Fundamentally, director share purchase strategies provide for money to be made available to buy out an individual’s shares from his beneficiaries in the event of his death.
DSP can alternatively be used to buy out an individual’s shares on his retirement but this is more expensive and considered unaffordable by many companies. However, I will consider that strategy in a future article.
Also in a future article, I will extend the strategy away from companies to consider similar strategies for partnerships. There are a number of very important differences here.
The concept of DSP is to try to prevent a situation arising where, for example, surviving shareholders in a company – particularly a small company with few shareholders – find that following the death of a fellow shareholder, the deceased’s shares pass to one or more people who have much less interest in the business.
In these cases, the beneficiaries might seek to realise the value of their inheritance, yet find that the only willing purchasers are the remaining shareholders, who might be unable to fund the purchase of the shareholding. Such an impasse works to no one’s advantage and might even lead to the progressive demise of the business.
DSP ensures that, on the death of the shareholder, ownership of his shares in the business will transfer to exactly the person or persons the shareholders have earlier selected, noting also the wishes of the deceased, of course.
This arrangement will ensure that financial consideration for the transfer of the shares is available to be paid to the deceased’s beneficiaries to compensate for the shares being directed elsewhere.
It is first of all necessary, in this largely introductory article, to distinguish between shareholders, directors and shareholding directors, as the need for inclusion in a DSP strategy will often differ between individuals in each of these categories. We will primarily be considering smaller to medium-sized companies not listed on the stockmarket.
First of all, shareholders. These are the people who subscribe the initial share capital to set up the limited company and therefore become its owners.
In small to mediumsized companies, there will typically be only a small number of shareholders – very often fewer than half a dozen – and all or most of these people are likely to hold positions as working directors.
Directors, in contrast to shareholders who own the business, are generally responsible for taking day-to-day decisions in the running of the company although non-executive directors will be less involved except in making more important decisions.
It is important to note that, while in small to medium-sized businesses most of the shareholders will be directors, the same generalisation can much less readily be made in reverse. Non-shareholding directors may have been recruited or appointed for the specific skills they bring to the company rather than money they may be unwilling or unable to put into the business in subscribing for shares.
Where an individual under consideration for inclusion in DSP arrangements is a director but not a shareholder, then provision might be seen to be irrelevant as he has no shares so there can be no such complication in relation to the transfer of shares on his death.
It may be deemed appropriate nonetheless to effect life cover on these individuals to provide funds to the company (compensation for the loss of a key person) or his beneficiaries (compensation for loss of earnings) but these are separate issues outside of DSP and, as such, I will not be discussing them in this series of articles.
Where an individual is a shareholder but not a director, provision for their inclusion in a DSP arrangement should be seriously considered but, in my experience, the greatest need for inclusion usually applies to those who are shareholders and directors. These individuals not only have a financial stake in the ownership of the company but also have an interest in its running as they are almost invariably being salaried employees of the company.
Let us start to consider the essential stages in the planning of a DSP arrangement and, in particular, identify areas where more thought should be given to avoid potential pitfalls.
Usually, when a shareholding director dies, his shares will pass to his beneficiaries and there will be no obligation on the surviving shareholders to purchase those shares. However, the financial adviser considering a DSP arrangement should be aware that there may be a clause within the company’s articles of association often known as a pre-emption clause.
Where included, the clause requires that the surviving shareholders have the right to be offered the first opportunity of purchasing the deceased’s shares if the beneficiary wants to sell them. In some cases, the clause might give the power to the beneficiaries to force the remaining shareholders to buy their holding but this is less common.
Consider, first, the saleability of inherited shares in a couple of examples – the first in the case of smaller minority shareholdings and the second (starting my next article) where a more significant proportion is held by the deceased.
Suppose Helen owns 95 per cent of the shares in company A, with Fred (not her husband) owning the remaining 5 per cent. On Fred’s death, his wife Janet inherits his shares and, not wanting any involvement in the company, offers them for sale to Helen.
But Helen declines to make an offer as, even without these shares, she has total control over all decisions made by the company, including the level of dividends.
If Helen determines in future years not to pay a dividend, Janet, while retaining a small but in theory quite valuable share in the company, is in fact left with an asset which will be difficult or impossible to realise by its sale to an outside party. Few, if any, third parties would be ready buyers of such a small minority shareholding, particularly where the remaining shares are held by just one person.
This is an example of a company which might well benefit from a DSP arrangement although, as I will discuss in my next article, there may be an even greater need or desire for such a strategy where the shareholdings are more evenly distributed.