Navigating a successful business exit when a marriage ends in divorce often presents challenges for both parties. Leaving aside the emotional tensions present in divorce, resolving conflicts regarding the ownership of business interests in the marital estate is also daunting. This post therefore reviews options for divorcing spouses to in their divorce proceeding. If couples can ratchet down the emotions and the acrimony, the tools discussed in this post may help allow the couple to optimize the financial outcome of their divorce settlement and preserve the value of the company they own or in which they share a large ownership stake.
The Valuation Dilemma
The most contentious business issue in many divorce proceedings is the value of the business that must be divided as part of the divorce settlement. Valuation is an inexact science, and the divorcing couple can easily spend hundreds of thousands of dollars on expert and legal fees battling it out over the value of one or more private companies included in the marital estate. This challenging issue is not subject to any easy fix. But there are some options the couple may want to consider before engaging in an expensive and time-consuming valuation battle.
(a) Marital Agreements. Couples can eliminate the private company valuation battle by entering into a marital agreement that specifies what specific assets will be shared on divorce, or what amounts will be paid, and the agreement can also specific how the value of any assets will be determined. While a pre-nup is more common, couples can also agree to enter into a post-nup that details a property division and removes any conflict regarding the valuation of specific assets. Texas statutes set forth strict requirements to follow for marital agreements be enforceable. See Chapter 4 of the Texas Family Code
(b) Designated Valuation Expert. The couple can agree to pre-select and designate a valuation expert they both trust to conduct the valuation for them and to be bound by whatever value is determined by this mutual, trusted expert. Alternatively, there are variations on this approach, which give the couple the right to retain valuation experts if they don’t like the value that is determined by the designated expert and the results of these additional experts will then be averaged to determine the final value.
(c) Value Determined by Arbitration. The litigation process is an expensive way to resolve valuation disputes that involves battling experts at a public trial, which will likely reveal financial information the couple may not wish to disclose and where the ultimate decision is made by juries that have little or no experience in valuing private companies. An alternative is for the couple to agree that any valuation disputes will be resolved in arbitration, which can be faster, less expensive and private. Our most recent post described fast track valuation procedures that can apply in the marital context, as well. READ HERE
The Liquidity Problem – Consider Kicking the Can Down the Road
One frequent business challenge in a marital divorce proceeding is the liquidity problem, which is created by the high value of the company in which the couple own an interest. More specifically, the couple together own a valuable business that has a high value, and one spouse wants to acquire (the Buying Spouse) the ownership interest of the other spouse (the Selling Spouse). The problem is that the marital estate does not include enough assets outside of the company for the Buying Spouse to pay the Selling Spouse for the value of his/her half of the business. There are simply not enough assets available for the Buying Spouse to pay for the Selling Spouse’s ownership stake—that is the liquidity problem.
There are a variety of strategies that are available to address the liquidity problem, which typically involve various buyout structures. These plans generally involve the Selling Spouse accepting a payout from the Buying Spouse of some length for the value of his/her interest in the company. The buyout terms also generally require the Buying Spouse to provide collateral in assets of the Buying Spouse, which may include a secured interest in the stock of the company that is transferred to the Selling Spouse.
A more creative approach to the liquidity problem, however, is the “kick the can” down the road strategy. Given that the couple does not have sufficient assets to fund a purchase/sale at the time of the divorce, the kick the can down the road approach calls for the following:
(a) The Selling Spouse will retain his/her interest in the company for some period of time—3-5 years. At the end of that period, the Buying Spouse will have an option to buy the Selling Spouse’s interest—a call right, and the Selling Spouse will have the option to demand the purchase of his/her interest by the Buying Spouse—a put right.
(b) During the holding period, the Selling Spouse will be subject to a series of negative covenants that place restrictions on the governance rights of the Selling Spouse such as the ability to borrow funds, pay bonuses and distributions, and add new partners. In addition, the settlement will include provisions to ensure that there is transparency in the operation and finances of the business.
(c) Finally, the parties will agree on a formula for valuing the interest retained by the Selling Spouse at the time the call or the put is exercised. Developing the valuation formula is generally less difficult to negotiate and conclude at the time of the divorce than conducting a contested valuation of the company.
What our experience has shown is that 3-5 years after the divorce concludes, the value of the business typically has appreciated, the tension between the spouses at the time of the divorce has dissipated and the spouses are able to negotiate a transfer of the business with less acrimony.
Jointly Held Assets – Special Cases
There may be some assets in the marital estate to which the following adage applies—it is better to leave well enough alone. For example, if the couple holds a minority interest in a private entity such as a REIT (real estate investment trust), a limited partnership interest in an oil and gas firm, or some type of closed end fund that makes regular distributions, it may be better not to try to divide this asset and leave it nominally owned by just one spouse after the divorce, but with a continued obligation to share future distributions with the other spouse. This approach may also be warranted if there are transfer restrictions in the governance documents of the entity that preclude one spouse from transferring his/her interest to the other spouse without written approval from all other owners.
If the spouses agree to allow one spouse to retain ownership/control the asset after the divorce, the owner/operator will be designated as a “constructive trustee” over this minority ownership interest. This fiduciary status which imposes the highest level of fiduciary duties on the operator. In this scenario, the non-operator will be a beneficiary of the constructive trust with full protection that any/all distributions made by the company will be shared equally.
The parties can also agree to include put/call options into the agreement to allow for a future sale of their interest in the asset (subject to transfer restrictions in governance documents). Alternatively, as part of an estate plan, the couple can provide that their ownership interest in the company will passed to their children or grandchildren via a trust as part of an estate plan they have adopted. Note: Under Internal Revenue Code Section 1041, property transfers that take place between divorcing spouses and which are included in written divorce settlement agreement are presumed to be incident to divorce (and therefore non-taxable) for six years—plans to transfer assets after this period need to consider the tax impact.
The Other Party in the Room
When divorcing spouses transfer ownership interests in private companies as part of the divorce settlement, a third party—the business itself—may need to be a party to certain aspects of the divorce settlement. The potential involvement of the company in the divorce settlement based on transfers of an interest in the business are discussed below.
For example, in the divorce settlement, when a spouse transfers his/her interest in the company to the other spouse, it is common for the Buying Spouse to grant a broad release to the Selling Spouse. In addition, the Selling Spouse should insist, as well, on securing a release that is provided by the business, and not just from the Buying Spouse. This release from the business will ensure that the Selling Spouse will not face any claim or lawsuit that is filed by the business after the divorce. Similarly the Selling Spouse will also want to request the business to provide an indemnity for any post-divorce lawsuit or claim that may be filed by a third party against the Selling Spouse after the transfer takes place and divorce is final. The Buying Spouse will want to omit (carve out) any indemnity provided to the Selling Spouse, however, based on or relating to conduct by the Selling Spouse that results in a claim.
The important take-away is that both spouses should consider what claims and/or rights the business may have in connection with the divorce. One or both spouses may need to request the business to provide a release or grant other rights to a spouse in connection with the ownership transfer that takes place as part of the divorce proceeding.
Conducting a business divorce during a marital dissolution creates a number of complex challenges that must be resolved for the couple to achieve a successful divorce settlement. These issues are not insurmountable, however, and the tools that we review in this post offer guidance to help navigate some of the most common conflicts that arise in the divorce process. The true key is attempting to set emotions aside as much as possible and focus on optimizing the value of the marital estate in order to achieve an outcome that is in both parties’ best interests.