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Business divorces take place in all types of private companies, including those owned and operated by family members. But families that are willing to engage in thoughtful planning can head off some of the internal conflicts that lead to business divorces, and if the exit of a family member from the company does becomes unavoidable in the future, the proactive steps discussed here can limit the negative impacts the business and the family may otherwise have to confront. The effort by the family to avoid or limit the downsides of a business divorce begins by adopting a clear governance structure and also requires all owners to sign off on a business prenup that controls when a family member/owner departs from the business. 

Adopting a Clear Governance Structure: Start with an Experienced Board

Achieving success in a new business is a daunting challenge. As a result, the owners of new and emerging companies, including family businesses, tend to focus their attention on the steps to succeed in the marketplace and much less on steps to govern their company. This simple focus on launching the business may work for a time, but as the company grows, the family members will need to put a clear governance structure in place to avoid chaos and/or major conflicts that would otherwise derail their success.

There are two aspects to governance. First is the creation of a board and, second, is to appoint officers and then define their roles. For corporations and LLCs, the governance structure requires the owners to install a governing board or group of managers (we refer to this as a board for both types of entities). In creating the board, the business owners need to consider these critical components for effective governance: (1) the best boards bring solid experience in the industry to the table; (2) board meetings should be held both regularly and consistently to review the company’s performance; and (3) the board must be empowered to take the steps necessary to successfully manage the business. 

Regarding the last point – the scope of authority – the board needs to have clear authority to make the final, “buck stops here” type of decisions for the company, including (i) hiring and firing each of the company’s officers and determining how they are compensated; (ii) approving the company’s annual budget forecast; (iii) determining what amount of profits each quarter to distribute, if any, to the owners of the business; (iv) evaluating whether to approve extraordinary expenses not included in the annual budget; and, finally, (v) developing a succession plan for the company’s executive leadership in the future. The board should fully disclose its work and the results of its decisions to the board members in written minutes and resolutions. These board actions also need to be sent to all non-board members at least in a summary format.

In a family business, the board typically includes multiple family members, but having non-family members also serve on the board should be considered, provided that they are truly independent, i.e., the non-family member(s) on the board should not have business or family ties to other members of the board. More specifically, it is generally best not to include the in-laws of family members on the board as this defeats the purpose of seeking independence.

The Roles of Officers Must Be Clearly Defined

The second aspect of governing is to appoint officers of the company and to ensure that they know their expected roles in some detail. Failing to provide clear definition of leadership roles has created many conflicts in business, and not just in family-owned companies. The board should lead this effort because it is not just assigning duties by appointing people to serve as officers of the company, but it is also defining the scope of authority that is being granted to these officers to achieve their specific business objectives. 

The exercise of defining roles is so important to the business and to the people involved that it may be helpful to obtain input from outside management consultants. This is money well-spent, because leaders in business are best positioned to flourish when they know and understand the role they are expected to perform and have clear guidelines regarding their authority. When the roles of leaders are not clearly defined, however, turf battles will invariably break out, which will cause discord and dysfunction in the business that can lead to a business divorce.

The board should also be devising a succession plan for senior officers. Putting this plan in place provides the business with continuity, stability and a sense of purpose both internally and externally to customers and others. If the board fails to develop a leadership succession plan, that may lead to internal conflicts, lack of focus and a sense of instability. If employees, customers and third parties sense that the business has lost focus because a leadership change is coming, but there is no clear plan for the future, it can lead to employee turnover, loss of clients, and loss of prestige in the marketplace.  

Adopting a Business Pre-Nup for All Owners

We have written extensively about buy-sell agreements in previous posts, and this type of agreement is an important part of partner exit planning that is even more critical for family businesses. In short, all family members with a stake in the business should consider entering into a buy-sell agreement as part of the governance document that is reflected in a separate shareholder/owner agreement. This agreement protects the interests of both those with a majority interest in the company, as well as those who are minority owners.

For those with a majority interest in the business, it allows them to purchase the interests that are held by a minority owner based on the fair market value of the interest. For those with a minority interest in the company, it enables them to to secure a buyout of their ownership interest if they do decide to depart from the business. Thus, minority owners are not “stuck” and unable to sell what amounts to an illiquid interest they hold in the business, and they will have a contractual right to require that their interest be purchased by the company or by the majority owner of the business, and for a price based on its fair market value.

There are some issues that are particular to family businesses in regard to a buy-sell agreement, and these can be addressed in the shareholder agreement. For example, the minority owners may fear that they will be removed from the business against their will when they want to continue to maintain their interest in the company. This valid concern can be addressed by requiring that a minority interest can be redeemed only with “super-majority” vote, i.e., the minority interest can only be redeemed by a high percentage vote taken of the total ownership of the business and not by a bare majority. In the family business, this will require a high percentage of the family to vote to oust another family member from the business.

Similarly, minority owners may also fear they will be bought out and then a transaction will take place in a short time at a much more favorable valuation, i.e., they will miss out on a large upside. This concern can be mitigated by including what is called a “look back” provision in the shareholder agreement. This term provides that the minority owner will receive additional consideration if a sale of the company or even another stock sale takes place for a higher price within an agreed period of time (usually within a year) after the minority owner’s interest was redeemed. This provision permits the minority owner to receive the full increased sales price if another transaction takes place during the restricted period after the redemption.

On the other side of the equation, majority owners may be concerned that a group of family members who are minority owners may all chose to exit at the same time and demand a payout of their interest. This situation can also be addressed by limiting the amount that will be paid out in redemptions to minority owners in any single year based on the company’s available finances. In short, minority owner redemptions will not be permitted to cash strap the company. 

In sum, the benefit of a buy-sell agreement is that it provides a defined process for the exit of a partner from the business. The buy-sell agreement governs when a buyout can be triggered, how the interest will be valued, how the payment will be structured, and finally, how any disputes relating to the buyout will be resolved. The parties can choose to arbitrate any disputes, which will permit them to resolve their conflict more quickly and in a confidential manner. 

Conclusion

Business divorces may be a fact of life, but in the context of a family business, they can do harm to the business as well as to family relationships. Fortunately, some conflicts may be avoided and relationships may be preserved if the family members engage in advance planning.  If the family will install an experienced board, clearly define the roles of company officers, and actively participate in the governance of the company, they may be able to work through the challenges that arise in operating the business and avoid a business divorce entirely.

In the event that a family member wants to depart or is asked to depart by a majority of the other owners, this type of partner exit should not result in a harsh impact to the business or a major conflict in family dynamics. Instead, if the parties sign a buy-sell agreement, they will be able to chart a path setting forth when and how the partner’s exit will take place, which will include the method for determining the fair market value of the departing partner’s interest and the terms for the paying that value. Buy-sell agreements are not easily negotiated, but when the family goes through the hard work of putting them in place, everyone knows the rules that will govern if a business divorce does take place in the future. This will avoid a host of conflicts that might otherwise create problems for the business and fray family relationships.

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Entrepreneurs are incredibly devoted to the success of their business, but even a thriving company may be severely impacted by a high conflict marital divorce. When a couple decides to part ways, the ripple effects can extend beyond their personal lives and potentially jeopardize the business they worked so hard to build. Although the couple may have irreconcilable conflicts that require a divorce to take place, preserving the value of their business should be a mutual goal. While their marriage may not be salvageable, both spouses share an interest in maintaining the success (and the high value) of their company as they go through their divorce. 

The Cost of Business Disruption in Divorce Actions

When divorce proceedings become contentious, the business in which the marital estate has an ownership interest may experience negative effects as a spillover from the conflicts that take place during the divorce process. The potential adverse consequences to the business may include all of the following:

  • Decreased productivity due to owner distraction
  • Uncertainty and reduced morale among employees
  • Loss of clients and loss of new business opportunities
  • Substantially larger legal and professional fees
  • Possible forced sale or liquidation of the business

These adverse factors can significantly reduce the business’ value, which can negatively impact the financial outcome for both spouses in their divorce. The elephant in the room here may be a cynical view that is held by the spouse who is seeking to acquire the interest held by the other spouse in the business in the divorce settlement. That spouse may believe that having the business crater during the divorce will allow the interest to be purchased for a below-market value and then the business will snap back to its true value once the divorce becomes final.

This self-serving view does not square with reality, however, for the following reasons. First, if the spouses do not shield the business from the conflicts inherent in the divorce, the negative effects are likely to be long-lasting with employees, customers and others, some of whom may depart or decline to do business with the company after the divorce. Second, the company’s competitors will see the business as weakened by the divorce and exploit this time of weakness. If the company loses market position during the divorce, this loss may not be readily regained once the divorce has been completed. Finally, a spouse who presents the company as having a steep loss in value to secure a lowball purchase price in the divorce may be opening the door to other negative outcomes, i.e., unintended consequences. These could include a lender declaring an event of default based on the company’s poor financial condition, the divorce court awarding the business to the other spouse, dealing with a hostile takeover attempt launched by the other spouse either alone or with employees and/or other investors, or the business being required to liquidate as problems cited by the spouse seeking a low-ball purchase price spin out of control.

The takeaway here is that a spouse seeking to purchase the interest in the business held by the other spouse is better off purchasing that interest by structuring the payment based on the company’s true fair market value. This avoids creating the potential for long-term damage to the business. In addition to the factors noted above, the divorce also likely impacts third parties, as well as the spouses themselves. Forbes reports that of companies that have more than 500 employees, almost 87% of them are privately held. Of companies this size, many, if not most of them, have multiple owners. When a divorce has potential negative consequences for other partners in the business, the stakes become even higher, because the other partners do not want their business dragged into a marital dispute. This multi-faceted ownership structure adds another layer of urgency in securing a prompt and amicable resolution of the business issues in the couple’s divorce.

Charting a Path to a Win-Win Outcome

While the risks to the business are significant in any high-net-worth divorce, there are steps the divorcing couple can take to achieve a positive outcome for their business for their mutual benefit. This type of win-win resolution is possible when the spouses seek to achieve a divorce that preserves the value of the business by taking the approach outlined below.

  1. Prioritize Business Continuity: By maintaining the value of the business as their goal, this allows both parties to maximize their outcome. This requires the parties to keep the business running smoothly during the divorce, including by keeping matters related to the divorce as private as possible. While the spouses likely have serious issues with the other spouse that led to the divorce, these marital conflicts should not be shared with others who are active in the business, because it may disrupt the business. The message from the couple needs to be that they share a common desire to see the business continue to thrive during and after their divorce.
  2. Obtain Valuation Result Without Trial: While it would be ideal for the couple to retain just one neutral business valuation expert to determine the company’s fair market value, that is not likely in the real world. Invariably, each spouse will want to retain their own valuation expert, but if they allow a dispute over the value of the business to become a battle of the experts that goes all the way to trial, that will prolong the divorce at great expense and also provide financial information about the business to competitors during the divorce proceeding. To avoid this unwelcome outcome, the couple can consider other options. They could agree to allow their valuation experts to decide on a third expert to value the business and then average the amount of all three valuation reports, or they could allow the court to appoint a third valuation expert who considers the other two reports and issues a final, confidential valuation report to which they both agreed to be bound.
  3. Consider Creative Buyout Structure: To avoid a valuation fight that requires a full buyout upon settlement of the interest of one spouse, the couple could agree that one spouse will become the majority or the sole owner of the business, but the other spouse will retain either a minority equity interest or continued contract rights in the business that provide for the departing spouse to receive additional financial returns over time. This could involve the spouse who sells the interest in the business to receive:
    • An initial down payment
    • Additional installments paid over time
    • A profit or revenue-sharing arrangement, which is a form of earn out based on the future performance of the company
    • An option to sell the minority stake in the future – a put right that requires the majority owner to buy this minority stake when the option is exercised
  1. Protect Other Stakeholders: If there are other business partners in the company, they can be involved appropriately in discussions about the company’s future, but in a private manner that ensures continued confidentiality. This buy-in of other partners who will support the creative buyout structure of a spouse’s interest in the business could be crucial for the company’s continued success.
  2. Plan for Tax Implications: Work with tax professionals to structure the settlement in a way that minimizes tax burdens for both parties.
  3. Maintain Open Communication: Strive for transparency and regular communication throughout the process. This can help prevent misunderstandings and build trust.
  4. Focus on Long-Term Value: Rather than seeking short-term gains, the spouses should consider the long-term potential of the business and structure a purchase that provides for a fair return over a time that extends beyond the divorce. A thriving business after the divorce can provide ongoing benefits to both parties.
  5. Seek Experienced Legal Counsel: Finally, engage attorneys who are experienced in high-net-worth divorces involving the division of complex business assets. This type of expertise and creative problem-solving can be invaluable in achieving a win-win resolution. Now is not the time to retain counsel to handle their first rodeo.

The goal of these strategies is to achieve a divorce settlement that is less contentious, more prompt, and more cost-effective, which will preserve the value of the business for the benefit of both spouses. Taking a  collaborative approach in the divorce proceeding not only protects the assets for both spouses, but it can also reduce the emotional and financial toll of the divorce process.

Conclusion

A high-net-worth divorce that involves the transfer of business assets in a settlement is a complex exercise, but it does not have to destroy the company’s value. If the couple can focus on securing a realistic valuation of the business, explore creative buyout options for the purchase/transfer of the interest owned by one spouse in the company, and prioritize the continued profitability of the business, they can achieve an outcome that is a true win-win. This approach will preserve the value of their hard-earned assets, and also set the stage for the continued success of the business.  The continued vitality of the business may be important if the divorce settlement provides for both spouses to receive financial returns based on the company’s future performance.

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Fast-growing private companies are exciting to observe as outsiders, but on the inside the company founder has the challenge of securing enough capital to fuel the rapid growth of the business. The company’s continuous need for capital places the founder in the position of having to manage the company’s operations while at the same time engaging in perpetual fundraising efforts. And as new investors come on board, the founder will face significant pressure to cede control and also to reduce the founder’s ownership interest in the company because the equity that the new investors are acquiring in the business have to come from somewhere – namely, out of the founder’s hard-earned ownership interest. 

This is the founder’s dilemma: how to grow the business in way that does not require the founder to say goodbye to control of the “baby” the founder has birthed and grown? This post reviews a game plan that is designed to help founders thread this needle successfully in growing their businesses. At a minimum, founders should take proactive steps that prevent them from being kicked to the curb by new investors who seek to leave them with little to show for their efforts.

How Fast to Go – Haste May Not Be the Founder’s Friend

The pace at which the company grows is one of the founder’s most vexing challenges. On one hand, growing the company quickly creates energy and excitement, which brings momentum that will help keep the company ahead of its competitors. On the other hand, a fast growth rate is what generates the need for the founder to secure more capital than the business can produce on its own. But when the founder secures new investors to provide this additional capital, not only will it dilute the founder’s ownership stake, but the new investors may also seek to remove or substantially limit the founder’s control over the business at some point, including by terminating the founder’s status as both an officer and employee.

To avoid conflicts with investors, the founder may want to consider growing the business at a slower rate. If the founder adopts a more moderate rate of growth for the business, this may enable the company to cover the cost of its expansion from its own earnings or from third-party debt financings rather than from equity investments. The loans that the founder obtains will have to be paid back, of course, but banks and other lenders may be better business partners than new investors because lenders do not tell the company founder how to run the company or seek to remove the founder from the business. The cost of capital is frequently a determining factor when a found decides between debt and equity financing, in addition to whether or not the company then satisfies a lender’s credit requirements.

In short, founders need to weigh the pros and cons of a rapid growth strategy. Both approaches carry some amount of risk, because growing the company at a slow pace may cause it to fall behind other competitors in the marketplace. But if a slow growth approach does not harm the company’s business prospects, this approach may avoid the need for the founder to obtain new investors and new capital, and this will, in turn, allow the founder to maintain control over the company throughout its growth cycle. 

Don’t Get Bitten by the Helping Hand – Maintaining Control Is Key

The founder’s ability to secure new investments can seem like a godsend at the time, but the new investors may turn out to be wolves in sheep’s clothing. Investors who provide growth capital do so with the clear expectation of securing a very substantial return on their investment.  Therefore, if the company does not perform as expected, or fails to generate returns as quickly as desired, the investors may turn on the founder. In their minds, this is just the nature of business, and they will exercise their power to replace the founder with a president/CEO they consider more capable of delivering the financial results they are seeking. 

There is no free lunch for founders, and sophisticated investors will not provide capital to purchase an interest in a private company without securing the rights to exercise some measure of control over the business. But the founder, to the extent it is possible in the negotiations with new investors, should limit the terms demanded by these investors to avoid what amounts to immediately turning over the keys to the castle. The devil is in the details, but the following are some critical parameters:

  • Veto Rights – The founder’s ownership percentage in the company will likely be reduced as new investors purchase interests in the company, but the founder should retain voting rights that prevent certain key actions without the founder’s approval. This may require the company to agree that unanimous consent is required for certain actions, which gives the founder a veto right to approve/reject these actions. Some examples of the types of veto rights the founder should seek to obtain may include the right to approve the sale of the business, material changes being made to the company’s governance document, the issuance of new shares/units, removing a director or manager, or expanding the size of the board.
  • Board Seats – Regardless of the ownership percentage held by the founder in the company, the founder should be permitted to serve on the board or as a manager of the business. In addition, the founder may insist on being able to appoint at least one other board member or manager to serve on the board regardless of the amount of equity that is held by the founder in the company. This may not place the founder in control, but it will give the founder another, hopefully persuasive, voice at the table involved in the decision-making process by the board.
  • Governance – When new investors join the company, the founder may want to require that the business operate with a greater degree of formality. For example, the founder may want to require that board meetings be held regularly/frequently to ensure that everyone is on the same page as to how the business is performing. In addition, the founder may want to preclude the board from taking actions by less than unanimous written consent. This will require all decisions by the board to take place at actual meetings or by unanimous written consent rather than behind the scenes without the opportunity for the founder to participate.

The provisions discussed above will provide the founder with protections when new investors join the business. These are subject to negotiation with the investors, and investors may not choose to go forward in making the investment if they determine that the rights that they are obtaining are too limited. That may be a good thing, however, because new investors who show no deference to or confidence in the founder at the outset may be signaling that the founder will be on a short leash and subject to quick replacement.

When Forced to Say Goodbye, Make Sure It Counts (in Dollars and Cents)

The final critical issue the founder needs to address when new investors come into the company is the status of the founder’s continued ownership in the business. Investors may insist on being granted the right to remove the founder as CEO/president as a condition of making the investment. The founder may agree to accept this condition to secure the investment, but if the investors do exercise this right at some point in the future, the founder needs to ensure that the termination takes place in a way that enables the founder to realize at least some portion of the value that the founder has created in the business.

Specifically, the worst case scenario for a founder is to be removed from the company without receiving any payment and then be left on the sidelines hoping for some future liquidity event that pays the founder something for his or her ownership interest in the business. This dire situation can be avoided, however, if the founder insists on securing an employment agreement or requiring the company to adopt binding provisions that protect the founder’s interest when the new investors make their investment. Here are some specific protections for founders to consider:

  • Termination – The founder can insist that his or her removal can only take place on a showing of cause, i.e., improper conduct. Alternatively, if the founder does agree to be removed by new investors without cause, that type of removal should trigger the payment of a substantial severance payment to the founder. The founder may agree to serve in a consulting role after termination, but these terms will need to be spelled out, including the founder’s new duties and compensation rights.
  • Put Right – In addition to the severance payment, if the founder is removed without cause by the new investors, the founder needs to be permitted to sell some or all of the founder’s otherwise illiquid equity in the company at a price that is determined by a formal process the parties agree to in advance.  
  • Noncompetition Restrictions – The company and the new investors may insist that the founder be subject to a noncompete restriction after termination. This may be acceptable to the founder if the company makes a substantial severance payment to the founder at the time of termination, along with purchasing all the equity held by the founder. But if the severance payment is modest and the founder does not receive a full buyout of all equity, the founder will want to narrow the scope of the noncompete restriction as much as possible to permit the founder to pursue other, possibly competing, opportunities after the termination takes effect. 

Conclusion

Company founders seem to be faced with a no-win choice: They need to bring in new investors to provide funds that fuel the rapid growth of their business, but securing this influx of capital puts them in a danger zone. The founder may have to cede control over the business to the new investors who later decide to remove the founder from the business when they become displeased by the company’s performance. There is a win-win structure available here, however, that strikes a balance between the new investors’ goals and the founder’s objective of staying active in the business or in providing for an exit on favorable terms.

This game plan for the funder has a number of components, but the goal is to permit the founder to retain some measure of continued control over major decisions by the company. To secure the new investment, the founder may need to grant investors with the ultimate right to terminate the founder’s employment in the future. But the founder should negotiate to include a provision providing that, if this right is exercised, the founder will receive a severance payment and obtain a buyout upon exit of the founder’s interest in the company (at least in part). The takeaway is that the founder who secures additional capital is doing right by the business, but the founder also needs to look out for No. 1. When new investors are brought into the company, the founder needs to insist on including terms that, in the event of the founder’s ouster, provide a reasonable return for the blood, sweat and tears the founder has devoted to the business.