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The humane ratio

This week, I will continue to look at the way in which a share-purchase arrangement could be structured for Owl Sewerage Services Ltd – the fairly typical company I have been using as an example over the last few articles.

Fundamentally, we have by this stage determined the financial needs of each of the shareholders on the death of one of the other shareholders (see table below).

By way of a quick reminder, these figures have been derived from a valuation on the company performed by the company&#39s accountant (to avoid any dispute between the shareholders or between the shareholders, the company and the Inland Revenue) and allocated according to the respective proportionate shareholdings of each individual (Trevor being the biggest shareholder, followed by Joanne, then Lynne and Paul).

Our earlier fact-finding revealed that, on the death of either Lynne or Paul, their shares would pass to the survivor who, in either case, would want to retain those shares. On the death of either Trevor or Joanne, their shares would pass to beneficiaries who, it was concluded, would ideally want to realise this inheritance for cash – hence the need to provide finance in the event of either of their deaths.

Having determined that suitable life insurance policies should be effected individually on Trevor and Joanne, we have now moved on to a consideration of who should pay the premiums.

In my last article, I suggested that two options in this respect should generally be deemed unfair and unsuitable – each shareholder paying premiums under the policy on his or her life or each shareholder paying an equal share of the total premiums payable. I concluded that, in my opinion, the most appropriate method of premium allocation is for each shareholder to pay an inversely proportionate share of the policies effected on the other shareholders.

What does this mean and why do I believe it to be the fairest method?

Let us consider the policy on Trevor&#39s life which, for the sake of simplified illustration, has premiums of £200 a month. His shareholding has been valued at £400,000 and the terms of the agreement (which we have yet to discuss in this series of articles) indicate that, on his death, his shares will be offered to the surviving shareholders in the ratio 50 per cent to Joanne and 25 per cent each to Lynne and Paul, this representing their proportionate shareholdings. This would mean that Lynne would require £200,000 to buy her share, with £100,000 required by each of the other two.

Would it not seem fair that, when effecting the life insurance policy on Trevor to provide these funds, the premiums should be paid by those standing to benefit? Thus, Joanne would pay 50 per cent of the premiums (£100 a month), with 25 per cent (£50 a month) each paid by Lynne and Paul. Trevor pays nothing towards this policy which, although effected on his life, offers him no prospect of individual benefit.

The same procedure can then be applied to the policy on Joanne&#39s life, with illustrative premiums of, say, £100 a month. We have surmised that 57.33 per cent of Joanne&#39s shares would be bought by Trevor so 57.33 per cent of the life insurance benefits would pass to Trevor on Joanne&#39s death. Surely, therefore, it would be fair and appropriate that Trevor should pay 57.33 per cent of the premiums on that policy (£57.33). By similar reasoning, the remainder of the premium would be paid in equal shares by Lynne and Paul (£21.33 each).

Adding these two policies together, we can compute the premium payment obligations (see table above).

This method of premium allocation now fairly represents the benefit each of the shareholders stands to derive from the arrangement.

Premium payments can be made either by deduction from individual bank accounts into a pool account (most likely, a company account) from which the premiums can be paid to the insurers or by deduction from salaries (if the shareholders are paid directors) or by reduction of loan accounts. The favoured option will depend on the individual circumstances of the client company.

So, let us review where we are in the process of recommending and effecting the proposed share-purchase arrangement by reminding ourselves of a five-stage structure.

•Agree the current and desired planned recipients of the shares of each of the shareholders in the event of their death, that is, the person(s) to whom each shareholder wishes their shares to eventually pass on their death.

•Agree a valuation or valuation basis for the shares, noting not only the wishes of the shareholders but also the potential taxation liability if the valuation differs significantly from Revenue guidelines.

•Arrange life insurance to enable any buyout of shares to be funded or otherwise establish that sufficient funds will be available at that time to enable the agreed purchase price of the shares to be met.

•Agree and help to implement the appropriate form of agreement so that there is a clear and written basis as to what has been agreed and tax-efficiency is maximised.

•Regularly review the arrangement with the shareholders after its installation, preferably at least annually.

We have now completed the first three stages, requiring us next to advise on the appropriate form of agreement. Unfortunately, my experience from the training to which I was subjected in my first few years in the financial services profession confirms that many advisers are content simply to effect the life insurance policies (often, as I mentioned in earlier articles, without any thought to proper share price valuations) and pay little or no attention to the need for formal share-purchase agreements between the shareholders. Without any such agreement, the dangers should be obvious.

On Trevor&#39s death, say, his shares would pass to a beneficiary who, let us assume, wants to liquidate that holding for cash. If ,at that time, the surviving shareholders choose not to buy the shares (perhaps because they have controlling interests already) the beneficiary could be left with a holding of potentially substantial paper value which is, however, unrealisable.

Conversely, perhaps the surviving shareholders are willing and able to buy the shares but the beneficiary resists the sale, creating a situation of a significant shareholding being held by an uncooperative beneficiary, potentially creating great inconvenience – or worse – in the making of the company&#39s major policy decisions.

It is crucial, therefore, that there should be clear agreement, not only of minds but also in writing, as to what the shareholders want to happen to their respective holdings in the event of their deaths.

In Owl Sewerage Services, our fact-finding revealed an agreement that the shareholdings of either Trevor or Joanne should be offered to the survivors on the death of either of them whereas the shares of Lynne and Paul should, on either of their deaths, remain with the beneficiary.

This agreement should be properly documented which, I suggest, should not be attempted by the financial adviser, even though standard wordings are widely and freely available from a number of insurance companies. The involvement of the company&#39s solicitor should be sought.

In my next article, we will examine the most appropriate types of agreement and start to summarise the whole process, including the way in which the company&#39s other advisers should become involved.

Keith Popplewell is managing director of Professional Briefing

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