to amend the life policies regularly, or whenever a significant event occurs. That ensures that the price paid for the shares can be covered by the policy.
A third is what happens if one of the shareholders becomes uninsurable at the expiry of a term of insurance, invalidates the insurance, or if the premiums become too expensive.
Shortfalls between the value of the policy and the value of the shares might be able to be met in other ways (such as by loans), or the value of the shares might be capped at the value of the policy (transferring all risk to the new owner).
After one side has exercised his or her option, there may be certain events that must happen before a transfer can take place. For example, probate may need to be granted, or life policy proceeds received.
A timetable can be set out in the agreement that states when transfer should ideally occur.
Business Property Relief
100% inheritance tax relief, in the form of Business Property Relief is available on business shares.
It is important that an option is used: that there is no obligation for either party to transfer the shares for cash unless the other insists. Obligated transfers (binding contracts for sale) do not qualify for Business Property Relief.
Usually a life assurance policy is held in trust for the remaining shareholders. In this way, the proceeds from the policy fall outside the estate of the deceased shareholder, and therefore are not subject to inheritance tax.
As with any potential tax matter, you should consult your accountant as well as your solicitor.
Should you include cross-options in your shareholders’ agreement?
When cross-option agreements are such a neat solution to potentially large problems, it may seem very logical to consider adding them into your founder shareholders’ agreement.
The one consideration is cost of insurance relative to the value of the company. Start-ups tend not to be valued highly. Insurance premiums may be high. The question for founders is whether the risk that the shares pass under misfortunate circumstances into less preferable hands is truly the greatest for the company, or whether the loss of a key man would spell the end of the enterprise anyway.
Additionally, founders who have invested in the new business may not have the cash to pay premiums.
It may be better to wait until the company is more established so that it can afford the insurance premiums. A future stand-alone agreement may be a better solution than terms incorporated into the shareholders agreement now.