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When a key shareholder departs

Resignation, retirement, death or incapacity all need to be planned for

When a key shareholder departs

Owners of SMEs are sometimes faced with a situation where the shareholding structure of their business has to change. This might be totally expected, arising from a well-flagged retirement, or it could come out of the blue, because of a resignation, sudden death, or incapacity.

Advance preparation is essential for navigating all of these situations with the least possible disruption. Tax and trust consultant at St. James’s Place, Simon Martin, says: “Operational, legal and financial plans will all be needed, and spell out: who will take over the day-to-day functions of a departing shareholder; who will purchase their shares; and how the purchase will be financed?”

Resignation or retirement

Co-shareholders won’t always be able to exit together, as would be the case if a business was sold lock, stock, and barrel. A shareholder may decide to resign for any number of reasons, or retire earlier than fellow shareholders.  

Richard Jones, corporate and commercial partner at law firm Blake Morgan, says thinking about how the operational role of any individual shareholder would be covered if they left is not only about making sure that day-to-day operations continue smoothly, but also to plan for the possibility of having to allocate equity to high-calibre replacements.

In terms of legal planning, he stresses the importance of shareholders agreeing upfront that if one of them departs, that person is obliged to sell to non-departing shareholders. This can be covered in the main shareholders agreement or in a separate agreement. A separate agreement is needed if not all shareholders (e.g. staff with very small stakes) are party to this arrangement. A methodology for valuing the shares should also be agreed upfront, to avoid disputes at the time of the transaction.

When it comes to financing the purchase, Richard says that this is usually done through the company, and is generally not a case of non-departing shareholders having to come up with the cash in their personal capacity. The company might pay for the leaver’s shares out of accumulated profits, or by raising debt or equity finance. The company would then buy the shares and go through a legal process of ‘cancelling’ those shares, with all shareholders raising their stakes proportionately.

He also points out that it is quite rare for a departing shareholder to receive all of their cash immediately. More commonly, there would be an element of deferred payment (known as vendor financing), which would ease the financial burden placed on the company.

Death or incapacity

The sudden death or incapacity of one shareholder is obviously more difficult to cope with from an operational perspective. But despite this, contingency planning should be done regularly to minimise the impact on the day-to-day running of the business, should this situation occur.

However, says Simon: “Dealing with the transfer of shares from a deceased or incapacitated shareholder should be a fairly straightforward process, if the correct legal and financing structures are put in place in advance. The legal side is usually covered by a ‘double-option agreement’, also known as a ‘cross-option agreement’, and the purchase is usually financed from the proceeds of a protection (life and disability) insurance policy.”

Richard explains: “A cross-option agreement is essentially an irrevocable guarantee that, in the event of the death or disability of a shareholder, the insurance will trigger and the surviving shareholders undertake to purchase the shares of the deceased for the amount paid out by the insurance policy.” He says shareholders should be revisiting the value of the business periodically, and updating the policy accordingly. If this isn’t done and the policies pay out less than the value of the shares, the deceased’s beneficiaries won’t realise the full value of the shareholding. He points out that the agreement can be structured in such a way that the company can bear the cost of the insurance premium.

The consequences of not thinking through the implications of a change in shareholding, and not putting these legal and financing structures in place upfront, can be truly awful.

Richard says: “The operational implications of losing a key member of the team will inevitably put some strain on the business. But if the transfer of shares isn’t sorted out properly, things can get infinitely worse. Without the correct legal agreements, the shares of the deceased can end up in the hands of someone who has never had anything to do with the business (a beneficiary of the deceased’s estate) but has all the controls and rights that were afforded to the deceased – such as putting people on the board and influencing the direction of the company.” He also points out the deceased’s beneficiaries might be free to sell their inherited stake to an unwanted shareholder, such as a competitor.

A last point highlighted by Simon pertains to tax. He says: “The legal and financial structures need to take into account the tax circumstances of all parties, and ensure that where possible, no unnecessary taxes are payable (as would be the case if insurance premiums paid by the company are deemed a ‘benefit-in-kind’) and no tax reliefs are lost (such as Entrepreneurs’ Relief and Business Relief).”

Readers should seek appropriate legal, financial and tax advice when considering the structures mentioned in this article.

The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.

Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.