Running a business comes with all kinds of risks, and having appropriate insurance cover can help reduce any unwanted risks or costs that come with death or critical illness. There are two main types of insurance that individuals and businesses may take out. The first is a life insurance policy, and the second is key-man insurance.
Not sure what type of policy you need or whether you need life insurance? This article is the first of two and will help you understand whether you need a life insurance policy, or whether you need key-man insurance (or both).
What is Life Insurance?
Life insurance is a policy that you take out on yourself. It protects your family and ensures that your loved ones are looked after. When taking out life insurance, you can add critical illness cover as an extra in order to give better protection.
How does life insurance work?
Normally if you die (or for critical illness cover become critically ill), a lump sum is given to your family (or you in the case of critical illness cover). In the case of shareholders in a company using life insurance, in the event of one’s dying, the policy pays out the proceeds to the other(s) who then use the money to buy the shares from the deceased shareholder’s estate, thus meaning:
- The widow (or children) can sell the shares in the company and effectively receive the proceeds of the life policy. She is unlikely to want to be running the company and will probably not want the value of this asset tied up in the company for the long-term (read on as to why); and
- The surviving shareholder(s) can buy the shares without having to find the money elsewhere (which might not be easy), so they can continue to run and control the business effectively and efficiently.
It is important that you set up such life policies correctly. With shareholders we call them “cross-life policies”, as if there are 2 shareholders, for example, then Mr A’s life policy pays out to Mr B if Mr A dies and then Mr B uses the proceeds to buy Mr A’s shares, and vice versa if Mr B dies first. You would put each life policy “into trust” for the other shareholder(s). Usually the life insurance company can set this up for you when putting the life policies into place with a simple trust deed that they will supply.
Why is this so important?
This set-up is essential to protect the widow. Firstly, it gives her the ability to turn the shares into cash, instead of tying up the value of the shares indefinitely. If the worst possible thing happens, you need to have taken the right steps to protect your family. If you ignore this, the chances are that if you die, the other shareholders would either (a) refuse to buy your shares (there being no duty to do so in the shareholders agreement) or (b) might offer far below the market value to do so and they might even be unable to afford to buy the shares without the help the life policy offers. Sadly, we have seen this happen and it leaves the widow to get ripped off when she has already lost her loved one.
Secondly, technically the shares in a private company are a high risk investment from an investment point of view. If the widow is unlikely to be in a position to take over running the company full-time as her late husband had (which is normally the case), then it would be even more risky for her to hold onto the shares. This is partly because she won’t be actively participating in running the company going forward. So to reduce her risk, she is better off selling the shares and she can then receive the proper cash value for them. In turn she can use the sale proceeds:
- to look after the family, and
- to invest in less risky investments if appropriate.
Do you have a shareholders agreement?
So it makes great sense to set up this protection for the widow:
- that the surviving shareholder(s) have to buy the shares, and
- she receives the life policy proceeds via their buying the deceased’s shares.
However, it is equally important to set all of this up correctly in the shareholders’ agreement. This is because, without it, the remaining shareholder(s) are under no obligation to buy the deceased’s shares. So they might simply:
- take the life policy proceeds (if there was one set up as a cross-life policy), and
- leave the value of the shares tied up indefinitely, or
- offer a pittance for the shares if the widow is desperate to sell them.
On the other hand, this set-up is also essential to protect the surviving shareholders. Without an appropriate provision in the shareholders’ agreement, they cannot force the deceased’s estate to offer the shares for sale to them. Without a life policy in place, they might not be able to afford to buy the shares without considerable difficulty.
So what do I need to do?
Firstly, the life insurance policies need to be:
- put in place, and
- held in trust (on the cross-life basis outlined above).
Secondly, the shareholders will need a good shareholders’ agreement to implement this. The terms of it need to include a requirement:
- for the parties to hold life insurance cover;
- to have the policies set up as cross-life policies via the trust;
- that the other shareholder(s) get the right to buy the deceased’s shares. The price would be the value of the life policy’s proceeds; and
- that the surviving shareholder(s) use the life policy’s proceeds to buy those shares.
To set up such an arrangement, simply get in touch with us at Legalo.
NB our standard shareholders agreement template does not include the cross-life policy provisions referred to: it does include an obligation that the deceased’s shares are offered to the surviving shareholder(s), but not the corresponding one that they are bought by them (in case they cannot afford to do so, as they don’t have the benefit of the life policy). However, we can still help you to put such provisions in place.