Picture: ISTOCK
Picture: ISTOCK

Most small companies involve a limited number of shareholders, who often own their shares in the business in their own names.

Let's assume A, B, C and D each own 25% of a company. The question arises: what happens if one of the shareholders, say D, dies?

The risk is that if there is no formal agreement, and the surviving shareholders don't have the money to buy out the family (in the case of a right of first refusal), then D's shares will end up with his or her family, and A, B and C will be stuck with D's family as their new co-shareholder.

That is unlikely to be good for the business, as the family would probably not have the required skills or interest to be an asset to the business.

Fights could break out over issues such as dividend payments.

The result is that both parties lose out - the remaining shareholders are stuck with a shareholder they don't want, and the late shareholder's heirs receive no real value for their shares.

The solution is for co-shareholders to sign a buy-and-sell agreement when they start the business.

The agreement should compel the sale of a shareholder's shares to the remaining shareholders on death or disability.

The agreement should also compel the surviving shareholders to purchase the dead or disabled shareholder's share.

Most important, the agreement should set a price, or an objective manner to determine a price, for the purchase of the shares.

Such an agreement creates a win-win situation because shareholders know that when they die, or if they are disabled, their family will receive full value for the shares, and the remaining shareholders will be able to take over the business without having an unwanted shareholder.

The big question that arises is: how do the remaining shareholders raise the money to buy the share of the dead or disabled shareholder?

The cheapest way is through life assurance. The shareholders will own life policies on the lives of the other shareholders.

When a shareholder dies, the policy proceeds will pay out to the remaining shareholders, who will then use the money to purchase the dead shareholder's shares.

This ensures that on the death of a shareholder, the proceeds of the life policy will pay immediately to the remaining shareholders, who will use the money to buy the shares from the deceased estate in terms of the buy-and-sell agreement.

The dead person's heirs receive the full cash value for the shares, and the remaining shareholders take over the business. All parties should be happy.

A similar chain of events would ensue on disability, except the shares would be bought directly from the disabled shareholder.

Define disability

It is important that the buy-and-sell agreement contains an objective definition of what will qualify as disability. It is normally linked to the definition in the life policy.

As long as certain requirements in the Estate Duty Act are complied with, the policies will be exempt from estate duty. To paraphrase the act, the three requirements are:

The policy must be taken out by someone who on the date of death was a partner or co-shareholder with the deceased;

The purpose of the policy must have been to acquire the whole or a part of the dead person's interest; and

The dead person must not have paid any premiums on the policy on their life.

This means the buy-and-sell structure has to be convoluted, where A, B and C will own the policy on D, and pay for the premium pro rata.

In that way, the policy will not attract estate duty on the death of D, and A, B and C will receive the proceeds to purchase D's share of the business.

In addition, because the policies will be owned by and paid for personally by A, B and C, the premiums on the policy are not tax deductible, but the proceeds will pay out free of income tax.

The most common cause of buy-and-sell polices failing to qualify for estate duty exemption is when the shares in the company are owned in trusts.

In this case the life assured does not own any shares and cannot be a partner or co-shareholder to the policy owners. The policies in that case will need to be increased to cater for the estate duty.

A buy-and-sell agreement between co-shareholders in a company, funded by life insurance, is the most efficient way to ensure continuity of the company on the death or disability of one of the shareholders.

Sadly, I have has seen too many cases where there were either no polices in place, or no signed buy-and-sell agreement, with the result that the company did not survive the death of one of the shareholders and the ensuing fight between remaining shareholders and the family of the deceased.

Joffe is head of legal services at Discovery Life