In my last article, I started to look at the process by which an adviser can properly assess and introduce a strategy, within a limited company, for what is commonly known as a director share purchase arrangement.
In that article, I suggested that the first stage in such an assessment should be to ascertain the identify and respective shareholdings of each of the company's owners, with particular regard to the relationship between the shareholders in their general corporate voting intentions. I gave an example to illustrate certain aspects of this point.
Shareholder % shares
Mary Frost 30%
Jack Frost 30%
Tony Green 20%
Theresa Green 20%
I then noted the difference in the true control of this company depending on which two or more of these shareholders might be likely to vote with each other where unanimity could not be achieved on business decisions, and in particular looked at the likelihood or otherwise of Mary and Jack voting together – perhaps (but not solely, of course) depending on whether or not they are married.
I summarised that article by stressing that, whatever the marital or family connections between combinations of shareholders, it is vital that the IFA ascertains the existence of any overall allegiances and alliances.
This requirement, to start the planning process for the need for, and possible introduction of, a director share purchase arrangement exists with every limited company except those with only one substantial majority shareholder, for example, a company with a 99 per cent shareholder and a 1 per cent shareholder.
Having identified these shareholdings, the next stage is to determine what would happen to these shareholdings on the death of one of the owners and investigate any shift in the balance of power.
For example, suppose that it is known that Jack's will indicates he wants his shares to pass to Tony on his death.
This would leave Tony with 50 per cent of the company's shares and would need only one of the two remaining shareholders to vote with him to secure a majority – a very different situation to that before Jack's death.
If, on the other hand Jack's shares were to pass to Mary she would, even alone, have overall control of the company and Tony and Theresa, although on the face of it substantial shareholders, would have little or no say in the major business decisions of the company.
Suppose, finally (for our deliberations at this stage), that Jack's shares would be passed equally to the remaining three shareholders, that would leave the following situation:
Shareholder % shares
Mary Frost 40%
Tony Green 30%
Theresa Green 30%
Here, any two shareholders acting together can secure a majority vote – perhaps particularly worryingly for Mary Frost if Tony and Theresa generally vote together.
In summary, thus far, the adviser should ascertain not only the current split of shareholdings (and groups of shareholders) but also the future split in the event of the death of each of the shareholders.
The next stage in the planning process is to ascertain whether (future split) the destination of each shareholder's stake in the company, on their death, and the resultant shift of power (if any) is the destination and result which is acceptable to all parties.
If not, this stage in the planning process is an ideal time to consider amending individual wills, trusts or even the company's constitution.
It will often be the case, however, that this discussion will be the first time that the shareholders have ever considered this issue.
Under questioning, it will then often be the case that each shareholder's stake will simply fall into the deceased's estate. If these were shares in a large stockmarket-quoted company and the shareholding in question represented only a small proportion of the value of the company, this would not be a problem, of course. The shares could easily be liquidated and, in any event, the smooth management of the company would be unaffected.
However, in a small to medium-size company or, indeed, in any size company whose shares are not quoted and are tightly held (that is, held by only a small number of individuals), there can be tremendous problems on the death of a significant shareholder to that shareholder's beneficiaries, the surviving shareholders and, frequently, also to the company.
As regards the shareholder's beneficiary, where this person does not seek to retain part-ownership or control of the business, he or she will seek to sell the inherited shares. But to whom?
It will usually not be possible (legally) or practical to advertise the shares for sale to the general public and so, typically, the only likely buyers will be the surviving shareholders who may not have the desire or the financial wherewithal to consider such a purchase.
The beneficiary may therefore be unable to attract a realistic financial offer for the shares if, indeed, any offer at all.
Thus, a theoretically valuable holding could, in reality, prove worthless (shares are only worth what someone else is prepared to pay for them).
This difficulty for the beneficiary is most likely to occur where there is only one major surviving shareholder who alone holds the majority stake in the company. In these circumstances, there is little attraction for that person to pay a significant amount of money as he or she already has control of the company and the only attraction is the potential dividend yield.
However, the surviving shareholders – unwilling and or unable to purchase the deceased's shares – might also find themselves in an unenviable situation.
Perhaps the beneficiary's stake is big enough to tip the balance in a shareholder's vote (as in many scenarios of our ongoing example, above) or is at least big enough to block certain special resolutions requiring more than a simple majority shareholders' vote.
In any event, this shareholding will usually qualify for dividend payments and so the remaining shareholders might be loathe to propose or agree substantial dividend payments to a “sleeping partner” – causing potential disruption to tax-effective strategies for distributing company profits to the working shareholders.
As for the company, there are many reported instances of companies where the deceased's beneficiary, unable to secure a fair price for the shareholding, creates an impasse in important voting decisions and appointments or dismissals of key directors.
This frequently leads to disenchantment among the working shareholders and/or the other directors of the company which, in worst-case scenarios, can lead to the financial demise of the company.
What can be done? Advisers should not take it for granted that shareholders – even those who for the first time realise the potential problem – will necessarily rush to find a financial solution.
The analysis we have covered in the first two articles in this series should be talked through with all of the major shareholders (although, for the clients we are particularly talking about here, more likely than not there will generally only be a small number of these).
The adviser should ensure that the decision-makers, in particular, fully accept the nature and extent of the problem and seek a solution.
Certainly, the shareholders of many companies controlled by only a small number of shareholders (and here I am deliberately identifying this as the target sector rather than the traditionally held view that share purchase arrangements apply only to small to medium-size companies – note the distinction) are happy their shares pass to, and remain with, their nominated beneficiaries.
But for many (or most?) this will not be the preferred outcome. Preferable by far, for many, will be the ability for the beneficiary to sell the inherited shares at a fair price.
But what is a fair price?
Having identified the future problem and hinted at a possible solution, the next main question is at what price?
In advance of my next art-icle, perhaps you might like to give some thought to the way in which the adviser can and/or should suggest the price at which the shares should be valued.
Keith Popplewell is managing director of Professional Briefing