Business Protection

Risks and solutions for business owners and investors

1

The risks

What would happen in the case of an unexpected and dramatic event such as the death of one of the owners or directors? Who would shares be transferred to in the case of death? How much control would be lost? What happens to the business in the case of critical illness? How would the value of the business (and therefore the investor’s asset) be affected? What action would dependents of the owners take?

Should this happen, is your business protected?

It is common for directors to focus on growing the business, staying competitive and dealing with economic risks. Many, however, do not consider the likelihood of unexpected and dramatic personal circumstances and how these might impact on the business – and indeed their families. These risks are real and cannot be ignored.

Source: see table in reference notes

Some solutions

Automatic Accrual Agreements

A life insurance policy is established for family or the estate. This is used to compensate the beneficiaries of the deceased while the business interests are transferred to the other business owners. (Page 5)

Cross-option Agreements

This type of agreement ensures that the surviving shareholders have the option to buy the deceseased’s share of the business. The widow(er) has the option to sell. (Page 6)

Buy/Sell Agreement

Using a Buy/Sell agreement, the business owners all agree that on the death of a business owner, the deceased's estate beneficiaries will sell the business interests to the remaining business owner(s). (Page 7)

Double Option Agreement

The surviving shareholders can either purchase the deceased’s shares, or liquidate the company and pay a share of the total proceeds to the widow(er). (Page 8)

In a company with four partners or directors with an average age of 35,

there is nearly a 50% chance that one will die before the age of 65.

2

Shareholder Protection

Executive cover for private limited companies A private limited company is owned by shareholders and run by directors. These shareholders and directors could be the same people, especially in the case of family and small businesses. On the death of a shareholder the standard Articles of Association will follow the rules of The Companies Act 2006, specifically Table A of the Act. This states that the shares of the company form part of the deceased’s estate.

The other shareholders will ideally want to keep control of the deceased shareholders shares. But the widow can technically sell them to anyone, even a competitor. If the shares are fully paid-up, then the new holding must be accepted by the surviving shareholder(s). If the purchaser is a minority shareholder, there are measures within the Act that ensure they are not mistreated by the other shareholder(s). Compensation or restitution can be sought through the courts. The situation can become very complex and stressful for all parties. To avoid other people getting hold of the shares and being in control of part of the company, and ensure that the widow is properly compensated, a Shareholder Agreement and Shareholder Protection plan is essential. A Shareholder Protection plan is essentially an agreement detailing how the shareholding should be treated on death or serious illness of a shareholder, coupled with a life assurance contract to facilitate the purchase of the shares by the remaining shareholder(s). There should also be an agreed basis for valuing that share in the case of a dispute. It is necessary for each shareholder to take out cover on their own lives, for the benefit of the remaining shareholder(s).

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Has your business got the succession arrangements in place that would avoid such a scenario?

3

Executive Cover for Partnerships

A partnership is made up of two or more people who work together in business. Because each partner owns a share of the partnership, they are entitled to a share of any profits. It is also usual that these partners will be self-employed. If there is no formal agreement, on the death of a partner, the partnership will automatically be dissolved. i If one partner died without a current partnership agreement, the Partnership Act 1890 states that all holdings were equal. Additionally, the surviving partner may want to take over the deceased partner's share so that they can continue to run the business without the complications of dealing with new parties. Further the deceased partner’s share of the business becomes a debt owed to their estate if it can not be paid-out immediately. This debt must be settled before any profits are shared among the surviving partners. So they are forced to create more revenue with fewer people. In short, a Partnership Protection plan must be in place. Partnership Protection is essentially an agreement detailing the respective ownership proportions of the partners, and how these would transfer on the death or serious illness of one of them. This would be coupled to a life assurance policy that will pay out to the remaining partner(s). This will enable them to purchase the deceased partner's share from the estate. The policy is taken out for the value of the share and is put in trust for the other partner(s). This is beneficial for the partnership and the family of the deceased - the partnership retains the deceased partner's share and the family is paid for them. There should also be an agreed basis for valuing that share in the case of a dispute.

Even if ownership is split between the partners in differing amounts (for example 60%/20%/10%/10%), on death of a partner, the law sees them all as EQUAL!

4

Critical Illness Risks

Source: The National Institute of Critical Illnesses

Critical illnesses such as a heart attack or the development of cancer can have an enormous impact on the company, the person affected, and their family. Should a shareholder or partner suffer from a critical illness, they may not be able or willing to work at all or at the same level.

How would the company deal with a director who could no longer perform? How might the director provide for himself and his family in such a situation? Would the company expect the director to sell their shares? Would the director expect them to purchase the shares at a certain value?

The answers to these questions are of crucial importance. It could be a disastrous error indeed for both parties just assume that the other would act as they expect. Drafting a written agreement while all is well, is essential. The average age for developing a critical illness? Forty three years old.

Study by Dr Freddie Bray, The Lancet Oncology, May 2012.

The average age for developing a critical illness? Forty three years old.

A 25 year old non-smoking male has a 24% chance of developing a critical illness before he is 65. If he were a smoker the chance rises to 49%.

Worldwide cases of cancer are likely to rise by nearly 75 percent by 2030. In 2008 there were 12.7 million new cases of cancer, which would rise to 22.2 million by 2030.

5

Third Party funding

Investing in the small to medium size enterprises (SMEs) can be a considerable risk as often the SME has few physical assets to match the investment. Essentially the investor is investing in a person, their idea and ability. In other words, intangible assets of the firm. The investor must therefore have great faith in the business model and the capabilities of the key people within the firm. Should one of these key people pass away or become seriously ill, the value of the firm (and therefore the value of the investment) falls considerably and may be wiped out completely.

If the key entrepreneur passes away, could an investor realise their investment? If a key person suffers a serious illness and the company’s value falls, could the

investor be compensated, or would they simply have to accept the loss? Business protection provision, in the form of a written agreement and corresponding life assurance contracts, can therefore provide considerable comfort and reassurance to such investors. Therefore such a plan offers an additional reason for the investor to choose the venture over its competitors.

Business Protection can help! Taking steps to formulate a business protection strategy should greatly enhance the appeal of an SME to

third-party investors.

6

Automatic Accrual Agreement

A life insurance policy is established for family or the estate, equivalent to the value of the interest in the business. This is used to compensate the beneficiaries for loss of the business interests on death. There is an agreement that the business interests are bequeathed to the surviving business owners only. What happens?

Each business owner sets up a life insurance policy, possibly in trust, for their family or beneficiaries

An automatic accrual agreement is also set up at the same time for the business assets to transfer to surviving business owners

On death, the life insurance proceeds are paid to the beneficiaries and the business assets transfer to the surviving business owners

In the event of death, the business owner's share automatically goes to the surviving business owners without going to the estate. For Inheritance Tax purposes the estate is treated as receiving the cash, unless the policies are in trust, and not the share of the business. This may mean that Inheritance Tax may be payable. This is an absolute agreement; the beneficiaries of the estate cannot prevent the surviving business owners receiving the interest in the business or reject the life insurance proceeds.

In this example the widow never holds the shares and must accept the life assurance proceeds in lieu of shares. The shares automatically pass to the surviving shareholders.

Shareholder A dies

Surviving shareholders Widow

Shareholding Life Assurance Policy

Shares Cash

7

Cross-option agreement

This type of agreement ensures that the surviving shareholders have the option to buy the deceseased’s share of the business.

The beneficiaries also have the option to sell the shares to the surviving shareholders.

If either party exercises their option, the other party is bound to comply. The value of the company is based on the audited accounts so the Life Company can accept the Sum Assured calculation.

In this example the widow holds the shares and has the option to sell the shares to the remaining shareholders. The surviving shareholders have the option to demand the share from the widow. Should either option be exercised, the other party must comply.

On demand but NOT automatically

Shareholder A dies

Surviving shareholders Widow

Life Assurance Policy Shareholding

Cash Shares

Shares

Cash

8

Buy and Sell Agreement

Buys and Sell Agreements use a life insurance policy with a special agreement for the business owners to buy the business interests from the family. What happens?

Each business owner sets up a life insurance policy in trust for the other business owners

A cross-option agreement is also set up at the same time On death, the life insurance proceeds are paid to and used by the remaining business

owners to buy the interest in the business from the deceased's estate. Using a Buy/Sell Agreement, the business owners all agree that on the death of a business owner, the deceased's estate beneficiaries will sell the business interests to the remaining business owner(s). This is an absolute agreement; the beneficiaries of the estate cannot reject the surviving business owners buying the business interest.

This is similar to automatic accrual except here the widow holds the shares. On death the shares must be sold to surviving shareholders at their current value. This may be considered a safer option for the widow than the accrual method, where she assumes that the life cover sum assured still reflects an accurate valuation. UK nationals should also read the additional notes in the reference section at the end.

Automatic transfer

Shareholder A dies

Surviving shareholders Widow

Life Assurance Policy Shareholding

Cash Shares

Shares

Cash

9

Double Option Agreement

Using a life insurance policy with a special agreement for the business owners to buy the business interests from the family or decide to cease trading and liquidate the assets.

What happens?

Each business owner sets up a Life insurance policy in trust for the other business owners

A double option agreement is also set up at the same time On death either:

- The surviving partner(s) purchase the shares from the deceased’s estate, using

the life policy proceeds. - Alternatively the surviving partner(s) liquidate the company and pay the estate

their share of the proceeds plus their share of the life assurance policy. The Agreement that allows the business interest to change hands:

This type of business owner agreement allows the remaining business owners to buy the deceased's share of the business from the estate as an option and business property relief for inheritance tax is still retained. This is an option agreement; there is a specified time during which the remaining partners can buy the share, and during this time the estate has a duty not to sell it to anyone else. The beneficiaries of the estate can reject the surviving business owners approach to buy if they do not act within a specified timescale.

Option A

Option B (liquidation)

Shareholder A dies

Surviving shareholders Widow

Life Assurance Policy Shareholding

Cash Shares

Shares

Cash

Liquidation

10

Keyman Cover

Of course it may well be the case that a business has a crucial employee – someone that is directly responsible for a vital part of the business and considerable income generation. Without this person, the business may cease to function as well (or even at all) and profits would be greatly impaired. It would be prudent to ensure that steps are taken to protect the business from the loss (permanent or temporary) of this person. “The premiums incurred on ‘Keyman’ insurance will be tax deductible if this insurance is an insurance against loss of profits to the company in the event of the death or physical disability of key personnel, subject to the condition that the capital sum insured does not exceed the annual profits of the company that are attributable to the relevant key personnel” Deloitte (Singapore) Corporate Tax note 2010 Key person Coverage is typically calculated as follows: Key person’s total remuneration Expected total __________________________ X gross profits X recovery period (years)

Total salary bill for the firm

Should the key person’s remuneration be quite low in comparison to their contribution to profits, larger coverage can be negotiated.

Bear in mind that a shareholder can also be a key person. It may be necessary to have two policies:

- one to cover the cost of share purchase - one to cover lost profits caused by their death or disablement.

Life assurance premiums for key employee policies can be 100% tax-deductible in Singapore.

11

References

Chance that one Partner/Director will die before age of 65

NUMBER OF PARTNERS/DIRECTORS

2 3 4 5 10 AVERAGE

AGE

35 28% 39% 49% 56% 81%

40 28% 39% 48% 56% 80%

45 27% 37% 46% 54% 79%

50 25% 35% 43% 51% 76%

Source: Assured Lives mortality Table AM80

Buy/Sell Agreement tax consideration for UK Domiciled persons: There could be a potential inheritance tax problem for the deceased person's estate. This is because the estate is deemed to have received cash, rather than a share of a business. This then means that Business Property Relief, where there is no inheritance tax payable on death for the transfer of business assets, would not be available if the assets were subsequently transferred from the estate to the other business owners.

Disclaimer:

The legal measures and scenarios in this document are correct according to our understanding. Meyado is not authorised to advise on legal matters. Meyado does provide professional advice and execution on insurance matters. Therefore separate legal opinion and advice must be sought from authorised legal professionals prior to enacting any change of policy or documentation. We would be happy to refer you to the excellent legal services firm with whom we work closely in this area, should you so require.

Neither this document nor any information contained herein shall be construed as an offer, invitation, advertisement, inducement, representation of any kind or form or any advice or recommendation to buy or sell any financial products. Please contact us for a full financial needs analysis.

Meyado Private Wealth Management Singapore Pte Ltd

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