What happens to a business if one of its shareholders dies?
What happens to a business if one of its shareholders dies?
Most business owners spend considerable time thinking about operational risks: what happens if they lose a major client, if a key member of staff moves on, or if trading conditions deteriorate. Far fewer have considered a more fundamental question, which is what would happen to the business itself if one of the shareholders were to die.
The answer, in most cases, is that the deceased shareholder's shares pass to their estate. That may mean a spouse, adult children, or other beneficiaries who have no connection to, or knowledge of, the business. The surviving shareholders cannot simply take back those shares; they need both the legal framework to do so and the financial means to make the purchase. Without preparation, a business can find itself with an unintended new shareholder and no clear route to resolving the situation.
In a hurry?
If a shareholder dies without protection in place, their shares pass to their estate; the business may gain an unintended new owner with no interest in running it. This article explains how shareholder protection insurance and the legal framework around it work together, and what the consequences of having neither in place can look like in practice.
Speak to a business financial adviser →Essentially, insurance products exist to provide the funds to buy the shares and a legal agreement determines what happens to the shares. In practice, the arrangement only holds if both elements are in place. An insurance policy without the legal agreement to back it, or an agreement without the funds to honour it, leaves the surviving shareholders with very little.
This article covers the main planning tools available to business owners who want to prepare for this outcome:
What is shareholder protection insurance?
Shareholder protection insurance is a type of life assurance (and often critical illness cover), arranged by business owners to ensure that the funds are available to purchase a deceased or critically ill shareholder's shares from their estate.
In practice, each shareholder typically takes out a policy on their own life, written in trust for the benefit of the remaining shareholders. The sum assured is set to reflect the value of their shareholding in the business. As a result, if a shareholder dies:
The policy pays out a lump sum to the survivors, giving them the funds to purchase the shares at an agreed price.
The deceased’s estate receives a fair cash settlement in return.
The surviving shareholders retain full control of the business without the disruption of an unplanned change in ownership.
The policies can also be structured to cover critical illness, which broadens the protection to scenarios where a shareholder becomes seriously ill rather than dying.
Whether the cover is arranged on a life-of-another basis or on each shareholder's own life will depend on the individual circumstances and the structure of the business.
Without this financial mechanism in place, the surviving shareholders may want to buy the deceased's shares but have no realistic means of doing so (particularly where the business represents the bulk of their personal wealth).
The situation can arise suddenly and without warning, which is why this type of planning is better addressed well in advance.
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Join our readers →What is a cross-option agreement?
A cross-option agreement is a legal document that sits alongside shareholder protection insurance. It defines, in advance, what happens to the shares when a shareholder dies.
Under the agreement, the surviving shareholders are given an option to purchase the deceased shareholder's shares from their estate. The deceased's estate is, in turn, given an option to sell those shares to the surviving shareholders. Neither side is compelled to exercise their option, and each holds the right without the obligation.
In practice, however, both parties generally want the same outcome. In many cases, the surviving shareholders want to consolidate control of the business and the deceased’s estate wants to convert the shares into a cash sum, rather than hold an interest in a company it did not choose to be part of.
As such, the options are exercised, the transaction completes, and the ownership of the business is settled on an agreed basis.
The cross-option structure is important not just for commercial certainty, but also because the way the agreement is drafted can have significant implications for how the transaction is treated for tax purposes.
Without this agreement in place, even where the insurance has paid out and the estate is willing to sell, the transaction relies on negotiation during an already difficult period, with no guarantee of reaching a satisfactory outcome.
Therefore, the insurance and the legal agreement are interdependent, and designing one without the other leaves the arrangement incomplete.
How is the business valued for shareholder protection?
The sum assured on a shareholder protection policy needs to accurately reflect the value of each shareholder's stake in the business. That requires an agreed approach to valuation.
Business valuations for shareholder protection purposes generally use one of three approaches.
Net asset value takes the book value of the business's assets after liabilities are deducted.
Earnings-based multiples apply a figure to the business's annual profits or earnings before interest and tax.
Alternatively, shareholders may simply agree a figure based on what the business would realistically achieve in a sale.
The chosen method needs to be agreed between all shareholders, written into the legal documentation, and revisited whenever the business changes materially.
Be aware that a policy arranged several years ago on the basis of a lower valuation may leave a material shortfall if the business has grown substantially since that figure was set.
That gap can mean the surviving shareholders receive insufficient funds from the policy to purchase the shares at their current value, creating tension and requiring the survivors to find the difference from their own resources.
Therefore, regular reviews of both the valuation and the sum assured are good practice, particularly following a period of significant growth or a material change in the business's trading position.
Are your shareholder protection arrangements up to date?
Many business owners have the insurance in place but not the legal framework around it, or a policy that no longer reflects the current value of the business. Our Chartered Financial Planners work with business owners across the UK to make sure the cover and the agreement are designed to work together. Arrange a free initial consultation to review your position.
Speak to a business financial adviser →What happens without protection in place?
Without the correct protection in place, the surviving shareholders face a straightforward problem with no straightforward solution: they cannot buy shares they cannot afford, and they cannot force a sale that was never agreed.
The most immediate consequence is that the shares pass to the deceased’s estate, and the beneficiaries may be a spouse, adult children, or other heirs with no involvement in the business and no desire to become long-term shareholders.
Nevertheless, they hold the rights that attach to those shares, which may include an entitlement to dividends and, depending on the company's articles of association, a role in decisions that require shareholder approval.
If the deceased's estate wishes to realise the value of the shares, it will generally seek to sell them to whoever is willing to pay. In the absence of a pre-agreed right of first refusal or a pre-emption clause in the company's articles, the surviving shareholders may have limited ability to control who that buyer is.
As a result, the surviving shareholders could be left with a competitor, an outside investor, or simply an individual they would not have chosen as a business partner acquiring a significant stake in the business, without having any practical means of preventing it.
In a worst-case scenario, the surviving shareholders may find themselves simultaneously unable to make major business decisions, unable to prevent an unwanted new co-owner, and without the funds to buy the shares back from the deceased's estate.
In the longer term, company creditors and key suppliers who become aware of the situation may respond cautiously, and the personal relationships that underpin most closely held businesses could be placed under additional strain at an already difficult time.
And yet, because none of these problems have an obvious solution without the right framework in place in advance, they tend to compound. Putting shareholder protection in place is, in that context, straightforward risk management.
What's next?
Shareholder protection is one of those planning measures that is easy to defer because there are always more immediate issues in the business that need resolving. However, the time to arrange the cover and the legal framework is well before either is needed, and the two elements need to be designed together rather than approached separately.
Our Chartered Financial Planners offer a free initial consultation to anyone who wants to review their existing shareholder protection arrangements or explore what putting protection in place might involve.
We work with clients across the UK. Locally, we advise clients throughout Kent and East Sussex, including Tunbridge Wells, Sevenoaks, Maidstone, Tonbridge, Crowborough and Eastbourne.
This article is for general information only and does not constitute personal financial advice or a recommendation. The suitability of any protection or financial arrangement depends on individual circumstances, objectives and the current regulatory environment. Tax treatment and related rules can change over time, and their effect will depend on personal circumstances.
