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When divorcing couples hold ownership interests in private companies as part of their marital estate, they will have to address a number of business issues related to these interests in their divorce settlement. Planning ahead to address these issues may help to avoid surprises and also lead to a less contentious discussion of their settlement options. This post, therefore, focuses on critical issues that divorcing couples will need to address in their divorce settlement negotiations if they have ownership interests in private companies.

Valuing a Private Company Interest Requires Current, Detailed Information

By definition, the stock of private companies is not traded in public markets. As a result, the process of determining the current market value of a private company will require assistance from an experienced business valuation expert. To provide a valuation report, the expert will need to analyze the company’s financial performance, review sales transactions of similar companies that have recently taken place in the industry and determine the value multiple used in the industry. This analysis, and the number of variables the expert is required to consider, can lead to wide variances in values when the spouses retain opposing experts.

Given the potential for a wide divergence in valuation opinions reached by the experts, spouses going through a divorce that involves private company ownership are advised to consider three things. First, the spouses will want to take steps to obtain the most up-to-date financial information regarding the company to provide to their experts because valuations can fluctuate greatly over time. Second, the scope of the information provided to the experts should be fairly broad and include documents that reflect recent valuations, offers for purchase made to the business, and previous sales of company stock or units. Our previous post focused on this specific issue. 

Finally, if one spouse is transferring his or her interest in the business to the other spouse in the settlement, the transferring spouse may want to negotiate to include a lookback provision in the settlement agreement. This provision provides that if the business is sold within a set period after the divorce settlement (often within a year) for a price higher than the value used in the settlement, the transferring spouse will receive a “true up” payment. The acquiring spouse is not required to agree to this lookback provision but may be willing to do so as part of the negotiations. 

Personal Goodwill May Play a Major Factor in Valuation

Another important issue related to the valuation of a business is the role that personal goodwill plays in the divorce setting. Personal goodwill is defined as:

“… [an] intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”

The International Glossary of Business Valuation Terms

In the family law context, personal goodwill that results from a business, which is known as enterprise goodwill, can be divided between the spouses in a divorce. But personal goodwill that belongs to an individual owner/operator in the business is not divisible, and instead, it is the separate property of the spouse to whom it belongs.

“Personal goodwill is the goodwill that is attributable to an individual’s skills, abilities,    and reputation.”

See Texas Pattern Jury Charge, 203.2. Personal goodwill arises in personal services businesses, such as law firms, accounting or medical practices, sales companies or financial services firms. The percentage of personal goodwill can be such a large part of the total value of the business that it is often one of the most hotly contested issues in a divorce proceeding. Indeed, in some cases, personal goodwill can amount to 60% or more of the total value of the business. 

For this reason, personal goodwill tends to play an outsize role in the divorce negotiations as it may substantially reduce the value of the business to be divided in the divorce proceeding.  The spouse who is subject to the application of the discount based on the personal goodwill determination may therefore want to consider the following factors before accepting the opposing expert’s personal goodwill discount. Personal goodwill is a function of reputation and prominence, and a number of areas that are discussed below can be investigated to determine if this discount should be as robust as may be claimed. 

  • First, most companies have a succession plan, and it should be obtained and analyzed as it may show that the spouse who is claiming the goodwill discount is not viewed as being crucial to the company or its succession plan.
  • Second, whether the company maintains a key life insurance policy on the spouse claiming the discount should be determined. The absence of this policy suggests the company does not consider the spouse claiming the discount to be invaluable to the business.
  • Third, the total headcount of the business should be examined. The more people who work at the business, the more an argument can be made that the value of the business is attributable to others at the company, and not as much to the spouse who is claiming the discount. 
  • Finally, the expert for the spouse challenging the goodwill discount will need to evaluate the connection of the company’s clients to the spouse who is claiming the discount. It may be that many or most of the company’s clients are not tied to the spouse, and that the company’s reputation is largely independent of the personal goodwill of the spouse. 

The issues noted above are for the valuation expert to address, but the spouse who is challenging the goodwill discount may have knowledge about the business that will impact the analysis that applies to the calculation of the discount.

The Transfer of a Spousal Ownership Interest Raises Business Issues

In a previous post we reviewed key business issues that often arise when a spouse’s interest in a company is transferred to the other spouse as part of the divorce settlement. In this scenario, we refer to the spouse who is acquiring the full interest in the business as the acquiring spouse, and the spouse who is transferring the business interest is referred to as the transferring spouse.

The following important concerns should be part of the parties’ negotiations and final settlement documents:

  • The parties should make it clear in the divorce settlement that the transferring spouse does not retain any ownership interest or other rights of any kind after the divorce from or related to the business. This includes a transfer of all rights to receive dividends, distributions, royalties, reimbursements or payments of any kind directly from or related in any way to the business.
  • The transferring spouse should obtain a full, broad release not just from the acquiring spouse, but also from the company to prevent the acquiring spouse from directing the company to pursue any claims of its own after the divorce settlement has been completed.
  • The transferring spouse should also seek an indemnity from the business in the divorce for any claims that are made by third parties after the divorce is final. This indemnity is particularly necessary when the transferring spouse previously worked in the business for some period.
  • Finally, the acquiring spouse should consider whether it is necessary to obtain a noncompete restriction from the transferring spouse. If there is any potential for the transferring spouse to compete against the business after the divorce, this noncompete restriction may be valuable, but it will also likely require that the acquiring spouse provide some consideration to the transferring spouse. Even if a noncompete restriction is not obtained, the acquiring spouse should require the transferring spouse to sign a confidentiality agreement.

Conclusion

In some divorces, the business issues are the most difficult ones to resolve. This is more often the case when the couples have accumulated ownership interests in private companies during the marriage, and these interests must be divided as part of the divorce proceeding. Once it becomes clear that a marital divorce is going to take place, planning ahead to address these business issues will help lessen conflicts and allow for the necessary negotiations to take place relating to the ownership of interests in private companies. This type of planning includes gathering financial and governance records related to the business, meeting with the business valuation expert to discuss the valuation process, and discussing with counsel the key business terms that will be included in the final divorce settlement.

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Hindsight can be a wonderful thing, especially if hard-earned lessons are adopted by others who are willing to learn from past mistakes. When private company owners and investors share with me some of the wisdom they have gained from their past dealings with business partners, they often cite the same three mistakes they made in relationships with their partners. In summary, these are (1) choosing difficult partners, (2) failing to enter into well-crafted buy-sell agreements with their partners at the outset, and (3) doling out ownership interests (equity) in the business too freely to new investors.

Avoiding Bad Apple Business Partners

The importance of picking good business partners cannot be overstated. Problems with a company’s services or products can be fixed over time, but a partner who is dysfunctional or who is hostile to the business can create conflicts and distractions that ultimately destroy the company. Of course, no one agrees to enter into business with other partners they believe to be dysfunctional. Instead, people become partners with others optimistically and with a sense that their interests and business objectives are aligned. It is only later they are dumbfounded to learn that their partners are selfish, inflexible, disruptive, or worse, unethical and uncontrollable.

Unfortunately, there is no fool-proof test to apply that will guaranty that a new business partner will be a great longtime fit for the business. But there are two approaches to consider before going into business with someone new, which will lessen the chance of picking a bad business partner. These two approaches focus on, first, checking known attributes of the potential partner and, second, avoiding serious red flags discovered as part of a due diligence process.

The first approach focuses on four aspects of the potential partner, which can be gleaned from this due diligence. The first aspect is experience: Does the potential new partner have a track record of success at other companies, and is he or she well regarded by former employees? Or does the potential partner’s past reflect a string of problem companies and fraught relationships with former employees? The second aspect is flexibility. Change is a constant in business, and a partner who is rigid and resistant to change is likely to be a difficult partner. The third aspect is reliability. Success happens when partners show up consistently and reliably and demonstrate accountability. The final quality may be the most important: integrity. Partners need to be open, honest, and loyal to each other – the opposite is not just bad for relationships, but detrimental to the company. It is a challenge to determine whether a potential partner has these qualities, but a discussion of these qualities should be discussed by the partners. A process should take place where some of the potential partner’s former colleagues are asked if this person exhibits these qualities or whether there are concerns in these areas.

The second approach is the red flags test. Every potential new partner should be subject to a formal background check, which also needs to include a credit report. In addition, each potential partner should be asked about all past and pending litigation in which they have ever been a party, as well as whether they ever filed for bankruptcy. The time and expense of conducting these tests and background checks are well worth it, and a potential partner who balks at providing this information is raising a red flag right at the outset. 

Get a Business Prenup in Place, Adopt a Buy-Sell Agreement

We will not delve deeply into buy-sell agreements here as we have discussed them in the past, and you can read about them in previous posts here and here. Suffice it to say that it is not uncommon for business partners to become at odds, and when their conflicts are irreconcilable, they will want/need a business divorce. If the partners have wisely put a partner exit plan in place, they will have a buy-sell agreement to follow that governs the process for the partner’s exit, which will avoid or limit headaches, heartache and expense.

The buy-sell agreement should cover (1) when the agreement can be triggered by the parties, (2) how the ownership interest of the departing partner will be valued, (3) the terms for payment of the purchase price to the departing partner, and (4) what happens in the event of a default in the payment of the purchase price.  

Retaining Majority Control Over the Business

The final mistake takes place when the company’s founder needs to secure additional capital to grow the business. To obtain this growth capital, the founder will issue stock or units to new investors, which dilutes the founder’s ownership percentage. As the investments mount and the extent of the dilution increases, the majority of the business may become controlled by the new investors. I have represented multiple founders of private companies who were later removed by the new investors from any role in the continued management of the company they had created. This undesirable outcome is likely be a source of significant disappointment for the founder, as well as bad for the business.

Growing companies will need to obtain capital, but that does not mean that the founder needs to cede control of the business to new investors. The founder can negotiate to ensure that he or she remains in control by requiring the investors to accept a minority ownership share. The tradeoff is that this will likely reduce the types of investors who are willing to invest in the company on this basis as many private equity firms will not invest in a company if they do not secure control over the business when they make their investment.

Even if the founder is willing to accept a loss of control over the business to obtain the new investment in the company, there are some fallback positions that the founder can take. The founder should consult with experienced counsel to evaluate the available options, which will enable the founder to maintain continued rights regarding the management of the business while also protecting the founder’s ongoing economic stake in the company.

Conclusion

It is often said that those who do not learn from history are doomed to repeat it. In the private company space, some of the lessons to be learned from owners and investors include (1) taking the time and effort to conduct due diligence regarding potential business partners to avoid being stuck with bad partners; (2) negotiating and adopting a buy-sell agreement at the time the new partner invests in the business to ensure that a business divorce can take place as necessary in the future; and (3) for company founders, if possible, seeking to avoid growing the business in a way that turns over control of the company to new investors. Taking these steps will help to avoid, or at least limit, major problems in the future with business partners. 

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As a business trial lawyer representing private company owners and investors in business divorce disputes and civil litigation for many years, my experience teaches that business partners should approach litigation with caution. Specifically, and for the reasons discussed in this post, I would advise business partners to sue their business partners only when it is required to stop wrongdoing or when a partner’s contract rights have been clearly violated.

First, business divorce lawsuits are expensive to litigate because the disputes are fact intensive, the value of the business will be likely be the subject of intense conflict, and a cadre of experts who need to be retained will add to the fees. Second, these cases are rarely resolved by motion practice, which means the litigation will likely go on for two years (or longer) before trial and eventual appeals. Third, courts in Texas have limited powers, and the verdict rendered by the jury at trial may not resolve the conflict. Specifically, Texas trial courts are not authorized to remove a corrupt partner from the business or order the company or majority owner to buy the interest held by a minority partner in the business. Finally, in many cases, the partner who is sued will respond by filing counterclaims, and as a result, the business partner who launches the lawsuit will be required to prosecute and also defend claims in litigation.

For these reasons, a business partner who is considering filing suit against other partners should consider whether there are alternatives to litigation that would resolve the conflict. If the ultimate conclusion is that litigation is necessary, the partner pursuing the action should evaluate what specific goals the litigation is designed to achieve, and work with trial counsel to develop a realistic budget and timetable for achieving those goals. 

Alternatives to Litigation

When business partners are in conflict about their views regarding the operation of the business, they may be unable reach consensus on a path that resolves their differences, but they may agree that a business divorce is their best option. The issue then becomes whether they can agree on the terms for a partner buyout. This is where a dispute over the company’s valuation (and the resulting buyout price) may create a roadblock that precludes a business divorce from taking place. This situation arises when the parties have not entered into a buy-sell agreement, and thus the minority investor cannot require either the owner or the company to purchase the minority interest via the terms of the buy-sell agreement.

When the partners reach an impasse in buyout negotiations, my suggestion is for them to consider participating in a pre-suit mediation. For the majority owner, the mediation provides the opportunity to secure a buyout of the minority investor without becoming embroiled in years of litigation. The majority owner can attempt to secure this buyout through a variety of creative strategies. As just one example, the majority owner may be able to secure an agreement to buy some, but not all, of the interest that is held by the minority investor, with the remaining interest converted into a contractual obligation that requires the owner to make a further payment tied to the future performance of the business. Unless the investor is demanding an exorbitant price for the minority interest, the majority owner should strive to secure a buyout that ends the distraction the investor has created, avoids the expense of litigation, and regains the shares for the company, which then become available for sale to another party.

From the minority investor’s perspective, a pre-suit mediation is an attempt to negotiate a reasonable sale price for the minority interest without devoting time and expense to litigation. Moreover, the investor may not even have the remedy of a buyout available in the lawsuit, so the mediation may offer the only path to secure a buyout of the investor’s minority interest. A sober assessment from the investor’s perspective includes accepting the reality that the investor will not be receiving any additional salary/bonuses or distributions from the company as these will all be eliminated by the majority owner. The bottom line is that the investor should be incentivized to strike a deal for the sale of its minority interest on reasonable market terms. 

Determine Whether Non-Litigation Options Exist

If the pre-suit mediation is not held or if the mediation is not successful, each side should evaluate if there are any non-litigation options available. The majority owner should be scrutinizing the governance documents to determine if they are subject to amendment. Under the Texas Business Organizations Code, unanimous consent is required to amend corporate bylaws and LLC agreements, but the owners can opt to give a bare majority or a super majority the right to amend. Where amendment is possible, the majority owner could elect to adopt a new buy-sell provision that authorizes the company to buy the interest held by the minority investor. Making these changes may result in litigation by the investor, but the majority should be on solid ground if the changes are consistent with the governance documents. 

For the minority investor, it may be possible to sell the minority interest to an interested third-party buyer. In all likelihood, the majority owner will have a right of first refusal, which will enable the owner to match any offer that is made to the minority investor, but which may lessen the investor’s ability to secure a purchase offer on favorable terms. The investor should, however, at least investigate whether a market exists for the minority interest if the majority owner is only offering to buy the interest for a low-ball price. The investor may find that other partners in the business will pay a price higher than what the majority owner offered for the minority interest.

In addition, the minority investor may also want to exercise the right to require the company to provide access to books and records if the majority owner has engaged in any type of self-dealing conduct. Highlighting misconduct by the majority owner is the right thing to do because it will stop the majority owner from continuing to harm the company. The process of investigating the majority owner’s conduct may also help to incentivize the owner to focus on negotiating a reasonable buyout of the minority investor’s interest.           

Assess the Strength of Claims and Remedies Available, Including Legal Fees

Certainly there are cases where litigation is not just necessary, but essential, which is the case when a business partner is engaging in misconduct that is harmful to the business. In these cases, the final step before filing suit against a partner is to engage in a pre-suit evaluation with assistance from experienced trial counsel. This process will include evaluating the merits of the claims, analyzing what remedies are available – including whether there are claims that provide for recovery of legal fees – and finally, developing an understanding of the legal budget and an estimate of the timetable for getting to trial. 

Regarding remedies, the majority owner may desire to oust the minority investor(s) from the business, but that is not likely to be a remedy the court can award even if the owner is able to successfully prove the claims alleged in the lawsuit. Similarly, if the minority investor is focused on securing a buyout, the court is not permitted in most cases to grant an order for the company (or majority owner) to purchase the shares or interest held by the minority investor. The court can award monetary damages to the minority investor to recover for the harm the company has suffered based on the majority owner’s breach of a fiduciary duty, but Texas courts have never awarded a buyout remedy to an investor based on a majority owner’s breach of fiduciary duty.

Conclusion

Civil litigation can be a powerful tool when one business partner sues another, but this litigation typically involves an expensive and lengthy process, which is unlikely to be positive for the underlying business. For these reasons, business partners are wise to consider whether there are options available that would allow them to achieve their business objectives without filing suit. In many cases, a pre-suit mediation is advisable where the parties can meet and attempt to negotiate mutually acceptable terms for a business divorce.

In those cases where litigation is necessary, the party filing the suit should evaluate the specific claims to be asserted in the case against the other partner(s), the remedies that will be available for those claims in the suit, and the litigation budget for pursuing them. The final point is that the business partner who is filing suit should consider what steps can be taken to mitigate any harm to the business once the suit becomes public. This includes developing messaging strategies to communicate with the company’s employees, clients and key vendors to provide assurances the litigation will not negatively impact the business.