Director/Shareholders: How to protect your interest with a cross-option agreement

The untimely death or critical illness of an owner-manager of a private company is a traumatic time not only for their family but also for the remaining shareholders.

It is important for business owners to consider what they would do if a shareholder died and their interest passed to a beneficiary (such as a spouse) under a Will or the rules of intestacy. This can be a significant problem if the beneficiary doesn’t have the requisite skills to contribute to the success of the business.

One way to protect the business is for shareholders to consider having options to purchase shares from the estate of the deceased or the critically ill shareholder allowing those remaining to retain control of the business. Such options may be included in the articles of association, a shareholders’ agreement or a cross-option agreement.

In the absence of protection, there can be a significant impact on business stability as a beneficiary may seek to sell the shares; if the remaining shareholders or the company did not have the capital available to purchase then the beneficiary may sell to a third party such as a competitor or simply someone the remaining shareholders cannot work with.

As to how to fund the purchase under an option, a cross-option agreement backed by a life insurance policy may be worth considering. This is where a lump sum is paid out on the death or diagnosis of a critical illness. This is on the basis that a policy of insurance is taken out on the life of all shareholders, the benefit of each is written in trust for all of the shareholders (as discretionary beneficiaries). On the death or critical illness of one, the remaining shareholders use the insurance proceeds to buy the shareholding of the deceased or ill shareholder.