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Managing 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 disputes over ownership of business interests in the marital realm is also daunting. This article therefore reviews the options that divorced spouses can consider when dividing their interests in private companies as part of their divorce proceedings. If couples can reduce emotion and acrimony, the tools discussed in this article can help the divorcing couple optimize the financial outcome of their divorce settlement and preserve the value of the business they own. or in which he shares a large ownership interest.
The evaluation 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 in expert and attorney fees arguing over the value of one or more private corporations included in the marital estate. This difficult problem has no easy solution. But there are some options the couple could consider before engaging in a costly and time-consuming valuation battle.
(a) Matrimonial Agreements. Couples can eliminate the private business valuation battle by entering into a marital agreement that specifies what specific assets will be shared in the event of a divorce, or what amounts will be paid, and the agreement may also specify how the value of all assets will be determined. Although a pre-nuptial is more common, couples can also agree to enter into a post-nuptial which details a division of property and removes any disputes over the valuation of specific assets. Texas laws set out strict requirements that must be followed for marital agreements to be enforceable. See Texas Family Code Chapter 4
(b) Appointed Valuation Expert. The couple may agree to pre-select and appoint an appraiser whom they both trust to perform the appraisal for them and be bound by the value determined by this mutually trusted appraiser. Alternatively, there are variations of this approach, which give the couple the right to retain appraisers if they do not like the value determined by the appointed appraiser and the results of these additional appraisers will then be averaged to determine the value. final value. .
(c) Value determined by arbitration. The court process is an expensive way to resolve valuation disputes that involves battling experts in a public trial, which will likely reveal financial information the couple may not wish to disclose and where the final decision is. is taken by juries that have little or no experience in evaluation. private companies. An alternative is for the couple to agree that any valuation dispute will be resolved by arbitration, which can be faster, cheaper and private. Our most recent article describes expedited assessment procedures that may also apply in the marital context.
The Liquidity Problem – Consider Tossing the Box on the Road
A frequent business challenge in spousal divorce proceedings is the problem of liquidity, which is created by the high value of the business in which the couple holds an interest. Specifically, the couple owns a valuable business together that has a high value, and one spouse wishes to acquire (the buying spouse) the stake of the other spouse (the selling spouse). The problem is that the marital estate does not include enough assets outside the business for the buying spouse to pay the selling spouse the value of his half of the business. There simply aren’t enough assets available for the buying spouse to pay for the selling spouse’s stake – that’s the liquidity problem.
There are a variety of strategies available to address the liquidity problem, which typically involve various redemption structures. These plans usually involve the selling spouse accepting payment from the buying spouse over a period of time for the value of their stake in the business. Redemption terms also typically require the buying spouse to provide security over the buying spouse’s assets, which may include a secured interest in the shares of the company that is transferred to the selling spouse.
A more creative approach to the liquidity problem, however, is the “kick on the road” strategy. Since the couple does not have sufficient assets to finance a purchase/sale at the time of the divorce, the punch in the road approach calls for the following:
(a) The selling spouse will retain their interest in the business for a certain period of time – 3 to 5 years. At the end of this period, the Purchasing Spouse will have an option to purchase the interest of the Selling Spouse – a right to purchase, and the Selling Spouse will have the option of requiring the purchase of his interest by the Purchasing Spouse. – a right of sale. .
(b) During the holding period, the Selling Spouse will be subject to a series of negative covenants which place restrictions on the Selling Spouse’s governance rights, such as the ability to borrow funds, pay bonuses and distributions, and to add new partners. In addition, the regulations will include provisions aimed at ensuring transparency in the operation and finances of the company.
(c) Finally, the parties will agree on a formula for valuing the interest retained by the Selling Spouse at the time of the exercise of the call or put. Developing the valuation formula is generally less difficult to negotiate and conclude at the time of divorce than making a contested valuation of the business.
What our experience has shown is that 3 to 5 years after the divorce is finalized, the value of the business has generally 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.
Assets held in common – Special cases
There may be certain assets in the matrimonial estate to which the following adage applies: it is better to leave well enough alone. For example, if the couple has a minority stake in a private entity such as a REIT (real estate investment trust), a limited partnership interest in an oil and gas company, or some type of closed-end fund that makes distributions regular distributions, it may be better not to attempt to divide this asset and leave it nominally held by one spouse after the divorce, but with an ongoing obligation to share future distributions with the other spouse. This approach may also be warranted if there are transfer restrictions in the entity’s governance documents that prevent one spouse from transferring their interest to the other spouse without the written approval of all other owners.
If the spouses agree to allow one of the spouses to retain ownership/control of the asset after the divorce, the owner/operator will be named as the “implicit trustee” of this minority 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 all distributions made by the company will be shared equally.
Parties may also agree to include put/call options in the agreement to allow for a future sale of their interest in the asset (subject to transfer restrictions in governance documents). Alternatively, under an estate plan, the couple may provide that their interest in the business will be passed on to their children or grandchildren through a trust under an estate plan they have adopted. Note: Under Income Tax Code Section 10441, property transfers that occur between divorced spouses and that are included in a written divorce settlement agreement are deemed to be incidental to the divorce (and therefore not taxable) during six years – plans to transfer assets after that. period must take into account the tax impact.
The other party in the room
When divorced spouses transfer interests in private companies as part of the divorce settlement, a third party – the company itself – may need to be a party to some aspect of the divorce settlement. The potential involvement of the company in the settlement of the divorce based on transfers of an interest in the company is discussed below.
For example, in divorce settlements, when one spouse transfers their interest in the business to the other spouse, it is common for the purchaser spouse to grant a broad release to the vendor spouse. In addition, the Selling Spouse must also insist on a release from the business, not just the Buying Spouse. This release from the business will ensure that the selling spouse will not face any claims or lawsuits brought by the business after the divorce. Similarly, the selling spouse will also want to ask the company to provide indemnification for any post-divorce lawsuits or claims that may be filed by a third party against the selling spouse after the transfer has taken place and the divorce is final. The Purchasing Spouse will want to omit (exclude) any indemnity provided to the Selling Spouse, however, based on or relating to the conduct of the Selling Spouse which gives rise to a claim.
The important thing to remember is that both spouses must consider any claims and/or rights the business may have in relation to the divorce. One or both spouses may need to ask the company to provide a release or grant other rights to a spouse as part of the transfer of ownership that takes place as part of the divorce proceeding.
Conclusion
Conducting a business divorce during a marriage dissolution creates a number of complex challenges that must be resolved for the couple to reach a successful divorce settlement. However, these problems are not insurmountable, and the tools we review in this article offer tips to help you navigate some of the most common conflicts that arise in the divorce process. The real key is to try to put emotions aside as much as possible and focus on maximizing the value of the marital estate to achieve an outcome that is in the best interests of both parties.
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