Listen to this post

When a married couple enters into a divorce proceeding, they generally expect to end things in a final decree that fully divides all of their marital assets. But when they fully own or have a large interest in a closely held, private business, for a number of reasons they may find that it benefits them to continue co-owning all or a portion of the company for some time period after their divorce becomes final. It is not surprising that a business partnership entered into between divorcing spouses can be rife with problems. This post therefore focuses on steps that each of the spouses can take to protect their interests while also continuing to maximize the value of the company in which they have a shared ownership interest.

There are a number of reasons why it may be beneficial for ex-spouses to continue in a business partnership after their divorce, including (i) to achieve the most favorable tax treatment, (ii) because the value of one of the individual interest held in the business cannot be fully realized at the time of the divorce, (iii) because the sale of an interest in the business by one spouse could lead to a substantial downturn in the business, or (iv) because both ex-spouses like the business and they do not want to relinquish their continued ownership in the company.

Once the ex-spouses decide to continue co-owning an interest in a business together, for this partnership to have any hope of working well, they should consider the following steps to put a workable structure in place. Specifically, the ex-spouses will want to (i) require the company to adopt a clear governance structure, (ii) specify a compensation strategy that determines how each of them will be paid, including dividends and distributions, and (iii) negotiate and implement a buy-sell agreement that sets forth a defined contract governing a future partner exit. Placing a set of rules and mutual safeguards in place will permit both parties to protect their investment and also minimize the potential for future conflict.​​​​​​​​​​​​​​​​

The Control Dilemma in Post-Divorce Partnerships

When a couple considers becoming business partners after their divorce, the most basic issue they need to confront is who will control the company after the divorce is final. It will be a recipe for disaster for them to adopt a joint management approach where they must agree on all business decisions on a 50-50 basis. Divorcing spouses likely have a low level of trust between them and requiring them to exercise joint authority will very likely lead to an impasse putting the company into stagnation or chaos. By the same token, allowing just one of them to make all of the business decisions for the company exposes the non-decision maker to an unacceptable level of risk in regard to the operation of the business.

The practical solution to the issue of control is to provide one partner with control over the day-to-day operations and routine decisions made on behalf of the business, but with an important set of exceptions. Specifically, the parties need to negotiate a clear set of veto rights by the non-controlling ex-spouse on matters that would impact the company’s long-term value. These are what can be referred to as “protected decisions,” and they are typically included in the governance documents for companies that are owned on a 50-50 basis. The protected decisions that may be subject to veto rights may include (i) the sale of the entire company or a sale of the company’s major assets, (ii) any large purchases made by the company above a certain amount, (iii) bringing new partners into the business that would cause a dilution of ownership rights, (iv) taking on substantial new debt by the company, (v) changes to the compensation paid to either of the parties, (vi) whether to issue any dividends or not and in what amount, and (vii) the hiring or firing of key personnel at the business. All of these specific veto rights are subject to negotiation during the divorce and before the couple actually become business partners.  

Another practical suggestion is for the couple to consider appointing either an entirely independent board for the company or to appoint a designated arbitrator to resolve disputes. They could then turn to the board or the arbitrator to address any conflicts arising between them that relate to the operation of the business. These outside parties then serve the role of preventing the parties from experiencing a conflict between them that could lead to litigation. For example, if the non-managing partner exercises a veto right over a business decision the managing partner party believes would seriously harm the business, the managing partner  could require that the exercise of the veto be subject to a prompt arbitration.  

Establishing Reasonable Compensation and Distributions

Once the couple have resolved control issues in managing the business, their next major challenge is to determine the financial returns that they will each receive from the company. The spouse who is actively managing the company will rightfully expect to receive compensation for these services, but the non-manager may also desire to receive distributions or dividends issued by the company on a current basis if the business is generating profits. If the compensation paid to the managing partner is too large, that will likely reduce the amount of distributions, so there is definite potential for tension here between the ex-spouses. 

The way to resolve this conflict is similar to the previous management discussion, with a pragmatic approach to the problem. More specifically, the parties’ divorce settlement will need to document not just their co-ownership of the business after the divorce, but it will also need to present negotiated formulas for executive compensation and for future dividends/distributions. The compensation levels will be tied to the company’s future financial performance taking into account both revenues and profits, and experts can assist the parties in developing formulas for the total amount of compensation that is reasonable to pay to the managing spouse.

Similarly, experts can also propose dividend/distribution formulas based on the earnings of the business earnings (EBITDA) taking into account the amounts that the company will need to retain for working capital and potential future expansion. At a minimum, the company should be making distributions sufficient to cover the income tax liability of both co-owners – neither one should have to pay taxes on income that is not distributed. But a dividend/distribution formula will call for the company to distribute some additional amount above the tax distribution based on a formula that includes working retaining capital and expansion capital – perhaps 15% to 25% of the company’s total profits can be distributed to the ex-spouses on an annual basis, without causing any negative impact to the company. 

Establishing these clear parameters on compensation and distributions/dividends in the divorce documents will help to avoid future conflicts and meet the financial objectives of both co-owners. These negotiated boundaries achieve the necessary balance that allows the company to continue to flourish and the ex-spouses to continue to coexist as business partners.

As a necessary corollary to the contract parameters set forth that govern compensation and distributions, the divorce documents need to provide for financial transparency to the non-manager. To ensure that the compensation level and dividends are based on information that is both accurate and up to date, the divorce settlement will need to require the company to provide the non-manager with consistent financial reports, likely on a quarterly basis.

The Final Lap: The Divorce Settlement Should Include a Partner Exit Plan

Even with all of the careful planning in place, most post-divorce business partnerships are temporary arrangements that are in place for a limited period of years until one or both of them wants to separate. At that point, a business divorce will become necessary, and the ex-spouses therefore need to anticipate and plan for the business divorce in the future when they are completing their marital divorce and creating their post-divorce business partnership.

The situations calling for a business divorce can arise when the business does poorly, when one of the ex-spouses wants to retire, becomes ill or remarries, or when the managing individual wants to grow the business requiring major reinvestment and the non-manager is content with the current situation and blocks the company from taking steps needed to grow. But if there is no partner exit plan in place, the non-manager who desires to depart from the company will be stuck holding what amounts to an illiquid, unmarketable interest — it has considerable value, but it cannot be monetized. On the other side of the ownership, the manager may desire to redeem the interest held by the non-manager, but if no contract right exists that permits the manager to require a redemption, the partners remain together unwillingly.

The partner exit plan should be set forth in a buy-sell agreement (BSA) that provides the ex-spouses with a defined path for them to exit the business. The agreement will therefore provide for all of the following: (1) the specific circumstances under which either ex-spouse can trigger the BSA, (2) the manner for determining the value of the departing individual’s interest once the BSA has been triggered, and (3) the terms for payment of the departing partner’s interest because the purchase price typically involves payment being made over a period of years and there may be collateral provided to protect the departing co-owner in the event of a monetary default. The payment terms have to be realistic and not cause undue economic stress to the company.

The mechanism for triggering the BSA will be the subject of negotiation at the time the divorce is finalized. The agreement may include a “shotgun” provision that enables either side to trigger the buyout but allowing the ex-spouse receiving the purchase offer to either offer to accept it or, instead, to purchase the interest held by the other party. This type of provision is designed to achieve fair pricing because the party making the offer must be willing to accept the same price in return for his or her own interest in the business.

Conclusion

When divorcing couples consider the possibility of continuing as partners in a company after their divorce, they need to take steps to head off potential conflicts as business partners. They can avoid disputes by creating a clear governance structure, by addressing the amount of compensation and distributions to be issued in the future, and by negotiating and signing off on a buy-sell agreement that provides a path to exit in the future. When these provisions are put in place at the time of divorce, the couple are positioned to meet their business objectives with reasonable hope for success as they embark on a post-divorce partnership.

Listen to this post

One of the thorniest issues private company owners and minority investors may be required to confront in going through a business divorce is determining the value of the minority interest being purchased. It is not unusual for experts to disagree over the value of the minority interest, and this conflict can delay or even derail the business divorce from being completed. Going through endless rounds of negotiation over value may have both of the partners singing the blues. This post therefore focuses on practical solutions for business owners and investors to consider when they need to value a minority ownership interest in the process of a business divorce.

Reasons for Disagreement Among Experts

Business valuation experts generally follow a similar methodology, and as a result it may seem surprising that they can reach results that vary so dramatically. There are a number of factors, however, that help explain these conflicts. First, business valuation experts make assumptions that impact value, and these different assumptions can lead to substantially different results. As a key example, valuation experts will project the future growth rate of the business based on past trends and anticipated future events, and as a result, when the experts use markedly different projected growth rates for the business, they will reach results that have major differences.

Second, the valuation experts also typically apply substantial discounts to minority held interests, which are based on the lack of control and the lack of marketability of the interest held by the minority investor. These discounts are determined, in part, by reviewing previous transactions of similar companies, but selecting different discount rates will have a large impact on the valuation of the minority interest.

Finally, the valuation experts may rely on different data that also leads to wide variances in their opinions. In this regard, the experts will compare and apply the sales of other businesses, but they may include or reject certain sales as applicable, and using different transaction data impacts their results. Similarly, based on their own analysis, the valuation experts may use different industry multiples to apply to the company’s earnings, which is a key driver of total value of the business. If one expert concludes that the proper multiple is 5 and the other says it is 7, that difference may sound small but it will actually be quite large when the multiple is applied to the company’s earnings.

Practical Solutions to Apply to the Valuation Dispute

Given the potential, if not the likelihood, that valuation experts will reach different opinions regarding the value of a minority holding in a private company, majority owners and investors are well-advised to consider options that may allow them to avoid or at least limit these conflicts. These pragmatic approaches are discussed below.

Expert Report Averaging

If the parties anticipate that a large variance will result between the reports of the valuation experts, they can agree to a process in which three different experts are retained, and they can then average the results of all three valuation reports. Typically, this means that the company/majority owner will retain a valuation expert, the minority investor will retain a second expert, and the parties will direct those two experts to select a third, independent expert. 

Once all three valuation reports are issued, the partners can agree to one of the following options: (1) they can average all three of the reports, (2) they can decide that the valuation report of the party (either majority owner or investor) that is closest in amount to the third valuation expert’s report will be controlling, or (3) they can average the amount of the two reports that are closest in value to determine the final valuation number. Selecting any of these options in regards to valuation will avoid a legal battle.

Adopt Base Value Plus Earn Out

A second option to avoid valuation conflicts is for the parties to agree on a base price for the purchase of the minority investor’s interest that references the valuation, but that also provides for an additional payment to the minority investor. In this scenario, the minority investor receives a fixed price at closing, along with a carried (non-equity) interest based on the company’s future financial performance. This structure thus provides for the investor to receive somewhat less than the full amount of the valuation price at closing, but with the potential to receive an additional amount greater than the valuation price based on the company’s future performance.

As an example, the valuation report values the minority investor’s interest at $3 million, which the majority owner considers excessive. The parties therefore agree that the investor will be paid $2.25 million at closing (25% less than the valuation report) for its interest, but the minority investor also receives a contractual right to be paid 3% of the total revenues that are generated by the company over the next three years. If the company has generated at least $10 million in revenue during each of the past three years, this might be a win-win scenario, as applying to this formula would generate at least $900,000 in a further payment for the investor if the company continued to generate annual revenues of at least that amount over the next three years. 

Obviously, the potential variety of formulas that might work is infinite, but this type of win-win negotiating allows for the majority owner to push back on the total amount paid at closing to the investor while also providing the minority investor with further upside. To make this proposal work, the majority owner may need to establish a floor for the future payment, i.e., provide the investor with a guaranteed payment of at least a certain amount in the future so that the investor is not taking on a totally unprotected gamble. 

Arbitration Limited to Resolution of Valuation Dispute

The third practical option to consider involves a targeted resolution process. The manner in which an arbitration is conducted is subject to contract, so rather than engaging in protracted negotiations over a lengthy period, the parties could agree to submit their valuation dispute to a prompt one-day arbitration. This is simple and straightforward as the parties should not need to obtain any discovery if they have all of the financial information necessary for the valuation. The scope of the arbitration can be limited solely to resolving the amount to be paid for the purchase of the minority owner’s interest in the company. In short, the parties submit their valuation reports and testimony from the valuation experts to explain their opinions, and the arbitrator (or panel) issues a final, binding opinion.

Considerations That Apply to Valuation Conflicts

Whatever path the parties decide to go down, they need to set guidelines that will help limit the disputes between them regarding the valuation and the ultimate cost of achieving their business divorce.  The procedure for dealing with valuation is generally set forth in some form of a buy-sell agreement. 

First, the parties need to set firm deadlines for issuing all of the required valuation reports. Second, they need to provide a mechanism and timetable for the minority investor to obtain access to the financial information that is necessary to determine the value of the investor’s interest, which the investor will likely provide to its own independent valuation expert. Third, they need to decide who pays the costs for the experts. Often, the company will prepare the first valuation at its sole cost, but if the minority investor then wants to secure a separate valuation, that comes at the expense of the investor. If there is a third valuation, the cost of the third valuation expert is shared equally by the parties. Finally, if there are disputes over the valuation, this is where the arbitration provision will specify how any/all disputes will be resolved promptly and efficiently.

Conclusion

The business divorce process can be frustrating, particularly when valuation disputes arise, but these conflicts can be anticipated, and they should not derail the parties’ efforts to achieve their desired business separation. The key is to be proactive.  Business partners need to agree in advance on an approach to valuation before disputes take hold, because once they are in conflict, it will be extremely difficult for them to reach consensus on any form of resolution. If the partners plan ahead and implement one of the practical paths to resolution reviewed above — averaging expert reports, adopting a base value/earn out structure, or implementing a targeted arbitration — they will have a much better chance to avoid singing the valuation blues. 

Listen to this post

Business divorces often involve turbulence as business partners go through this process. But partners who plan ahead can navigate through their business divorce to avoid capsizing the company or frustrating their personal business objectives. This type of planning requires each of the partners to (1) review and understand the terms of the agreements in place that govern their separation, (2) develop a real world, objective appraisal of the value of the interest that is being transferred, and (3) consider the business issues that may arise for both sides after the divorce, e.g., future competition by the departing minority partner. 

The change and separation involved in a business divorce can be hard for all parties, but anticipating the issues that are likely to arise provides a compass for partners that will help them chart a predictable course to smooth sailing on the other side of the transaction. In the following post, we will consider the goal of becoming prepared for a business divorce from the perspective of both the majority owner purchasing the interest of the departing partner and the minority investor whose ownership interest is being purchased.

Step 1: Closely Review the Written Agreements That Apply to the Business Divorce

The first step in approaching any business divorce is to know the rules of the game.

The Majority Owner

The majority owner needs to understand whether a buy-sell agreement exists that allows the owner to redeem the interest held by the minority investor or that will permit the investor to demand a buyout. If this type of agreement is in place, it governs the manner in which either party can exercise a call or put option that will result in a redemption of the minority interest. In either case, the agreement will address how the value of the minority interest is determined, and it will also set forth the payment terms after the value of the interest is determined.

In the absence of a buy-sell agreement, the majority owner does not have the right to trigger a repurchase of the minority interest and therefore has to negotiate with the investor to find terms that are acceptable. If the investor demands payment of an excessive amount or insists on including unreasonable terms, it is likely that a buyout will not take place in the near term. In this scenario, the majority owner will have to consider taking actions that cut off all further economic benefits to the investor before a liquidity event takes place that cashes out the investor’s interest in the business. This is known as a freeze out or squeeze out situation.

Minority Investor

The minority investor also needs to determine whether a buy-sell agreement exists that permits the majority owner to exercise a call right to redeem the minority interest or that authorizes the investor to exercise a put right, which requires the majority owner to purchase the investor’s interest. The terms of the buy-sell agreement are therefore critical to fully appreciate before a business divorce is considered.

If no buy-sell agreement is in place, the good news is that the minority investor cannot be forced out of the business by the majority owner on terms the investor considers unfavorable.  The bad news, however, is that the investor cannot require the majority owner to purchase the investor’s interest for the price desired by the investor if the investor wants to exit the business for any reasons. Without a buy-sell agreement, the minority investor must assess whether leverage can be obtained that will bring the majority owner to the table to discuss a buyout. This leverage may be available if the majority owner has engaged in self-dealing in managing the business. The bottom line is that the minority investor needs to evaluate the majority owner’s conduct to determine whether any misconduct by the owner will provide some leverage that the investor can apply to facilitate a buyout discussion with the owner.

Step 2: Develop a Real World (Objective) Assessment of Value

The next critical step for the partners to prepare for a business divorce is to understand the actual fair market value of the minority interest that will be changing hands.

The Majority Owner

If a buy-sell agreement exists, it will specify the method the parties must use to determine the value of the minority investor’s interest that is being purchased in the business divorce. If no buy-sell agreement exists, the majority owner will need to negotiate the purchase price directly with the minority investor. At the outset, the majority owner typically directs the company to retain an independent valuation expert to determine an objective value of the minority interest that the parties can use as the basis for their negotiation of the purchase price.

Under these circumstances, however, the majority owner should expect the minority investor to demand payment of a premium for the minority interest, because the investor has no contractual duty to sell. As long as the minority investor’s proposed purchase price is within the realm of reason, the majority owner who wants to purchase the interest should seriously consider paying a premium of some amount, because (1) the owner will secure the return of the investor’s equity in a manner that avoids a prolonged exit, (2) the purchase of the investor’s interest will avoid incurring any legal fees dealing with claims or litigation by the investor, and (3) the owner will capture all future appreciation in the value of the business.  

Minority Investor

As noted above, the minority investor cannot renegotiate the purchase price for his or her interest in the company if a buy-sell agreement exists that dictates the process for determining the value of the investor’s interest. When there is no buy-sell agreement, the minority investor can choose to hold out to secure a purchase price that reflects full market value of the investor’s interest. As a cautionary note, however, the majority owner has no contractual obligation to purchase the investor’s interest in the absence of a buy-sell agreement. Therefore, if the investor drives too hard a bargain in the negotiations, the owner may simply walk away from buyout discussions and also terminate all distributions or dividends to the investor. As a result, the investor who insists on receiving top dollar for his or her minority share of the business, must be prepared to wait a very long time to be in a position to monetize his or her interest if the majority owner is not prepared to pay what the investor perceives as full value for the minority interest.   

Step 3: Consider Post-Separation Business Issues

The final step in preparing for a business divorce concerns the need to consider what will take place after the business divorce has been completed.

The Majority Owner

For the majority owner, the planning process needs to address how the company will operate after the minority investor departs, which is more of a significant issue if the investor had an active role in the business. If so, the majority owner will need to take steps to arrange for a smooth transition of all duties previously handled by the investor relating to customers, vendors and the supervision of other company employees.

The majority owner will also want to ensure that the departing minority investor does not create problems for the company after leaving. First, the majority owner will want to retrieve all confidential information that is held by the investor as part of the business divorce. Second, the majority owner needs to consider whether to request the minority investor accept restrictive covenants that prevent the investor from competing with the company and from soliciting its employees for some period of time.

If the majority owner believes these restrictions on the investor are necessary, the owner will likely have to pay additional consideration to obtain them in addition to the purchase price that is paid to the investor for his interest in the business. The majority owner should require that this additional amount be paid to the minority investor over time so that the unpaid amounts can be withheld if the investor fails to comply with the restrictive covenants during the period that they remain in force.

Minority Investor

The minority investor does not need to retain confidential information that belongs to the company, but the investor does need to decide to what extent she has any interest in remaining active in the same industry as the company. If the investor wants to remain active in the industry in some capacity, the investor needs to make sure that complete clarity is reached regarding the exact scope of any restrictive covenants that the owner seeks to impose on the investor’s future conduct. The extent of the restrictive covenants will also impact the amount that the minority investor seeks as additional compensation for accepting these new restrictions. 

But, if the minority investor is receiving a fair price from the majority owner for the purchase of the investor’s minority ownership interest in the business, the investor should be wary of overplaying his or her hand. If the minority investor seeks too much compensation from the majority owner in payment for the restrictive covenants that are requested by the owner, the investor may cause the entire deal to fall through and lose the opportunity to monetize the minority  interest in the business for a reasonable price.

Conclusion

Most business divorces include some rough waters to cross for the partners, but if they plan ahead, they can successfully weather the storm. This advance planning requires the partners to (1) develop a keen understanding of their contract rights based on the terms of the agreements in place, (2) determine the objective, fair market value of the minority interest that is being sold in the business divorce, and (3) consider the business goals of the other partner after the business divorce has been completed.

This careful planning by business partners will enable them to navigate their way through a business divorce in a manner that saves them time and expense, preserves their relationship, and also avoids running the business into rocky shoals.