GUEST INSIGHT: Robert Harvey explains shareholder protection
Shareholder Protection is a type of business insurance commonly purchased by companies with two or more shareholders.
Should one shareholder pass away or become critically ill (if you add Critical Illness Cover to the policy), the policy kicks in to pay out a lump sum, which is then used to buy back the deceased / absent shareholder’s shares.
Having Shareholder Protection provides the business with ready capital to buy the shares and also provides monetary compensation for the family by offering them a willing and able buyer for the deceased shareholder’s shares.
Without Shareholder Protection, the remaining shareholder(s) may not be able to raise the funds to repurchase the absent shareholder’s shares and the family won’t receive any money from the sale. This could see the family selling the shares to a competitor to realise their value or becoming a ‘dead weight’ within the business, drawing an income but not having the aptitude to contribute to the company’s success.
The Different Types of Shareholder Protection
Shareholder Protection is among the most complicated types of protection our advisers sell, but that doesn’t mean it’s impossible to get your head around or it should only be offered by specialised advisers.
There are three ways to purchase it, each with their own pros and cons – it’s essential you understand all three when advising clients to ensure you pick the best option for their business.
The first and probably the simplest option is generally the best choice for companies with just two or three shareholders (any more than this and this option becomes very complicated very quickly).
Known as ‘life of another’ Shareholder Protection, this sees each individual take out an insurance policy written on the life of the other shareholding individual(s) within the business equivalent to their share of the company. In the event of the death of a shareholder, the surviving shareholder(s) receive the payout from the policy and can use the funds to purchase the deceased’s shares.
The problem with life of another policies is that they can quickly become unwieldy. Imagine a company with five shareholders and each individual has to take our four policies on the lives of the four other shareholders, resulting in twenty policies being written. Also, if shareholdings are likely to change hands, the policies written on that person would have to be cancelled and written again on the life of a new shareholder as one person exits the business and another person enters.
The second option is own life under business trust. Here, each individual shareholder takes out just one policy on their own life written into trust for the remaining shareholders to benefit from. In the event of an individual shareholder passing away or becoming critically ill, the trust receives the funds from the insurance payout and can buy out the absent shareholder. There are two ways to pay for it: either the business can pay or individuals pay.
Where individuals pay, it’s essential to retain the ‘commerciality’ of the agreement for inheritance tax purposes. If each owner pays a different amount for the protection — as is likely given each individual will have a different health and demographic profile — then it could be seen that the policy is a gift from older individuals paying the most to younger individuals paying the least. This is because the younger owners have a higher chance of increasing their interest in the business if an older owner dies or becomes critically ill.
As such, Shareholder Protection premiums must be equalised if you choose to have individuals pay for their own cover.
The third type of Shareholder Protection is company share purchase. Here, a company itself purchases insurance on all of its shareholders’ lives. In the event of the death or critical illness of a shareholder, the company receives the proceeds from the policy and uses it to buy back the absent shareholder’s shares and cancel them, increasing the shareholding of the remaining shareholder(s).
Where trusts are required to set up Shareholder Protection, it can be beneficial to know which companies offer the simplicity and convenience of online trusts.
This bypasses the need for paper trust forms going to and fro in the post and allows you to write a policy in trust entirely online, either without a signature or using a simple e-signature.
While not every provider offers this easy way to set up a trust, it’s becoming increasingly common for insurers to offer this as an option, so there’ll likely be an expansion on the horizon in terms of the number of companies which offer this.
Toolkits and Calculators
Certain providers offer a range of additional aids and tools to help advisers get companies protected.
These range from premium equalisation calculators, which calculate how to ‘even out’ premiums between shareholders of different ages for tax purposes (see above), to examples of the cross option agreements necessary to dictate how the shares of the absent shareholder will be handled should their absence trigger the policy.
Also available are business valuation calculators, which are meant to provide the value of the business and therefore how much each shareholding director’s shares are worth.
You can’t insure a business without knowing how much it’s worth and therefore how much each director’s shareholding represents in monetary terms, so such tools can be an incredibly valuable starting point for those not sure how to value a business.
This said, it’s always better to take business valuation calculators with a pinch of salt, notes Rob Harvey, Head of Protection Advice at Drewberry.
“We’ve dealt with tech startups in the past whose valuation in the first few years isn’t massive, but they have a huge amount of intellectual property and potential stored up. Such companies can be particularly hard to value and can require some negotiating with insurers to get them to see the bigger picture and recognise the ‘true’ value of a business rather than what can be calculated on paper.
“One client in particular was valued at around £200,000 in the initial valuation but later sold to a social media giant for in excess of £100 million, so it’s important that you take such factors into account.”
Guaranteed Insurability Options
Fortunately, insurers understand that the needs of a business change over time. That’s why most providers have a list of guaranteed insurability options built in to their policies that can allow the insurance you buy to evolve with the needs of the business should certain circumstances arise that require it without having to provide additional medical evidence.
This can accommodate rapidly-growing companies, although some providers will put limits on how much of an increase is available to you and how often it can be applied. This makes it important to choose an appropriate insurer if you believe your company is about to undergo rapid growth.
As you can see, every company offers a guaranteed insurability options if there’s an increase in the value of their shareholding or an increase in a key person’s value to the business, which is a good starting point towards flexibility should it be required further down the line.
Despite the range of tools, calculators and other options designed at making the process easier, purchasing Shareholder Protection is still a complicated protection product and one best undertaken with expert advice. That way, you can be sure that someone who knows what they’re doing always has your back.