Shareholder protection is a form of insurance – usually life insurance but it could also include critical illness insurance – designed to pay a lump sum in the event of serious illness or death of a shareholder; the lump sum would usually be payable to the remaining shareholder(s) in order to provide them with the funds needed to ‘buy out’ the shares from the ill party or their estate / beneficiaries.
This means that sufficient monies would be available to those remaining (as the owners of the policy) to enable them to fund the purchase of the ill / deceased party’s shares, allowing the company to continue to be owned by the existing shareholders.
In turn, this avoids the potential issue of unsuitable (or uninterested) parties becoming a shareholder in the company (which may occur as a default if the shareholding is retained, or may be because an inappropriate third party offers to buy the shares).
As well as being beneficial for the remaining shareholders, a shareholder protection plan also benefits the family of the party that suffers ill health or death; in particular, it gives certainty to sufficient funds being available for the remaining shareholders to buy their stake from them.
In order for shareholder protection plan to work, it needs to be used in conjunction with an appropriate shareholder agreement, which defines the way in which the shares would be valued, and on what terms they would be offered. Such an agreement would typically be a Cross Option arrangement, although this will depend on the exact circumstances and needs of the company and its shareholders.
Under a Cross Option Agreement, surviving shareholders have the option to buy the shares from the ill / deceased party or their estate within six months of the event; the insured party (or their representatives) have to sell their share to the other parties if asked to do so. Similarly, such an agreement would require the other shareholders to buy out the shares of the person insured if asked to do so by them (or their representatives).
Life cover can be written on a ‘life of another’ basis, where each shareholder takes out a policy on each of the others (this is much easier where there are only two lives!); there is however a disadvantage to this in that younger, healthier parties end up paying more to cover older, less healthy ones.
Alternatively, each shareholder could take out a policy on their own life, with the benefits then placed under trust.
In either case, it can be useful to ‘equalise’ the premiums so that each person covered pays their ‘fair’ share of premiums, which reflects their likelihood of benefiting from the cover.
With such arrangements, the company would not normally be involved; premiums are normally paid by the individual parties (shareholders), and so no tax relief is available; correspondingly, no income or capital gains tax would usually be due when the benefits are paid (although you should always seek professional advice on this).
Shareholder protection is usually arranged by way of simple term assurance plan (life assurance – or life cover with critical illness), with the level of cover provided sufficient to buy out the value of the shares.
It may be written to retirement age or another appropriate term (depending on circumstances), and may also have the option to extend the term or convert the plan to a ‘whole of life’ arrangement (without the need for extra medical underwriting) for additional flexibility.
Whether the plan should remain ‘level’ (i.e., the cover provided stays the same throughout the term) or increase over time (by a set amount or in line with inflation) should also be considered, as the value of the shareholding will it is hoped increase over time!
As with all insurance, it is important that any conditions or exclusions applied to such a policy are considered rather than simply price; similarly, you should ensure that the cover you take out and the way the agreements are written are appropriate for you and your business. You should always seek professional advice if you are in any doubt.