Cross Option Agreements

It is an agreement entered into by owner/shareholders of a private limited company. Each owner/shareholder grants to the other shareholders first choice options over their shares. The agreement becomes active on the death of an owner/shareholder.

The core purpose of Cross-Option Agreements are to prevent disruption to the continuing business of the company should one of the owners die and also provides certainty to the families of the owners that there is a way to avoid having to become a part owner of a business they have no interest in running.

The death of a fellow business owner can cause major consequences for the business, the other owners and the beneficiaries of a deceased’s estate. In the same way when you are drawing up a Will, where you think about the scenarios that could occur and who should be empowered or benefitting in different situations, it is as equally important to consider what happens to your business if you or a co-business owner dies. This is as vitally important and as much an integral part of your business continuity and risk planning, as planning for risks in your private life.

When thinking about the structure of a Cross Option Agreement you should consider the following (amongst other core questions): Who is going to benefit from the estate of the deceased owner and realistically will they want to take an active role in the business? You should also consider the risk of them, if they don’t want to be personally involved, selling their share to a hostile or unhelpful entity or even a rival? Is there an agreement for the other owner-managers to agree to have first option to buy their colleague’s shares in the company and, if so, how will that be structured so the beneficiaries of the deceased get a fair price for that share?

So, how does the Cross Option Agreement actually work? Each shareholder is provided with an ‘option’ for their shares in the event of their death. So, if the shareholder/owner dies the following occurs:

The surviving owners/shareholders can trigger their options that require the deceased owner’s family or beneficiaries to sell their shares in the business to the surviving owners, therefore retaining control of the business within the existing group of owners.

Conversely, the Agreement gives the beneficiaries/family of the deceased owner the option to force the surviving owners to purchase the deceased owner’s shares/interest, therefore meaning they can benefit from the inherent value of that share. It provides a win/win situation for both sides and peace of mind that there is a route to avoid potential deadlock.

To ensure that cash flow does not become an issue when purchasing a shareholding, the ‘options’ are tied into life insurance policies that are taken out by each business owner. This is to ensure that there is sufficient cash available, no matter what the trading situation or personal financial circumstances are at any one time, to provide the facility to deal with the share purchase/sale.

Circumstances change and the value of a business can change and therefore the associated share values can also change. A Cross Option Agreement needs to be reviewed at regular intervals to address this area, so life insurance cover can be adjusted accordingly. There are tax implications (of course!) and professional advice should be taken to minimise an impact from tax. Traditionally, the life policies are written into a discretionary trust, but this needs to be reviewed in connection with the tax regime at the time they are taken out.

Cross Option Agreements are designed to be tax efficient. The valuable Business Property Relief is usually retained over the value of the individual shareholdings if the Option Agreement is drafted correctly. When we say ‘drafted correctly’ we mean that the Agreement drafting must make it clear that the option for the continuing shareholders to buy the deceased’s shares and the ability for the deceased’s personal representatives to sell the shares are a right, rather than an obligation.

The fallout of getting this wrong would be that if any of the parties is under an obligation to buy or sell the deceased’s shares, the transfer of the shares would effectively be subject to a binding contract and, so for inheritance tax purposes it would be treated as a transfer of cash and, consequently the business property relief would be lost which is obviously highly desirable to avoid.

To summarise, where there are multiple owner/shareholders involved in a business it is essential to review different future scenarios and consider arrangements if one of the owners died. You need to ensure the surviving owners, the business operation and the deceased persons beneficiaries are all protected.

Contact rhw’s Commercial Team to learn more about the benefits of a Cross Option Agreement for you and your business.

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