Finance

A Guide to Shareholder or Partnership Protection: What Is It? And the Common Mistakes

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Most business owners may not appreciate the risk of not structuring shareholder or partnerships protection policies.

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Most business owners are used to addressing risk. They insure against fire, break-ins, damage to trade vehicles, etc. They may even insure themselves, but do they appreciate the risk of not structuring shareholder or partnerships protection policies correctly? The evidence would suggest not.

Ever since humankind first discovered fire, we have sought to harness the power of the flames and, as we know, we have not always done so successfully.

There is evidence of human societies fighting fire dating back to ancient Egypt, with records of a dedicated fire brigade being in force under the stewardship of the Roman Marcus Licinius Crassus around 85BC.

Crassus was an opportunist, exploiting the noblemen of Rome fearful of fires ruining their properties. Noting their anxiety and utilizing his significant political influence, Crassus created his own private fire brigade of around 500 men charged with visiting properties ablaze at the first sign of distress. When appearing at the fire, the firefighters simply did nothing, awaiting Crassus’ arrival, where he then sought out the property owner to ‘discuss’ the cost of his brigade’s services. If his demands were not met, the brigade stood by as the fire overwhelmed the property.

In Britain, it was not until after the Great Fire of London in 1666 when Nicholas Barbon formed the first private fire insurance business, The Fire Office, no doubt spotting an opportunity like Crassus before him.

Just as with the Roman model, Barbon employed his own small brigades of fire-fighters, made up of locals living and working close to the Thames. Each team of fire-fighters was to attend fires at the first call for help, and then await evidence that the property owner had indeed paid Barbon for this very direct form of fire insurance.

Initially, policy holders were given a certificate to evidence their insurance and to confirm the premiums had been paid up to date. However, as the certificates were usually kept inside the very building that was burning, this was not a very effective form of proof – and without the supply of a certificate, buildings were simply left to burn.

Modern fire-fighting is now thankfully much more efficient than it was in the 17th Century, and insurance is now taken out to cover any losses suffered from the impact of a fire, not to ensure that the fire itself is fought. However, these examples highlight how important not only having these arrangements is, but also ensuring that they are effective and appropriate for the type of cover you need. Without such protection in place, or having this set up incorrectly with the wrong supplier, it can essentially render it worthless at the time when you need it most.

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Still many - if not all - business owners now take out fire insurance as a matter of course. And no doubt, they are keen to consider that all potential losses and liabilities are insured – either personally or with the help of a broker – so that, should a property catch alight, the financial impact of such an event is not business-ending.

Remarkably, fewer business owners actually insure their most valuable asset – themselves, than insure against fire and other risks that would have a less devastating impact on the financial security of their business and their family.

That said, many business owners will have life insurance of one form or another. But the question is not just ‘are you insured?’ or ‘do you have enough cover?’, but ‘is your protection structured correctly?’

Let’s assume that a business owner has life cover in place. If they suddenly die, not only would it be a tragedy for their family, but it could jeopardise the financial security of the business, and thus the long-term financial security of their family, too.

In the event of death of a business owner, from a financial perspective there are two key issues to address to ensure things go to plan;

  • Control of the business should end up with the relevant people within or associated with the business.
  • The deceased business-owner’s loved ones should receive fair value for the business interest.

There are no set rules over who these people should be – who am I to tell a business owner who their loved ones are? But there are set rules over the treatment of business ownership in the event of an owner’s death.

Mostly commonly in this scenario, those left behind will want the control of the business (shareholding or the partnership interest) to pass to the surviving shareholders or partner, the family will wish to receive fair value for the shares or partnership interest, and no one will want to pay any unnecessary tax. And this can all be achieved through proper planning:

Having a professional shareholders or partnership agreement drafted – one that considers and overcomes any contradictory clauses in the articles of association.

  • Evoking the use of a cross-option agreement.
  • Ensuring the deceased’s will does not leave a business interest to someone unexpected.
  • Making sure the business interest is accurately valued (…and that funds are available to meet this value).
  • Ensuring all parties know what should happen in such a time.
  • Get the above steps right, and a good (financial) outcome can be achieved in what will otherwise be a very difficult time for all parties involved.

However, if a business owner fails to plan correctly, there may be adverse consequences for everyone involved.

For example, a shareholding could be left to a spouse who desperately needs the value of the business in order to secure the family’s future but has no mechanisms by which they can sell the shares. The surviving business owners then do not have the funds to provide for the surviving spouse.

Alternatively, the spouse could become overly involved in a business they know nothing about, interfering with the running of the business and the livelihoods of the surviving business owners’ who now have no mechanism for regaining control of the company.

A business interest could also potentially be transferred, however due to the fact that a binding contract for sale was (unwittingly) in place, Inheritance Tax (IHT) is applicable at 40%. If the business was undervalued, this could also cause problems where other parties feel cheated upon receipt of the ‘value’ of the business interest. The business could then easily fail, as the market learns of the death of a business owner and key decision maker.

All of these scenarios could be avoided with proper planning in place, and the key message to take away is that if a suitable shareholders agreement or partnership agreement is not in place, the consequences are severe.

Astoundingly, nearly half of the UK’s £5.7m private sector businesses have no specific arrangement for their shares if a shareholder dies.

And that’s about as negligent as keeping your insurance certificate inside a burning building.

Written by Nick Gwilliam DIP PFS, Integrity365

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