For many business owners, one of the key challenges in business succession planning following the death or incapacity of a shareholder (Outgoing Shareholder) is balancing the competing priorities of the company and remaining shareholders (Remaining Shareholders) with those of the family of the Outgoing Shareholder. These include:
ensuring that the business stays under the control of the Remaining Shareholders;
ensuring that the Outgoing Shareholder’s family receives fair value for their shareholding; and
ensuring that the Remaining Shareholders are able to fund the purchase of the Outgoing Shareholder’s shares.
Without a clear mechanism in place, these objectives can come into conflict. Remaining Shareholders may not have the means to acquire the shares, while the Outgoing Shareholder’s family may be left holding an illiquid asset with limited involvement in the business, or control of the business could pass to an ‘outsider’.
A cross-option agreement is widely used in owner-managed and family businesses to address this issue, which is often backed up by key person insurance.
What is a cross-option agreement?
A cross-option agreement is a legal arrangement between shareholders that governs what happens to shares on death or other triggering events, such as permanent incapacity.
In a nutshell, the Remaining Shareholders are granted an option to purchase the Outgoing Shareholder’s shares; and the Outgoing Shareholder’s executors / attorneys are granted an option to require the Remaining Shareholders to purchase those shares. These options are typically exercisable within a defined period following death / incapacity.
While neither party is initially obliged to proceed, once one option is exercised, the transaction becomes binding. This creates a practical mechanism for transferring ownership while ensuring that both sides are protected.
How cross-option agreements work in practice
Cross-option agreements are usually designed to sit alongside the company’s Articles of Association, any shareholders’ agreement; and the individual shareholder’s Will. They can also be incorporated into a shareholders’ agreement rather than as a standalone agreement.
In many cases, the agreement is supported by key person life insurance policies taken out by the shareholders. On death, the policy proceeds are used to fund the purchase of the shares. The typical outcome is that the surviving shareholders acquire the shares and the deceased’s estate receives cash equivalent to their value. Key person policies can also be extended to cover critical illness, incapacity and total and irreversible loss of autonomy. It is important to ensure that any insurance policy aligns with the events that trigger the cross-options.
Why cross-option agreements are used
Without a cross-option agreement, a number of practical issues can arise. Shares may pass to family members who do not wish to be involved in the business or who the Remaining Shareholders do not wish to be involved in the business, Remaining Shareholders may lack the funds to acquire the shares; or disputes may arise over valuation or timing of a sale.
A cross-option agreement addresses these points by:
providing a clear route for the transfer of shares;
Including a pre-agreed value or value methodology (which allow insurance cover to be adjusted as necessary);
ensuring that funding is available (where insurance is in place);
reducing the likelihood of disputes between shareholders and the deceased’s family.
For many businesses, this makes it a central component of effective business continuity planning.
Valuation of shares
A key element of any cross-option agreement is how the shares are to be valued.
Common approaches include:
agreeing a fixed value, reviewed periodically;
using a formula-based valuation;
appointing an independent expert to determine value at the relevant time.
Whichever approach is adopted, it is important that the valuation mechanism is clear and workable in practice and aligned with the level of insurance cover in place. Outdated valuations can lead to shortfalls in funding or disputes between the parties.
Inheritance tax considerations
Cross-option agreements are often structured with inheritance tax planning in mind.
Shares in a trading company may qualify for Business Property Relief (BPR), potentially reducing the inheritance tax liability on death. However, care must be taken to ensure that the agreement does not inadvertently prejudice that relief. In particular, a binding obligation to sell shares (rather than an option) can affect the availability of BPR; and the structure of the agreement must preserve flexibility until the option is exercised. This is a technical area where coordination between corporate and private wealth advice is essential.
Interaction with Wills
A cross-option agreement should always be considered alongside the shareholder’s Will to ensure that the documents complement one another. Difficulties tend to arise where:
the Will and the cross-option agreement have been prepared independently; or
the implications of the agreement have not been fully considered.
A joined-up approach helps ensure that the overall outcome is clear and consistent and minimises the disruption to the running of the business following a death
Funding through insurance
As mentioned earlier, cross-option agreements are supported by life insurance policies and can be extended to provide cover in other circumstances such as incapacity and critical illness. These policies are typically structured so that, on the occurrence of the trigger event, funds are available to the Remaining Shareholders (or the company) to purchase the shares, and to ensure that the transaction can proceed without placing financial strain on the business or the individual Remaining Shareholders.
The level of cover should be reviewed regularly to ensure that it reflects the current value of the business based on the valuation process set out in the cross-option agreement or shareholders’ agreement. Without appropriate funding, even a well-drafted agreement may be difficult to implement in practice.
Family considerations
A cross-option agreement can provide certainty that the shares will be realised, clarity as to the value to be received and liquidity at a time when it may be most needed.
However, it is also important to consider how these arrangements interact with wider family circumstances. For example, where shares might otherwise pass to a spouse or children, the loss of an ownership interest in the business may need to be balanced against the receipt of cash. In some cases, this may feed into broader discussions around estate planning and family wealth structuring.
Common pitfalls
As with many aspects of succession planning, issues often arise where arrangements are incomplete or out of date. Common pitfalls include:
no cross-option agreement in place;
agreements that are not aligned with the Articles or shareholders’ agreement;
insufficient or outdated insurance cover;
valuation mechanisms that are unclear or impractical;
lack of coordination with Wills and inheritance tax planning.
Regular reviews can help ensure that the arrangement continues to meet the needs of both the business and the individuals involved.
A balanced solution
A cross-option agreement is not the only way to address succession on death or incapacity, but it is one of the most widely used and effective tools for owner-managed businesses.
By providing a structured mechanism for the transfer of shares, it can:
protect the continuity of the business;
provide fair value to the Outgoing Shareholder’s estate;
remove financial burden on the Remaining Shareholders;
reduce uncertainty and the potential for disputes.
If you would like to discuss cross-option agreements or how they fit within your wider business succession planning, please contact Laurence Twiselton in BPE’s Corporate team or Philip Allen in the Private Wealth team.
