What is a cross option?
A cross-option gives each shareholder both the legal right to sell his or her shares, and the right to buy the shares of another shareholder (and perhaps others) in certain circumstances.The cross option does not place an obligation for the shares to be bought or sold in the circumstances, unless one of the shareholders exercises the option.
Although a cross option can be put in place in a stand-alone document, it is usually incorporated as a clause within the shareholders’ agreement alongside other methods of ensuring business continuity when a shareholder leaves.
Why might I want to include one in my shareholders’ agreement?
If a shareholder is a key decision maker within the business, then an unforeseen event that results in a change of ownership can significantly disrupt the running of the business.
Particularly in circumstances where a shareholder dies or becomes incapacitated, or becomes bankrupt or insolvent, other shareholders have very little control over to whom the shares are passed.
The new shareholder may be inexperienced, or uninterested in managing the business, or may want to change the strategy of the company (perhaps from one where profits are reinvested, to one where profits are distributed as dividends).
In any case, he or she is unlikely to be as knowledgeable about the business and the industry, to be as experienced, to share the same vision, to commit the same time or to have the same personal relationships with the others.
On the death of a shareholder, under his will, his shares pass to his wife and his two young children. Whereas the deceased was a majority shareholder with 60% of the shares, the new shareholders are all minority owners with 20% each. This changes the dynamic of the shareholder meetings. The wife is inexperienced and uninterested in the details, often happy to vote alongside her former husband’s best friend who doesn’t always see eye to eye with the others.
The shares left to the children are placed in trust since the children are minors. The trustees are the sisters of the deceased, who want the company to maximise dividends in order to pay for schooling. Although together the trustees do not control the company (they control less than 50% of the shares), they do have the largest holding, and therefore are very influential.
A shareholder declares himself bankrupt after having mortgaged his house in order to provide capital to a second business.
The new shareholder is a bank. The representative isn’t particularly interested in the running of the business. She doesn’t attend meetings often. However, as a majority shareholder, the bank places pressure on the other shareholders to put the most profitable part of the business up for sale. It does this by refusing to allow the company to renew a revolving credit facility with another bank, forcing a possible liquidity crisis.
A cross option becomes very useful in both of these circumstances. The remaining shareholders could exercise it and force the new shareholders to sell. In doing so, they would avoid losing control of the company to an outside party. It would benefit the new shareholders as well as they probably would prefer cash. Alternatively, the new shareholders could force the remaining shareholders to buy.
Finding financing to enable an option to be exercised
Because cross options are exercised at short notice in unforeseen circumstances, shareholders may find it difficult to fund the purchase.
The solution is for insurance policies to be taken out at the same time as the cross-option agreement is entered into. Each shareholder is insured to a sum that matches the value of his or her holding, and that value is adjusted regularly.
When money needs to be found, the policy pays out.
Either the company could take out a policy in favour of itself, or the shareholders could take out personal life insurance where the others are the beneficiaries.
If the company is insured, it buys back the shares, leaving the remaining owners with the same number of shares, but a greater proportional ownership.
If the shareholders have personal policies, then the policy of the former pays for the remaining ones to buy the shares in proportion to their current holdings. The remaining ones end up owning a greater number of shares and also have greater proportional ownership.
There are tax implications to shares changing hands. Whether it is better for the company to take out an insurance policy, or for the individual shareholders each to do so depends on the particular circumstances.
Tax law can change, so you are advised to consult with your tax accountant.
If an individual person takes out a life policy, the policy is usually written into a discretionary trust.
Full tax relief (called Business Property Relief or BPR) is available on inheritance tax when company shares are transferred. You may wish to read about leaving your business in your Will.
However, obligated transfers (binding contracts for sale) do not qualify for BPR.
It is therefore important that an option is used because an option doesn’t create an obligation for either party to buy or sell the shares unless the other exercises the option.
If the company takes out the policy, it is usually held in trust for the remaining shareholders between them. The proceeds from the policy fall outside the estate of the deceased shareholder, and therefore are not subject to inheritance tax.
What to consider
Including a timetable in the case of each or some events helps shareholders understand the process for purchase, sale and transfer and helps reduce misunderstandings.
After the option is exercised, certain things must happen. For example, probate may need to be granted, or life insurance policy proceeds applied for and received.
Not everyone will think that the company is valued fairly.
A company can be valued in many ways, and even using the same valuation method might result in different valuations if assumptions vary. For example, valuing intellectual property and forecasting future earnings are very subjective.
The key is to agree how the company will be valued at the same time that the option agreement is put in place.
Regular amendment of key man policies
The shareholders should be obliged to amend the insurance policies regularly, or whenever a significant life event occurs.
If this is not done, the proceeds from the policy might not cover the value of the shares of the leaving shareholder.
If the policy is taken out by the company, then the directors (who are probably the shareholders) should be responsible for maintenance.
If a policy becomes too expensive to maintain
A shareholder may become uninsurable at the expiry of a term of insurance (for example, if he or she reaches a certain age).
There may be something that happens that invalidates the insurance.
Or the premiums might become too expensive.
Shortfalls between the value of the policy and the value of the shares might be able to be met in other ways, such as by loans.
Alternatively, the value of the shares at transfer might be capped at the value of the policy, transferring all risk to the new owner.
Deciding whether to incorporate a cross-option in your shareholders’ agreement
The decision as to whether to include a cross option within a shareholders’ agreement is one of whether the risk that shares fall into unwanted hands outweighs the cost of the insurance premium.
For young companies, the loss of a key man would usually significantly change the business.
Continuity would be hard to preserve. It might be a risk that really cannot be insured against, and in any case, would be relatively expensive.
For established companies that can afford to pay for the insurance, cross options can be the solution to many possible problems. However, one could be put in place as a separate agreement.
Further reading and documents
We have other articles about clauses that might be included within a shareholders' agreement.
If you are looking to amend your agreement, we offer a number of shareholder agreement templates for UK private limited companies.