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Splitting shares

In my last couple of articles, I started to highlight and discuss some of the major points in identifying the need for director share purchase arrangements for limited companies in different circumstances. I have so far restricted my thoughts to relatively simple examples of company share structure and so, in this article, I will start to look at more usual – although slightly more complex – situations.

Let us take an example of a company called Totley Printing. Of 1,000 shares issued in this company, Jeremy owns 500 (50 per cent), Marie 300 (30 per cent), Claire 150 (15 per cent) and John 50 (5 per cent). The company is valued at 1m.

Should Jeremy die, then 500 of the company’s shares will pass to the remaining shareholders under a buy and sell agreement in proportion to their shareholdings following Jeremy’s death. Marie now owns 60 per cent of the remaining shares (300 out of 500 shares not held by Jeremy’s beneficiaries) and so will buy 60 per cent of Jeremy’s shares – a further 300 – for a consideration of 300,000. Using similar calculations, Claire will buy 150 shares for 150,000 and John will buy 50 shares for 50,000.

Their respective shareholdings after these transactions will be Marie 60 per cent, Claire 30 per cent and John 10 per cent. It should – only in passing in this article but exceptionally important in real life – be noted that Marie now has total control of the company, with Claire and John’s holdings potentially valueless as a strategic position.

The mathematics are in practice rarely as convenient as in this example and, indeed, are slightly more complex if we consider the calculation in the event of the death of Marie.

If Marie should die, her 300 shares will pass to her nominated beneficiaries, leaving 700 shares held by the surviving owners of the company. Under the buy and sell agreement, 500/700ths of Marie’s 300 shares (214) will pass to Jeremy for 500/700ths of 300,000 (the value of Marie’s 30 per cent holding) which is 214,285.

Similarly, Claire will buy 150/700ths for 64,286 and John will buy 50/700ths for 21,429. Again, the power balance in the new structure must be anticipated when the share purchase arrangement is agreed and established, Jeremy now owning a controlling interest of over 70 per cent of the company’s shares where he previously held only 50 per cent.

As each of these surviving shareholders will receive a proportionate share of the deceased’s shares and must pay accordingly, funding must be in place or anticipated. Thus, Claire must ensure she will have 150,000 available should Jeremy die and 64,286 available should Marie die.

The table shows how much each shareholder must have available on the death of any of the other shareholders. You may wish to confirm the calculations for yourself. In considering the table, you should be able to identify quite clearly how life insurance policies to fund the arrangement might be written.

It should be noted that other methods of splitting a deceased’s shareholding may be preferred to the proportioned method outlined above. The main point to note is that under a buy and sell agreement, the shares passing to the beneficiaries must be sold to pre-agreed third parties for a pre-determined financial consideration.

However, some arrangements provide not for the surviving shareholders to buy the deceased’s shares but for the company itself to buy them and cancel the shares, meaning that fewer shares remain issued than was previously the case. These arrangements can work just as efficiently as arrangements with individual buyers, as further consideration of our example illustrates.

Still using Totley Printing as our example, if the share purchase arrangement makes provision for the surviving shareholders to buy a deceased’s holding, then Marie would have to ensure she has funds available of 300,000 should Jeremy die, Claire would have to ensure 150,000 was available to her and John would have to ensure he had 50,000 available. Marie would then own 60 per cent of the shares (600 out of 1,000), Claire would own 30 per cent (300) and John 10 per cent (100).

If instead of the survivors buying Jeremy’s shares the arrangement is for Totley Printing to buy the shares, it is first important to note that Jeremy’s beneficiaries will still receive 500,000, as they would from the individual buyers.

Jeremy’s shares are then bought by the company and cancelled. Now only 500 shares remain in issue and there is no magic behind the mathematics to note that Marie owns 300 (60 per cent) Claire 150 (30 per cent) and John 50 (10 per cent).

In other words, although the survivors then have a lower number of shares than would have been the case through the individual buyer strategy, they have exactly the same percentage shareholding. However, for the company to buy the shares, a potentially unwanted capital gains tax problem may arise which must be discussed with the firm’s accountant.

If this second strategy is used, funds for the purchase of a deceased’s shares must be made available within the company, not by the individuals. This option is convenient as changes in shareholdings before a death are easily or automatically accommodated.

As an example, should Marie dispose of her shares to a new buyer, there would be no need to make any different provision for the purchase of shares on Jeremy’s death. The sum of 500,000 would have been needed by the company on his death before Marie’s sale of shares and the same amount is required after Marie’s sale.

Had the arrangement been set up on the original basis I discussed this week, then prior to the sale of Marie’s shares, she would have had to ensure funding was in place for the possible 300,000 purchase of Jeremy’s shares whereas, after the sale, such funding is the responsibility of the new buyer.

In practice, either method can accommodate such changes in shareholdings but there are vital implications for the way in which any associated life insurance policies are effected as regards the recipient of a sum assured.

As I have stressed in my previous articles on this subject that I believe the involvement of the company’s accountant and almost certainly their solicitor is essential to ensure that the correct shareholdings have been ascertained, the wishes of each of the shareholders have been verified and, as I will detail more thoroughly in my next article, the shares are properly valued.

By way of a quick foretaste of that article, I will recount the way in which I was taught to do this during a training session many years ago. When, during this session, I asked how the shares should be valued and by whom, the trainer simply suggested that we should ask the directors how much they thought the shares should be worth.

In my naivete, my subsequent discussion with my first potential client revealed that, unsurprisingly, the directors could not get anywhere near an agreement as to the value and so the agreed strategy could not be implemented.

That abortive work and effort on my part proved a useful and inexpensive lesson, as I was later to learn and understand that the taxation implications of an ad hoc valuation could prove disastrous. More on this in my next article.

Death Amount surviving shareholders of sharemust have available holder

Jeremy Marie Claire John

Jeremy – 214,285 88,235 26,316

Marie 300,000 – 52,941 15,789

Claire 150,000 64,286 – 7,895

John 50,000 21,429 8,824 –

Total 500,000 300,000 150,000 50,000

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