That person may have no interest, knowledge or experience in being a shareholder, yet they will suddenly find themselves in a position of importance within the company. Needless to say, that can lead to numerous problems for both the surviving shareholders and the person that's unwittingly received the deceased's shares. That's where a cross option agreement alongside Shareholder Protection Insurance comes in, as together they can help all parties navigate through what is a difficult time for all.
In this guide, we look at what a cross option agreement is, why they are used in conjunction with the company taking out Shareholder Protection Insurance, how you can create one and much more.
A cross option agreement, also known as a double option or put and call agreement, is a legal contract between the shareholders of a private limited company that facilitates the sale or purchase of a shareholder's shares in the event that they should die.
Most frequently set up in conjunction with a Shareholder Protection Insurance policy, it forms an important part of a limited company's succession planning.
A cross option agreement guarantees that if a shareholder should die, the surviving shareholders will have the option to buy (put) their shares at a fair price. It also enables the initial recipient of those shares i.e. the deceased's beneficiaries, to have the option to sell (call) the shares to the other shareholders.
Put and Call Options, in relation to a Cross Option Agreement and Shareholder Protection Insurance, are the instruments that allow surviving shareholders to compel a deceased shareholder's estate to sell their shares, and equally, allow the estate to compel the surviving shareholders to buy those same shares.
To explain that more simply, in the event of a shareholder's death, the remaining shareholders have the ability to exercise their 'Put Option', which forces the beneficiaries of the deceased's estate to sell the shares to the surviving shareholders at a pre-agreed price. If the surviving shareholders don't use their Put Option, the deceased's estate has the ability to exercise their 'Call Option', which forces the remaining shareholders to buy the shares back, again at the pre-agreed price.
As you can see, while Put and Call Options will likely result in the shares being sold by the estate to the surviving shareholders, it's not guaranteed as neither party is obliged to exercise their respective options.
Shareholder Protection Insurance is a type of business protection that provides the means for surviving shareholders to acquire the shares of a deceased shareholder from their estate. Used in conjunction with a cross option agreement, it ensures that the surviving shareholders retain control of the company and the beneficiaries of the deceased receive fair value for the shares.
Firstly, it's important to note that there are two types of cross option agreements:
- Buyback of shares by the Company
- Acquisition of shares by the surviving shareholders
Both types will include Put and Call Options and importantly, so as to maintain Business Relief from Inheritance Tax, those two options need to run consecutively, as opposed to concurrently.
What that means is the structure of an agreement will usually look like the following:
- The surviving shareholders (or company) can exercise their Call Option, compelling the deceased's shareholder's estate to sell the shares to them, but if this option is not exercised, then
- The estate of the deceased shareholder has the right to exercise the Put Option, compelling the company or surviving shareholders, to buy the shares using the proceeds of the Shareholder Protection Insurance life policy.
By structuring the cross option agreement in this way, you ensure that it is not viewed as a binding contract for sale in the eyes of HMRC, and in doing so, preserves Business Relief. Crucially, it is seen as a 'right' to buy or sell and not an obligation.
If shareholders choose to take out a critical illness policy, the agreement will be slightly different, namely, it will be a single option agreement which will be created. The terms of a single option agreement only includes provision for the shareholder who has become critically ill to exercise their Put Option, with the other shareholders not getting a Call Option. That means the person who has become critically unwell, can force the other shareholders to buy his or her shares with the proceeds of the insurance policy, but the remaining shareholders can't force the critically unwell individual to sell the shares.
An important part of the creation of a cross option agreement is the valuation of the company, and there are three ways to do that.
- Fixed value - this is where the valuation is linked directly to the sum assured in the life policy. A fixed value is often the simplest to agree upon, however it may not accurately reflect the value of the business and lead to the beneficiaries of the deceased feeling short-changed.
- Fair/market value - this option seems like a reasonable way to value the company, however, care should be taken to ensure that the proceeds of the life assurance policy are sufficient to cover any potential fluctuations or significant increases. This method can also result in a dispute as to what constitutes fair/market value.
- Valuation model - this method of valuation is a pre-agreed way to value the company, taking into account the sector and nature of the business, but like the previous option there is a risk that the sum assured may be insufficient.
Regardless of the option that you and your partners choose, we'd suggest that the best thing you can do is to keep the value of the company under continual review to ensure that the sum assured is sufficient based on the current value.
The risks of not having a cross option agreement with a shareholder protection policy are numerous:
- Without a cross option agreement, should a director/shareholder die, their stake in the business could be inherited by a beneficiary that has little or no interest in the company - they could even sell the shares to a rival.
- The death of a shareholder is often a shock that can bring a variety of challenges within a business, not least what will happen with their shareholding. By not having a cross option agreement in place, you open yourself up for potential complications and even disputes which could otherwise be avoided.
- For some beneficiaries, receiving shares in a business they know nothing about can be daunting and create unnecessary worry and anxiety. A cross option agreement, along with a Shareholder Protection policy, gives them clarity and certainty, so reducing those fears.
- Many small businesses and their shareholders simply don't have the means to buy the shares of the company. It may well be that all parties are willing to exchange the shares, but without the means (Shareholder Protection Insurance) they're unable to.
Alongside your cross option agreement and Shareholder Protection policy, it's essential that all of the shareholders have a personal will that details the protection arrangement. This will ensure that in most cases those shares qualify for business protection relief for inheritance tax purposes.