Marital divorces are often difficult under the best of circumstances, but tensions may be even higher when the marital estate includes substantial interests the married couple own jointly in private companies, which they are seeking to divide in their divorce proceeding. The issues likely to create conflict include (i) determining the fair market value of the business(es) included in the marital estate, (ii) negotiating the amount one spouse will pay to acquire the interest that is held by the other spouse in the business, and (iii) negotiating the payment terms to acquire this spousal interest. This post reviews options for spouses to consider that will help them reach an objective value of the private company interests they have and divide these interests in a manner that prevents their divorce from dragging on for years at great expense. Adopting some of these options for resolution, however, would require the spouses to agree to adopt an outside-the-box approach to their divorce settlement.
Preparing for a Successful Business Divorce
The planning process for a business divorce in a marital case involves securing a number of business and financial records the parties will have to exchange. Before they can negotiate a divorce settlement that involves a division of their ownership interests in private companies, they need to confirm the ownership of the business (identify all owners), review the governance rules that apply, obtain financial information about the company’s performance that will enable them to determine the value of the company, and assess the financial resources available in the marital estate. In this planning stage, the parties will want to focus on the following issues:
- Were there previous valuations that were conducted of the business, internally and externally by third parties, and were written offers for sale (term sheets, letters of intent) to buy the business made to the company/owners in recent years?
- Do any buy-sell or other similar agreements exist between the company and/or the partners that provide an agreed method to calculate the value of the business?
- Who are all the partners in the business, and if there are other partners, are there restrictions on transferring interests in the company’s governance documents that require other partners to approve transfers between spouses?
- Are there sufficient assets in the marital estate to support an immediate buyout of the interest held by one spouse in the business, or will the couple have to negotiate the terms of a structured payment for the spousal interest?
- What is the level of debt on the business, i.e., if the business is wholly owned by both spouses, is it possible for the business to secure sufficient financing to enable a buyout of the interest held by one spouse in the business?
Determining the Value of Spousal Interest in the Business
In a marital divorce, the ownership interest the couple holds in a private company may be their most valuable asset. Therefore, negotiating the price to be paid by one spouse to acquire the interest in the business held by the other spouse may be one of the most contentious aspects of their divorce. Determining the value of a company may seem like a simple exercise, but valuing a business involves considering many different variables that can lead to large variances between experts regarding the value. Further, the spouses have opposing goals with the spouse who is transferring his/her interest desiring a high value for the business and the spouse who is paying for the spousal interest desiring a low value to apply to the business.
Both spouses likely share the goal, however, of avoiding a protracted dispute over the value of the business, which will then become a battle of the valuation experts, and result in high legal and expert fees that require a lengthy time period to resolve. When the spouses share the goal of reaching a prompt, cost-effective and fair agreement regarding the value of the company on an objective basis, the following are some options they may want to consider:
- Retain Single Valuation Expert – The spouses could jointly retain a single business valuation expert who they both respect and agree that they will be bound by this expert’s report on the company’s value and the transfer price to be paid. They could also request the valuation expert to consider the company’s financial performance over the past three years to determine its value, i.e., they could attempt to have the company’s value based on what amounts to a three-year average.
- Retention of Multiple Valuation Experts – Each spouse could retain their own expert to prepare a valuation report, and if the values determined by the two experts are more than 10% apart, they could agree these two experts would then select a third expert, and they would agree to be bound by the value determined by the third expert. Alternatively, they could agree that after the third expert issues his or her valuation report, the company’s value will be based on the average value of all three reports or an average of the two reports that are closest together in value. Thus, the couple is agreeing to allow the third expert to establish the value of the company, and to be bound by that determination.
- Arbitration of Company Value – The couple could agree they will authorize the value to be decided by an arbitration panel at a timely hearing, i.e., they could set a date for an arbitration hearing to be held in 90 days, which would allow for them to each secure reports from their own valuation experts. The spouses would submit their valuation reports (and any related testimony) to a panel of arbitrators to decide the company’s value. The panel could also decide the specific structure for payment of the transfer price to be paid by the acquiring spouse if the couple cannot agree on the payment terms.
Additional Creative Options to Consider
In addition to the approaches discussed above for determining the value of the company (or companies) at issue in the divorce proceeding, there are some other, more creative options that are also available for the spouses to consider, but that will require them to accept less common/traditional settlement structures. These options are reviewed below.
- Company Value Determined by Trusted Advisor(s) – Rather than directly retaining the business valuation expert themselves, the couple could retain a single trusted advisor or appoint a committee of three advisors and task them with determining the company’s value. This sole advisor or panel of advisors could also be retained to set the terms for payment of the transfer payment/price. Thus, the couple would turn this decision over to a trusted individual or group to retain the valuation expert, oversee the determination of value, and establish the payment terms for the transfer of the spousal interest.
- Defer Payment Until Company is Sold – Rather than transferring the spousal interest in the business from one spouse to the other at the time of the divorce as is customary, the couple could agree to each retain their ownership in the company after the divorce. This continued ownership, however, would be with the stipulation/agreement that the business will be sold in the next five years and the couple will split the net sales proceeds at that time. In this scenario, the couple will need to discuss what division of the sale proceeds is appropriate on a post-sale basis. In most cases when the transfer of the spousal interest takes place at the time of the divorce, the parties will agree, or the court will require the parties to split the value of the business on a 50-50 basis. But if the couple continues to own their interests in the business after the divorce, they may negotiate a different split that takes into account either the appreciation or the decline in value of the business when the sale of the business takes place years after the divorce. Importantly, when the couple continues to jointly own a company after their divorce is final, they will also need to take steps to create transparency, including providing the non-operating spouse with periodic financial reports. They also need to include restrictions on the powers of the operating spouse that adequately protect the interests of the non-operating spouse. By way of example only, during the holding period before the business is sold, the operating spouse cannot declare large bonuses for himself or herself and cannot add new owners that would dilute the ownership interest of the non-operating spouse.
- Grant of Options to Exercise in the Future – Another option, which is similar to the one above, is one in which both spouses continue to own the business after the divorce is final. In this scenario, however, each spouse receives an option to exercise in the future, perhaps in three years or five years. Specifically, the spouse operating the business would have a “call option,” providing that he or she can purchase the interest held by the other non-operating spouse when the option is exercised. The non-operating spouse would have a “put option” that would allow him or her to trigger the option and require the operating spouse to purchase his or her interest. The company would have to be valued at the time that the option is exercised by either spouse, but they could agree on a specific formula in their settlement agreement to determine the value of the business at the time the option is exercised. Finally, and similarly to the previous option, the couple will need to include transparency regarding the company’s ongoing financial performance, as well as restrictions that protect the non-operating spouse during the holding period.
Divorces can be stressful, and the conflicts involved may be heightened when the couple jointly owns valuable interests in private companies. Determining the value of the business and the terms for payment of the spousal interest can be a challenge, because so much is riding on the outcome. But, having this conflict over the value of the business can become a protracted battle that will be very expensive and time consuming, which is not good for either spouse or for the business. If the couple is willing to be creative in their approach to the valuation of the business, however, there are options available that will provide them with a path for the division of their ownership interests in private companies in a manner that is objectively reasonable to both of them.