By: Taylor Toombs Imel, Shareholder KoonsFuller Houston
Divorce is a reality for nearly half of all married individuals in the United States. Despite this alarming statistic, individuals often fail to financially prepare and protect themselves from the devastating effects that inevitably accompany divorce. This is especially true when it comes to closely-held businesses.
The ownership interests of these small businesses often account for the largest asset of a family both in terms of value, income generated and the investment of time and money spent building the business. Thus, the disposition and valuation of these closely-held business interests become some of the most highly contested issues when marriages dissolve.
Plan for the Future – Premarital, Post-Marital, and Buy-Sell Agreements
If you have an ownership interest in a business, whether you’re considering divorce or not, it’s essential that you begin protecting your interest now before any divorce proceedings are initiated by any co-owner, partner, or his or her spouse. Ideally, these protective measures would be implemented at the outset of the business enterprise and before co-owners or partners are married. However, the reality is often quite different.
One of the most common ways to protect your individual interest in a business is by executing a premarital (prenup) prior to marriage. A prenup is simply a contract entered into by prospective spouses before the wedding that’s intended to clarify you and your soon-to-be spouse’s financial rights and obligations and offers protection against protracted litigation in the event of a divorce. Whether you’ve already started a business or intend on starting one in the future, the prenup can be used to define how that business will be divided in the event of a divorce or even how to derive its value. The agreements can mirror similar provisions contained in the entity’s governing documents or even provide alternative methods of how an owner spouse’s business interest will be divided and/or valued. Much like an insurance policy, a prenup can be used to protect not only you and your spouse but also your business interests against the worst-case scenario – the dissolution of your marriage and the financial turmoil that can come with it.
If, like many Americans, you didn’t execute a prenup before getting married, a post-marital (postnup) may still be an option – that is, of course, assuming your spouse is open to executing one. Much like a prenup, postnups contain vital information about assets and liabilities of each spouse and can even be limited to govern a specific business transaction and/or enterprise. These agreements can be useful in determining how income, debts and any property will be divided in the future, especially as your financial situation evolves over time. A word to the wise: don’t wait until marital turmoil occurs to request a postnup. These documents should also be drafted in conjunction with a buy-sell agreement or other formation documents to provide added protection to not only spouses and business owners but also to potential investors.
If the stress of speaking to your spouse or fiancée about a prenup or postnup is too great to fathom, at the very least your shareholder, partnership, LLC or buy/sell agreement should include provisions that protect the interests of the business in the event of a divorce. Unfortunately (or rather fortunately if I’m representing the non-owner spouse), I rarely encounter divorce provisions in such agreements that have been drafted correctly to bind the non-owner spouse to the agreement. Most fail to define when the divorce provisions are actually triggered (i.e. upon the filing of a divorce). Many include inappropriate standards of value that are either outdated or are designed to deprive the non-owner spouse of a fair value. Others tend to only include provisions that govern situations in which the non-owner spouse is awarded an interest in the company and have zero effect on the value of the actual business interest. Still fewer are signed by the non-owner spouse or fail to include an executed consent and joinder by the non-owner spouse indicating that he or she was even informed of its contents.
Know the Laws of Your State – Characterizing and Valuing the Business Interest
The laws governing divorce vary from state to state, including how assets and debts are characterized and divided and how business interests are valued. First and foremost, you need to understand the distinction between separate property and marital property. Although there are some differences from state to state, separate property generally includes property owned prior to marriage, inheritance received by one spouse, gifts received by one spouse, and recovery for pain and suffering for personal injuries. It’s essential that you keep all separate property separate. Otherwise, you could inadvertently cause your separate property to become marital property.
All other property, including income, that’s acquired during marriage is considered marital property regardless of how it’s titled or which spouse owns it. This means that if you start and capitalize a business during your marriage, outside of special circumstances (i.e. capitalization with separate property), that business interest will be considered marital property, and thus subject to division.
As a general rule amongst states, all marital property including business interests, must be valued for the purposes of property division regardless of title. Assuming you don’t intend on co-owning your business with your spouse following a divorce and an agreed-upon value cannot be reached, a formal valuation of your business interest will be essential to fair disposition.
So, what does a valuation entail?
Every valuation will identify and define applicable standard of value for your business. The value of your business will likely be its fair market value – the price at which the property would change hands between a willing buyer and seller having reasonable knowledge about the asset and under no compulsion to buy or sell it. However, a few states do apply other standards of value, such as fair or investment value. You should consult with your chosen lawyer and/or business valuation expert to determine the standard of value that will be applied in your state.
You should also understand that the value of your business is not only limited to the identifiable tangible assets and is often far more valuable than that of its individual parts. When valuing, selling or buying a business, its goodwill – the value that is above and beyond the worth of the separately identifiable tangible business assets – will be considered and determined. While experts agree that goodwill exists in a business, the existence and value of the same is often subjective, with experts having markedly different conclusions regarding a company’s goodwill. Depending on your state, goodwill may be divided into two components – enterprise and personal. Personal goodwill relates specifically to the individual person and is not an asset owned by the business enterprise. Personal goodwill will continue to exist if the loss of a key person would reduce future income of the business. Most internally created goodwill is personal in the early stages of a business.
Why does this matter?
The distinction between enterprise and personal goodwill, and whether they’re considered marital property, can dramatically affect the overall value of the business owner’s individual interest that’s considered divisible by the trial court. Currently, 25 states (including Texas) hold that personal goodwill is not marital property and cannot be divided. Five states hold that neither personal nor enterprise goodwill are marital property. On the other hand, 13 states, including California and New York,hold that personal and enterprise goodwill are marital property and thus divisible. Still, another seven states have yet to determine whether any form of goodwill is marital property, thus those courts remain divided.
Regardless of your state, you should prepare yourself for the fact that the valuation process will be invasive, time-consuming and expensive. Key personnel within the business will be interviewed at least once by each party’s chosen expert. The valuation process will also entail extensive document gathering and review. You should expect to produce financial statements (i.e. profit and loss, balance sheets, statements of retained earnings and cash flows, etc.) and tax returns for the business for the last five years; aged accounts receivable/payable; prior business valuations; contracts and other agreements of the business; articles of formation; buy-sell agreements, shareholder agreements, and other documents detailing ownership transaction; list of owners, ownership interests and compensation; and organizational charts.
If Possible, Maintain Control
As a practical matter, you should avoid splitting the business interest and ceding control to your soon-to-be ex, especially if your divorce will be or is contentious. Warring spouses tend to become warring partners in co-owned businesses, thus decreasing the longevity and sustainability of the business. If at all possible, find a way to maintain full control of the business. Often, other assets can be exchanged for the business interest to reach a fair division. When such assets are insufficient, consider a long-term payout (with interest) of the amount you would owe your ex-spouse to reach a fair and equitable division of your marital estate. This can be in the form of a promissory note or even an alimony package. If choosing the latter, consider tax-affecting the same as the IRS no longer allows alimony to be deducted by the payor. As with any property settlement or division, it’s essential to consult an accountant or CPA regarding any potential tax consequences of the division prior to signing on the dotted line.
If you decide to continue to own and operate the business with your ex-spouse, then make sure you have a shareholder agreement or other entity agreement that gives both of you the option to buy out the other owner or partner. Consider including the execution of the agreement as part of the divorce settlement. Given the potential for discord, it’s important that you have a built-in escape hatch.
Consider the Effects of COVID-19
In a state where small businesses employ roughly 46.4% of the private workforce, many Texas businesses have been or will be negatively impacted by the global pandemic and the resulting economic instability. Such volatility could lead to potential layoffs of clients or a significant reduction in the value of your closely held business, which may be the single largest asset of your community estate. This also creates a complex issue for valuing and dividing a closely-held business interest during a divorce.
Traditionally, business valuation experts look at historical performance of the business (typically, the last 5 years of financial information) in order to ascertain its current value. Such an approach is particularly problematic for a small business owner during this global pandemic as prior performance is likely not indicative of current and/or near-future economic conditions of the business. This is especially true for oil and gas enterprises. Thus, any proper valuation and division of the closely-held business should take into consideration the current economic conditions and cannot simply rely on historical financials to ascertain the current value.
For a small business owner, the divorce process can severely disrupt the ongoing nature of the business. Consulting with a family law practitioner adept at handling valuations of business interests and the division of the same will ensure that you, your family and your business are protected from the instability that can occur both during and after a divorce.
About the Author:
Taylor Imel is a board-certified family law attorney based in Houston, Texas with nearly a decade of experience, and a member of the GWHCC’s 40 Under 40 Advisory Board. Her expertise includes pre- and postnuptial agreements, as well as highly complex property division and custody cases. As an adult-child of divorce, Taylor uniquely understands that it can be a traumatic event for most individuals and families and that its potential collateral damage must not be ignored when representing her clients.