By Ladd Hirsch
“Water, water, everywhere,
And all the boards did shrink;
Water, water, everywhere,
Nor any drop to drink.”
The Rime of the Ancient Mariner, Samuel Taylor Coleridge, published 1798
This riveting poem by Coleridge relates the story of a sailor who is cursed for killing an albatross, which results in the ship’s crew nearly dying of thirst while they are surrounded by the great expanse of the ocean. While not nearly as dramatic as this scene from the poem, divorcing spouses who own substantial interests in successful private companies do commonly experience a similar dilemma. The couple’s interest in a private company may be a highly valued asset that is worth millions of dollars, but the spouses and the company lack the cash necessary to fund the purchase of the interest held by the selling spouse. In the Coleridge vein, there is value value everywhere, but no cash to pay for it. Without a creative solution in place, this lack of liquidity creates a significant problem for the divorcing couple in achieving a “just and right division” (as required by the Family Code) of what may be the most valuable asset in their marital estate.
A Road Less Traveled—Postponing Asset Division Can Pay Dividends
The conventional wisdom is that all marital assets must be divided at the time of divorce. But, when a liquidity problem exists in divorce cases that involve the ownership interest held in a substantial private company, the best solution for the couple in some situations may be to continue their joint ownership of the business for a period of time. This approach to the division of a marital asset can be termed a “phased buyout,” and this settlement structure provides the spouse who is acquiring the full ownership interest in the company (the buying spouse) with the time necessary to secure the capital required to purchase the other spouse’s interest in the business (the selling spouse).
Postponing the division of the business ownership interest until after the divorce is also advisable for another important reason. The most contentious business issue in many divorces is the value of the private company or the interest in the company. This “valuation battle” can be both expensive and protracted. By postponing the buyout of the spousal ownership interest for several years, however, the valuation battle may be avoided or at least minimized. In an ideal situation, when the buyout of the selling spouse takes place 3-5 years after the divorce is final, the tension between spouses has largely dissipated, the value of the business has substantially appreciated and the delay produces an outcome that is a financial win-win for both spouses.
When is delaying the division of the ownership interest in the business for this 3-5 year period the right option for a divorcing couple to deal with the liquidity problem, and what factors need to be dealt with for this phased buyout to work? The best scenario for this approach and the structure necessary for it to be successful are discussed in the remainder of this post.
“Kicking the Can” Down the Road—When Does it Make Financial Sense
The potential for a phased buyout in a divorce case only exists when there is a liquidity problem. Specifically, this approach comes into play only when the marital estate includes a highly valued ownership interest in a private company and there is not sufficient cash or marital assets (or separate property) available to permit the buying spouse to pay cash or transfer assets to the selling spouse that are equal to the value of his/her interest in the company. In these circumstances, the phased buy-out approach is one both spouses may wish to consider. The most significant factors that make a phased buyout a potential alternative to divorcing spouses are listed below:
- Appreciating Value — The business is likely to appreciate in value over time, which means a delayed buyout will create more value for the selling spouse down the road.
- Other Marital Assets Exist — When each spouse receives valuable assets in the divorce settlement unrelated to the business, they can afford to “let it ride” in regard to the business interest, and not force a division of this valuable asset at the time of divorce.
- The Business Has Little Debt – a business that has few large debts can be leveraged to permit the company to take on some debt to fund the purchase of the selling spouse’s ownership interest in the company.
- The Couple Can Tolerate Each Other Post-Divorce — Many divorcing couples have negative feelings toward each other, but the delayed buyout approach requires them to jointly own the business interest for just a few more years. If the relationship has been abusive or is otherwise intolerable, however, it may not be possible for these spouses to remain co-owners of a company for any period of time.
Making the Delayed Business Divorce A Success
For the phased buyout of a private company ownership interest to be a success, which takes place after the divorce is final, there are a number of key issues that must be addressed to protect the selling spouse who is no longer active in the business. These include a “put right” that authorizes the selling spouse to secure an exit from the business on a defined timetable, as well as other terms to ensure the accountability of the buying spouse during the period before the purchase of the selling spouse’s business interest takes place. These key provisions are:
Defined Exit—Put Right
Every phased buyout provides both spouses with exit rights set on a definite timetable. Specifically, the selling spouse will have a put right that allows him/her to demand a buyout of the selling spouse’s remaining interest in the business. The put right cannot be triggered for a set time, often 3-5 years. In effect, the buying spouse needs to be prepared to arrange the financing necessary to purchase the selling spouse’s interest as of the date on which the put right can be exercised. The selling spouse’s put right is an option, not a requirement—the selling spouse can elect not to immediately exercise the right and continue holding the interest in the business if the value of the company is appreciating and/or the company is paying handsome dividends.
But, the buying spouse also has a redemption right. If the selling spouse declines to exercise the put right to sell the interest when the option becomes available, the buying spouse can redeem the interest of the selling spouse. In effect, the buyout spouse is not required to allow the selling spouse to remain a business partner indefinitely, and retains the right to force a buyout of the selling spouse’s interest after a set number of years.
It is vital for the selling spouse to have the right to monitor the operations and financial performance of the company after the divorce is final and during the interim period before the buyout of the selling spouse’s interest takes place. This oversight and required transparency can be assured in a number of ways that include mandatory audits of the company performed at least annually by outside, independent auditors, issuance of regular financial reports by the company and even online access to accounts – access that permits accounts to be viewed only with no any rights to remove or transfer any funds. The selling spouse will also retain the right to obtain access to financial and other information regarding the company to evaluate and address any concerns that arise during this holding period.
The selling spouse will cede day-to-day control over the company to the buying spouse at the time of the divorce, but the selling spouse will retain some important approval rights to make sure that the buying spouse does not exploit or abuse this right of control. These approval rights are set forth in what are termed “negative covenants” and, examples of some of the restrictions imposed on the buying spouse during this interim period are described below:
- Fixed Compensation — The buying spouse cannot increase his/her compensation or declare a bonus without the selling spouse’s consent.
- No Sale of Business/No New Equity Issued — The business cannot be sold without the selling spouse’s consent, although the parties can agree in advance on a floor price for the sales price and the buying spouse can sell the business for any price greater than the established floor. The buying spouse will also not be permitted to bring in any new owners in the business without the selling spouse’s approval.
- Mandatory Tax Distributions — The buying spouse must agree to issue distributions that, at a minimum, will cover all tax payments that must be made by the selling spouse based on her/her continued ownership interest in the company.
- No Excessive Leverage — The buying spouse will not be able to saddle the business with additional, heavy debt during the holding period and all loans above a certain level will therefore require the selling’s spouse’s consent.
Adopt Valuation Formula
A chief benefit of the phased buyout, as noted, is avoiding a hotly contested and likely very expensive battle of the valuation experts in a divorce proceeding. But the divorcing couple will need to determine the value of the selling spouse’s ownership interest once he/she exercises the put right several years after the divorce conclude. Therefore, one of the most critical terms in this settlement structure is the formula the parties adopt to value the interest in the business that is held by the selling spouse.
While this valuation formula is not an easy term to negotiate during the middle of a divorce, working out a valuation provision is frequently done. Not surprisingly, it is much less controversial for the parties to negotiate an acceptable formula by which to determine the value of the selling spouse’s interest in the future rather than actually determining the value of the interest held by the selling spouse while the parties are going through their divorce.
The liquidity problem in marital divorces is serious, but not insurmountable. Forcing the business interest to be divided by the couple during their divorce proceeding is the conventional approach, but in many cases, it is not the best way for divorcing spouses to optimize the value of their ownership interest in a privately-held business. While it may seem to be a non-starter for a divorcing couple to continue to own a business asset together after their divorce concludes, this road less traveled may be a much better path for them to maximize the value of their interest in the company. With the right protective measures in place, including a defined exit for the future purchase/sale of the retained business interest and transparency during the holding period, the phased buyout of this valuable asset that takes place several years after the divorce concludes may result in a financial win-win for both spouses.
 Special thanks to Jill Tananbaum, a good friend and exceptionally skilled trial attorney, for her close review, thoughtful comments, and helpful suggestions regarding this blog post