Episode 87 Transcript: Business Interests in Divorce

In today’s episode, I wanted to talk about how business interests are handled in a divorce. I want to start off by just explaining what am I talking about when I say business interest?

There really is a range of scenarios that that term and concept includes. On the one hand, you can have one or both spouses who have created a business during the marriage that is their primary and fulltime job. Let’s say they own 100% of the business. That’s on one end of the spectrum. At the other end of the spectrum might be that you had a 1% or 0.5% ownership interest in some business venture that you invested in a couple of years ago during the marriage, but that you have no active role in whatsoever. It was just an alternative way to invest some capital, in exchange for which you have an ownership stake in a business entity but you haven’t worked on it during the marriage. It is definitely not your fulltime job.

Then, of course, business interests can fall anywhere in between those two poles. Most often, they will either be a spouse’s primary endeavor, their fulltime job, what they work on. Often, the spouse will have a pretty large ownership interest of the business, unless the business is quite a large business or potentially a startup where they only own, say, 5% of it, but it is certainly their fulltime job. Then it could also be that neither spouse has any involvement in the business. They just chose to invest marital assets in another business entity as an investment opportunity that they continue to own a stake in.

The first step when you are trying to figure out how to handle a business in the context of your divorce is to determine whether or not the business interest itself is what we would call marital or subject to division in a divorce. Generally speaking, if the business was created during the marriage or you really grew the value of the business during the marriage it is considered marital, and its value is up for division in your divorce. What happens then? Let’s say that you determine it’s very clear. The business was created during the marriage. This is a marital business, even though in the example I’m thinking of, let’s say it’s 100% in one spouse’s name. If created during the marriage, it’s marital. It’s to be handled and divided in a divorce.

So, what do we do then? Assuming the business is marital, as with every other marital asset, we need to figure out the value of the marital interest in the business. Unfortunately, unlike, for instance, your brokerage account or your retirement account, your business doesn’t come with an easy account statement that just tells you, “This is what the business is worth as of today, as of the end of the quarter.” Instead, what’s far more common is that parties will retain a neutral appraiser to value the business interest to say, “Look, I have researched the business. I’ve gone through their books and records. I have looked at comparables in the industry. I’ve interviewed the owner or owners and the CPA to understand the makeup of the business, the client base, etc.” A whole host of things. “And I determined that the business is worth this much.” That’s certainly the most common way to come up with the value of a business.

That being said, many clients, especially many business owners, will feel like, in some ways, that number does not mean a lot to them because really what their business is worth is whatever they’re able to sell it for. So having a neutral appraised value can feel almost arbitrary sometimes to the business owner. That said, unfortunately, when it comes to trying to assign a value to the asset of the business, we don’t have a lot of better approaches, so we rely on an appraisal of the business value. Then what happens from there? Once the appraisal is completed, you will receive a report from the appraiser setting forth what they have determined the business value to be. From there, you have to come to an agreement about whether and how you’re going to distribute that value between you. You have a lot of options there.

In a very simple example, if for instance, it were determined that, let’s say, the wife’s business which she owns 100% of, created during the marriage, was worth a million dollars, and the parties had many other liquid assets available to them so that the wife could easily transfer to the husband an amount of money that would compensate him for his interest in the business, essentially to buy the husband out of the business. That’s one approach you can take. It does require the titled business owner to have accessible to them enough capital to buy out their spouse’s marital interest in the business. For many people, the business interest may be by far the most valuable asset that they have in their marriage, and they don’t have liquid assets available to compensate the non-titled, the non-business owner spouse for their interest in the business.

What else can you do if that’s the case? Well, a second option that’s also common in certain situations is you can transfer the ownership stake in part to the non-titled spouse. That depends on a lot of different things being in place. First of all, typically, if you do not own the entire business or have a controlling stake in the business, the other owners of the business may well not be open to the idea of the non-business owner spouse now being an actual owner of the business. I should say, being an owner of the business does not necessarily mean, for instance, if a portion of shares in the business is transferred to the non-business owner spouse doesn’t necessarily mean that they get all the voting rights associated with their share.

There are many different ways to structure the transfer of ownership directly to a spouse, but it does require either (a) that the organizing documents of the business, the documents that regulate the operation of the business permit the transfer of ownership to someone other than the titled spouse, or (b) if that’s not currently permitted, that the titled spouse, the business owner spouse has enough of a controlling stake that he or she can change those documents in a legitimate way to allow for the transfer of an ownership stake directly to the non-owner spouse. If you’re able to do that, that certainly solves the problem of (a) needing to even agree on a value of the business because you’re just transferring a percentage of ownership, and (b) it solves the problem of needing to come up with liquid capital sufficient to transfer to the non-owner spouse, to buy them out of their stake in the business. In certain situations, that can work very well.

The other thing, or almost like a variation on that, that people may agree to in the event they would like to transfer ownership to a spouse but they’re not permitted to do that, the business governing documents will not allow that, doesn’t allow the transfer of ownership without, say, approval of the board, and there’s no way the board is going to approve a transfer of ownership to the spouse. What you can do is have your agreement say that the business owner spouse will retain all of the shares in the business, the entire percentage ownership that he or she already had, but that a portion of that ownership (and you would designate what portion, whether it be by percentage or number of shares), a portion of that ownership, in fact, belongs to the non-titled spouse, and the business owner spouse is just holding that on the non-titled spouse’s behalf.

If that’s the case, you would need to come to agreements about under what circumstances can the non-titled spouse direct the business owner spouse to transact with their share of the ownership. What freedoms and rights do they have to sell their share in the business? Is it only when a third party sale manifests? Could they sell to an outside third party investor on their own if the other business owners agreed to it? Basically, if the spouses are continuing to have an overlap in ownership in that neither has the non-titled spouse been bought out outright and thus has no claim over the business, nor does the non-titled spouse own outright, in his or her own name, shares in or a percentage of equity of the business, but it’s some hybrid in a way, which is that the business owner spouse is holding the other spouse’s ownership interests for them. You need to get very clear about what are the rights of the non-titled spouse vis-à-vis that asset which is legally theirs but is also controlled by the business owner spouse. And what are the constraints on that ownership, and what are the entitlements of that ownership?

In the context of a buyout, I did want to add just a little bit more color, a couple more details of things that you want to be thinking of. When you have determined the value of the business interest asset, you want to think about what percentage division of that asset feels appropriate to you. Business interests, at least in New York, are generally not divided 50/50. So you want to think about what percentage division feels appropriate here? If the asset is valued at a million dollars, are you looking for a 25% division of that asset to the non-titled spouse? A 40%? A 10%? That varies a lot based on the specific facts of your particular case

Also in the context of a buyout, if you don’t have the capital available upfront, well, it doesn’t necessarily mean that you can’t do a buyout. You may be able to structure a buyout over time. You may be able to say, “Well, I have this much in capital to transfer to you now. Over the next three or five or ten years, I’ll transfer the remaining amount to you, whatever we’ve determined that is your percentage entitlement to the business of the business value.” Then you want to think about, well, okay, if you’re transferring money over time, and the recipient spouse doesn’t have the benefit of having received that money and being able to invest that money, is there some kind of interest rate that you’re going to assign to the outstanding amount that’s owed to the recipient? How will that be calculated? Then, of course, you just want to clarify, over what period of time is this payback going to occur? So, what’s the buyout amount? Over what amount of time will it be paid to the recipient spouse? Will there be any kind of interest rate on the amount still outstanding, yet to be paid to the recipient spouse? In particular, if the payback timeline is on the longer side.

To add another piece of color with regard to the outright transfer of ownership or a portion of the ownership to the non-titled spouse, I spoke about the ability to transfer the shares. Are you legally permitted to under the governing documents of the business entity? There’s another consideration which is more of an optics consideration. If this is a business that has investors, that anticipates taking on future investors, you’ll want to think about how, if at all, it would impact the ability of the business to get future investment or the attractiveness of the business as an investment opportunity to future investors, if it’s clear that the business owner is going through a divorce, has gone through a divorce, and that the business owner’s ex-spouse is now a titled owner of the business. The answer may be, “Well, that’s going to be great because the ex-spouse is also a real leader in this industry, and so, total value add.” Or it may be, “You know what? That is not optimal from an optics perspective for the purposes of trying to look as good as we can to future investors.” So, maybe even though we can transfer shares outright to the non-titled spouse, maybe we don’t structure it in that way to optimize our chances of getting the best possible investment structure that we can in the future.

If you are agreeing to have the business owner spouse continue to hold for the other spouse their ownership share in the business, and that would be payable to the other spouse upon a sale, you also want to think about, as time goes on from the date of the divorce, a year, three years, five years, 10 years passes, and the business owner is continuing to work in the business and continuing to, in theory, build the value of the business, should that increase in value be shared by the ex-spouse? Conversely, if they are sharing the upside, then the assumption would be that they would also share in the downside, so that if the value of the business happened to go down and it were sold for 50% of what you thought it was worth at the time of the divorce, then that would impact, reduce by 50% the value that the non-titled spouse receives from the sale.

Finally, you want to clarify, try to get as much understanding as possible around the likelihood of future capital calls from investors, if there are anticipated to be any, and the consequence in terms of dilution of the non-titled spouse’s interest if the non-titled spouse does not have capital to invest in the business ongoing. You may not have perfect visibility as to what is going to happen in the future vis-à-vis that or what’s going to be needed with regard to investments of additional capital, but to the extent something is on the horizon, or it’s an inevitability, and you know there will be a capital call from investors and that the non-titled spouse, if he or she has retained, let’s say, 10% of the business, will be called upon to pony up x amount of dollars as a future investment, that’s something you want to make sure that person is as aware of and prepared for as possible and that they understand what the consequence is if they’re not able to do that, which they may not be able to be. Then do they understand what happens with the dilution of their ownership in their interest as a consequence of that?

One final point I want to make is that in a situation where the business interest is really the owner spouse’s main, often only, source of income and is really being relied on to support the family, there’s a concept that recognizes the tie between the value of the business and the business owner’s ability to contribute to the finances of the family. Specifically in New York, if the business owner’s income or part of the business owner’s income was assessed and used in arriving at the calculation of value of the business, that portion of income that was used to calculate the value of the business is then excluded from conversations about spousal maintenance if the business owner spouse would have been the one to pay spousal maintenance to the non-business owner spouse. That may not be the law in your jurisdiction, but the thing you want to consider is this concept of double-dipping. If the business is being used to provide predominantly for the family, and that’s happening in the form of child support and spousal maintenance from the business owner to the non-business owner spouse, you want to think about, in that context, to what degree does it also feel fair to divide the asset of the business. I don’t mean that as it’s all or nothing kind of question, but I just mean you want to include that as part of your thinking about the business.

Now, if there’s no spousal maintenance between the spouses and no kids, so no child support, nothing to consider there, then you’re only talking about dividing the asset of the business. Often, the business is both an asset, but it is also essentially the fulltime job of, and provider of income for one of the spouses in the family and thus plays somewhat of a dual role in providing the income that allows the business owner spouse to support the family. I don’t mean primarily support the family because it may be that they’re an equal contributor or that the non-titled spouse contributes more to the family. Who knows? But the two are intertwined and you want to make sure that the overall agreement that you’re coming to in terms of how to divide the asset of the business, but then also how to look to the business owner for a contribution to spousal maintenance, if that’s relevant for you, for a contribution to child support, if that’s relevant for you, that those things make sense in a context together and that you are not handling them completely divorced from one another and without consideration of one another.

That was our episode on how to handle business interests in a divorce. I hope it was helpful for you. was helpful for you.

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