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Director's Shareholder Protection

Posted on February 24, 2011

Michael Aitken, Founder and Managing Director of Magus Financial Management, explains why Director's Shareholder Protection is crucial for business stability.

It is a common fact that entrepreneurs are generally positive forward thinking people. The cup is usually half full if not overflowing.

However running a business always involves an element of uncertainty. This uncertainty includes the risk of loss or damage to the assets of the business as well as the death or long term illness of a shareholder.

The figures speak for themselves, and therefore none of us are immune from health risk. The chances of death and critical illness occurring in a group of 4 people during their working life (18-65) are as follows:

  Males Females
Death 29% 23%
Critical Illness 68% 59%

Source: Munich Re 2007

The death or diagnosis of a critical illness of a significant shareholder can have far reaching consequences on a business. Take the scenario of death, the shares will be passed to their estate and then the family has two main options:

1. A member of the family could take over the deceased's position as director;

2. The family could realise the value of the interest by selling it.

Neither of these avenues is problem-free.

Commercial experience, age, qualifications, ability or commitment could prevent any member's of the deceased's family being capable of becoming a director.

If the family, of the deceased, wishes to sell their interest in the company, the remaining director(s) may find themselves working with an unwelcome new director. Also, it may be difficult to find buyers, which could lead to financial problems for both the family and the business. A solution is for the remaining shareholders to buy the shares from the family. But then there is the issue of having readily available funds or raising the funds from their bank; this is where shareholder protection can be a practical and simple solution.

How does Director's Shareholder Protection Work?

Each director takes out either a life assurance or life assurance and critical illness cover written in trust for the other directors. They also enter into an agreement, typically a cross option agreement. In the event of a death or specified critical illness of a director, the other directors then have the money to help buy the director's shares.

The business would usually pay the premiums and this is taxable on each of the directors. Since premiums reflect the age, gender and sums assured of each individual, the amounts paid do not reflect the benefits each may receive in the event of a claim. However premiums can be apportioned according to each director's stake in the business. This is known as premium equalisation. The sum assured of each policy equals the value of each director's share in the business.

The cross option agreement is a reciprocal arrangement that helps the surviving directors to keep control of the business by giving them the option to buy the interest of any director who dies. If critical illness is also covered and a claim is made, this is often dealt with using a single cross option agreement. This ensures the decision to sell off shares lies with the ill director when he is ready to sell or if he wants to sell, rather than having the decision imposed upon him.

RM2 is pleased to recommend the services of Magus Financial Management, who are specialists in providing financial planning and advice. For further information on any of the issues raised in this article, please contact Magus FM at www.magusfm.co.uk or 0845 8882988.

 
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