No one likes to think about death, but for private companies – often family owned and managed – the death of a shareholder can be overwhelming. A small investment of time today, to prepare a coherent set of company rules and document a straightforward procedure, can pay huge dividends in the future. Otherwise, the death of a shareholder can cause unnecessary turbulence and heighten the stress of what will always be a challenging time.
What risks might a private company face when a shareholder dies?
Without specific provision in the company’s articles of association, or a comprehensive shareholder agreement, several issues may arise on the death of a shareholder:
1 Impaired ability to control the company's ownership and management
The shares of the deceased will be transferred to comply with the terms of the will, or if there is no will, in accordance with the rules of intestacy. These procedures are described in our post on how to transfer shares if a shareholder dies. Unless restricted by the articles of association or shareholder agreement, a shareholder can leave their shares to anyone they wish. The shares may pass to beneficiaries who do not hold with the aims and values of the business or that lack the experience or interest desired for a key stakeholder in the company. There will be additional consequences where the deceased individual was also a director of the company.
2 Funding the purchase of the deceased shareholder's shares
Even if the articles of association or shareholder agreement do contain provisions requiring that the deceased’s shares are transferred to the remaining shareholders, a problem may arise if the existing shareholders do not have the necessary funds to achieve this.
3 Problems valuing the shares
Where the articles require that the deceased’s shares be first offered to the remaining shareholders, rather than automatic transfer to the beneficiaries, problems may arise if a method of valuing the shares cannot be agreed upon. This will be compounded if there are also differences in expectation with regards to the timing of any payments due for the share transfers.
However, with a little forethought all of the above risks are avoidable. By tailoring the company’s articles of association, or composing a bespoke shareholders’ agreement, the future ownership and control of the company can be guaranteed.
Model and Table A articles of association
The importance of the articles of association in determining how a company manages the death of a shareholder, cannot be overstated. The articles of association represent the
written rules about running the company agreed by the shareholders [and] directors
Unfortunately, much of UK corporate law was established with the needs of public companies in mind and this can result in unintended consequences for private companies. This is particularly apparent in the area of share transfers, where company law starts from a position that shares should be transferable without any restriction. However, if time is taken to tailor the articles of association, it is possible for the company to retain control over who shares are transferred to, whether these are sold, gifted or bequeathed.
Problems can arise, however, when private companies are formed with model articles of association, or if they were incorporated before 1 October 2009, with Table A articles. These default company rules contain very few restrictions around the transfer of shares, and both allow a shareholder unfettered choice as to who he bequeaths his shares to. They also allow the beneficiary to freely choose whether he wishes to become the holder of the shares or to transfer the shares to another person. As the articles of association take legal precedence, these default company rules could prevent existing shareholders from prohibiting the transfer of shares to an undesirable third party (even if the third party works for a competitor business).
Section 26(5) of the model articles does state that
the directors may refuse to register the transfer of a share
However, in reality this power can be insufficient.
The directors must reach a majority agreement before they can prevent a share transfer, and this is not always simple. There are multiple scenarios in which difficulties may arise:
- a company with only two directors: if one director proposes to transfer shares, the other director cannot prevent him;
- where the directors cannot reach an agreement between themselves; and
- where the directors and shareholders are not the same people and may have different aims for the company.
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It is far better to avoid these potential difficulties with a well-designed, bespoke set of articles.
How can the articles be improved to remove these risks?
The articles of association take precedence when determining how to transfer shares on the death of a shareholder. The inclusion of specific provisions can guarantee the company retain control over future share transfers:
1 Rights of pre-emption
The right of pre-emption is a very commonly included provision and requires that the deceased’s shares must first be offered to the remaining shareholders (usually in proportion to their current holdings) before they can be transferred to a third party. Issues may arise with this provision if a company policy is not devised to determine a fair price for the shares. Provision for valuation of shares can be included in the articles or set out as a clear procedure in a shareholder agreement (more of which later).
2 Approval in advance
This rule requires that any proposed transfer (including those arising on the death of a shareholder) first receive written approval. This provision can be structured in a number of ways. For example, the consent of a particular shareholder could be called for (perhaps the majority shareholder or founder of the company); or the agreement of a majority, or even all remaining shareholders may be required. However, for bigger companies with many shareholders, requiring the consent of all may present the company with unnecessary obstacles. It could allow an individual with a very small shareholding to effectively prohibit any share transfers.
3 Family transfers
It is possible to include a provision that allows free transfer of shares to family members or family trusts, whilst transfers to other third parties are subject to more prohibitive provisions.
How can a shareholder agreement help?
If a company already has a shareholder agreement it may find it simpler or preferable to include provisions surrounding share transfer in the shareholder agreement rather than the articles. An alternative route is to include restrictive provisions in the company’s articles of association, but provide detailed procedures (covering share valuation, option agreements, payment schedules etc) in the shareholder agreement that will work alongside the provisions in the articles. When including share transfer provisions in a shareholder agreement, it is vital that they are compatible with the rules as defined in the articles. Where a conflict arises, it is the articles of association that will prevail.
Why might a company choose to put share transfer provisions in the shareholder agreement?
While some companies choose to rely solely on share transfer provisions they have included in their bespoke articles of association, others choose to insert most share related rules in a shareholder agreement. They may choose to do this for a variety of reasons, including:
- No filing on public record: Shareholder agreements do not have to be filed at Companies House and are not therefore available on the public record.
- Good place for details: It can be easier to explain detailed procedures, such as a method for share valuation or payment terms and timetables, in a shareholder agreement.
- All parties must agree to it: Before changes can be made to a shareholder agreement the consent of all affected parties must be obtained.
- Avoid statutory formalities: It can be easier to amend a shareholder agreement as it does not require a special resolution of the shareholders to approve any changes.
What about a cross-option agreement?
A cross-option agreement is a contract between the shareholders. When a shareholder dies, the contract may entitle his representative to require the remaining shareholders to buy the deceased’s interest in the company. Alternatively, the existing shareholders may be entitled to buy the deceased’s shares, thereby preventing transfer of ownership to unknown third parties.
Cross-option agreements are usually underpinned by the purchase of a life insurance policy for each of the shareholders. This is held on trust and the proceeds from the insurance policy are available to the remaining shareholders to enable them to buy the deceased shareholder’s shares. Cross-option agreements usually set out how the shares should be valued. They can be very worthwhile. They provide a way to guarantee that control of the company remains with the existing shareholders as well as providing the funds to purchase the deceased’s shares. Additionally, if they are drafted carefully, they may enable the deceased’s beneficiaries to receive the proceeds from the sale of the shares free from inheritance tax.
Whilst the terms of a cross-option agreement can be included in the company’s articles, they are more usually drawn up as a separate contract or included in the shareholder agreement.
Next steps?
If your private company has been formed with default articles and there is no shareholder agreement in place, you may wish to take steps to remove the risks posed by shareholder death. A good place to start are our blogs looking at When you might want enhanced articles of association and how to change a company’s articles of association. You may also wish to look at our articles explaining What is a shareholders’ agreement and if you are thinking of drafting one to remove the risks posed by shareholder death, you may also find our piece on What to include in a shareholders’ agreement invaluable.
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