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Use of Shareholder Agreements (and Other Business Agreements) to Protect Closely Held Businesses from Marital Divorce

Based on:

The New Standard
Marriage/Divorce: Protecting Closely Held Businesses

By: Marguerite C. Smith

Maggie can be contacted at Maggie@flexxlaw.com


These materials (slightly adapted for the website are extracted from some handout materials from a recent seminar which I held for attorneys. Many of the answers to the questions posed to the attorneys (set out below) are in my book which can be obtained at the King County Law Library and the U.W Law Library as well as purchased on Lulu.com and Amazon.com.)

Disclaimer:  Nothing in these materials is intended to be tax advice.  References to tax are for issue spotting only. A CPA or other tax expert should always be consulted.

Non-Attorneys: This is a complex area and you should consult an attorney who is familiar with the impact of family law on business assets. Note that many of the ideas discussed in this work are cutting edge. That does not mean that they will not work; it just means that we do not know their effectiveness until a court tests them.  That does not mean that one should not try to protect the business with new ideas. Merely be aware that they may not work….or maybe they will, in which case you/your business could benefit considerably.

For anyone who might not be aware of the significant impact a marital divorce can have on a business, see what business owners have said:


I. What Business Owners Say


One Shareholder Writes:

We had eight equal shareholders. At a board meeting one of our shareholders, not active in the business

but an equal partner in ownership, divulged that he and his wife were separated. We discussed the situation and decided that we should devise a way to help a divorcing shareholder to “buy” his wife out. This would allow the shareholder to remain apartner and serve on the board. What we didn’t want was a disinterested and non-experienced spouse meddling in the business. As a result, we (the corporation) decided to lend the shareholder ½ of his interest in the form of cash to expedite the purchase from his wife.

The problem arose two years later when, at a much greater valuation, another two partners divorced in the same year; one more divorced within ten years. The cash cost to the company of these divorces was significant. [In addition and as an aside, the divorce of one and the perceived valuation he wanted to give his wife killed a potential sale.]

Interestingly enough, the shareholder for whom we originally made the accommodation and his wife reconciled. He later passed away, and his wife became a shareholder and a board member as a result.

PS. We could have used some advice from Maggie at the time.


From Another Business Owner:


I had no idea how devastating a fellow shareholder’s divorce could be to our company. Then it

happened.  We spent so much time in court resisting the aggressive tactics of the divorce attorneys that we had little time for business. Our business attorney did not advise us adequately on how to prevent this nightmare scenario. Now, too late, I know that we could have avoided much of this mess by a good shareholder agreement.

NOTE: A word before we begin. Whereas we are using the terms “marriage” and “divorce” for simplicity there are of course other couple relationships which may give rise to rights under family law. In addition a married couple may choose legal separation rather than divorce. Drafters of business documents might keep this in mind for the definition sections.

  • Dealing with the Non Shareholder Spouse:

Q. Full Disclosure and Procedural Fairness: When might this apply when dealing with divorce related issues in shareholder agreements?

Q. What fundamental safeguards might you employ when dealing with the non -shareholder spouse?

II. Working with Estate Planning/Family Law Attorneys: Prenuptial and Other Marital Agreements:

It is a good idea to make provision for the possibility of divorce and other marital disputes involving your business in the form of a prenuptial, separation or other marital agreement (collectively referenced here as marital agreements). The odds of divorce are daunting. Approximately one-half of marriages will end in divorce, so this precaution is well worth addressing. Remember, even if you never divorce, your business partner may, so it is a good idea to encourage all key business personnel to enter into such agreements with their marital partner.

Mirror Agreements:

Marital agreements should reference and mirror business agreements wherever possible to increase the chances of legal enforcement of corporate business protections by divorce courts. Examples of typical business agreements are: shareholder agreements, partnership agreements, buy/sell agreements, confidentiality agreements, stock option plans, non-competition agreements, employment agreements, etc.

Can the Shareholder Agreement require a Marital Agreement?

Consider the following: A provision in a Shareholder Agreement that she/he will obtain Marital Agreement with spouse specifying set list of requirements within # of days of agreement or is default (at option of corporation). The marital agreement could be an attachment that has to be signed. The feasibility/enforceability of this approach is more fully addressed in my book.

Consider what provisions you would like to see in the Marital Agreement and why?  Why might you want/not want to include the following?

Business/Stock Valuation Date

Valuation Methodology

Agreed Statement of Cooperation of Both Spouses in Signing Business Documents Governing Marital Interests and Liabilities During Divorce

Provisions to Keep a Lid on Litigation

Non-Interference of the Non-Active Spouse in Business Decision Making During Divorce

Provision for the Appointment of an Arbitrator

Provision for the Appointment of a Business Monitor

Provision for the Appointment of a Discovery Master

Identification of Interests of Spouses at Divorce

Terms for Buying Out the Spouse’s Interest

III. Business Agreements


Starting the Conversation with the client:

  • Most corporate attorneys routinely discuss business planning and exit strategies with their client.
  • Discuss the potential impact of marital divorce on those strategies and ways to mitigate the effect.
  • Even if you are never a party to a divorce, your fellow shareholders/partners might. It is a good idea to have an agreement setting expectations and procedures among and between business associates if this happens.
  • To what extent will the owners’ long-term business plan and exit strategy be affected by marital divorce? Factors: Cash flow? Future business development?
  • Planned exit strategies: Are they negatively affected?
  • Some of the protection provisions discussed in these materials are cutting edge. Some are untested in the courts. No agreement is guaranteed to be bulletproof. Nonetheless, this does not mean that they should not be tried. They may not work, however, a carefully thought out and carefully drafted provision could have a considerable upside.
  • Provisions tailored to the particular client’s needs should form part of shareholder agreements.
  • Prenuptial and other marital agreements.


How Far Does A Corporation/Its Shareholders Want to Go to Prevent Interference in its Daily Activities by a Shareholder’s Marital Divorce?


It should be noted that I have never met anyone who has been through the turmoil caused by divorce who has not wished that the mess could have been avoided.

           

Here are  a few questions that I asked a group of attorneys to answer in one of my recent seminars. Many of the answers are provided in my book (which is on the shelf at King County Law Library as well as at the UW Law Library so there is no need to buy it). Asking the questions stimulates people to think about the issues.

Keeping the Business as Separate Property:


Beware of comingling.

Q: How would you advise your client to keep the business separate?


Getting the Spouse to Sign:

Q: What language would you use? Why? Discussion

  • To what extent can the non-shareholder spouse be obligated to a shareholder agreement?

Q: Consideration?

Q. Potential pitfalls to watch for?

Q. What do you want from the spouse? A promise to do/not do… what? Discuss.

Marital credit:

(I shall give the reader a clue to this which my lawyer seminar attendees did not have when they tried to answer the questions: If you involve marital credit in with a business you are trying to keep separate you may find that the other side will argue that this act gave the marital community an interest). Therefore you have to be very careful in how you structure this, if you do it at all.

Q: Do you discuss the impact of marital credit with your clients? What do you discuss?

Q. Why in this an important topic for divorce?

Q. How do you protect the business against giving the other spouse an interest?

Q How do you ensure continuing credit after divorce is filed?

Q. What language might you use?  


Can the Provisions of a Shareholder Agreement be Mirrored in Prenuptial and Marital Agreements?

Work with the family lawyer/estate planner to provide mirror provisions.

Have a marital agreement provided which must be signed by the spouses (whether shareholder spouses or one not shareholder).


Buying Out the Spousal Interest:

Q Why is this different than buying out any other shareholder?

Q: Who is impacted and why?

Discuss these issues with your client:

  • Buying Out a Fellow Shareholder Spouse


If a fellow shareholder is also a spouse, special provision should be made for a buyout. This may include such matters as who buys out whom (this is often a consideration in a family business where other shareholders are related to one spouse only). Terms may cover e.g. price and business valuation methodology, payment over time, etc. These terms which come into effect UPON divorce should be stated in the shareholder agreement and captured in a corresponding marital agreement.

  • Buying Out a Non-Shareholder Spouse

A spouse who is not named as a shareholder may still have an interest as far as the divorce courts are concerned. Typically the shareholder spouse will buy out the marital interest if she can however, due to shareholder cash flow problems experienced during divorce, this can be impossible.


Q: What happens when the Divorcing Shareholder Cannot Afford to Buy Out the Non-Active Spouse?           Discuss.

Issues:

  • Prohibition against “transfer”
  • Redemption option by the company
  • Provision for fellow shareholders to buy the stock
  • Accommodation for the active spouse/employee.
  • Valuation and timing.
  • Financing options (if any) may be described.
  •  “shadow” or “phantom” shareholding agreements between divorcing spouses.
  • Impact on divorcing active spouse

Discuss the practicality, financial feasibility and economics of each circumstance with the client. Every     situation is different and the best solution is usually reached with applied forethought.


Corporate Redemption in a Divorce Scenario:


- Terms of the Redemption

If divorce leads to redemption will the redemption be on favorable or unfavorable terms to the shareholder. The parties should consider the number of factual variables which can lead to redemption. Here are a few:

  • The shareholder spouse does not have the funds to buy out the marital interest and puts part of his shares    to the corporation.
    • Both spouses were shareholders and one leaves due to the divorce and puts her shares to the corporation.
    • The shareholder attempted to “alienate” his stock contrary to the shareholder agreement prompting a   

      forced corporate redemption.

Q: Will all of these have the same terms? 

What about, for example, an automatic redemption in two months of filing divorce? Is that a good idea? Why? Why not?

IV. Beyond the Basics: Business/Stock Valuation

Impact of Exit Strategies:

Closely held business owners generally have an exit strategy in mind, especially if they are considering retirement. The following are amongst the typical ways to exit the business:

    • Selling to employees using an Employee Stock Ownership Plan (ESOP)
    • Selling to co-owners
    • Selling to outsider third party (individual investor or strategic acquirer)
    • Selling to key employees as part of an incentive plan
    • Transferring to key employees as part of an incentive plan
    • Retain only passive ownership
    • Transfer to a family member
    • Initial public Offering
    • Liquidation

The exit strategy chosen can have a significant impact on valuation. That valuation might be acceptable to the divorce court if considered relevant.

Q: In the event that a shareholder wants to buy out his/her spouse which of the above scenarios might lead to a favorable for the shareholder in a divorce? 

Your case could be significantly bolstered if you can show that, prior to divorce proceedings, a clearly established exit plan was in place. If it is intended that the business will be sold to family members, this may eliminate a high strategic, sale-based valuation. Formalization of the plan in written agreements is advisable. Inclusion in premarital and marital agreements as well as business agreements is also helpful.

Why Is A Reasonable Working Knowledge of Business Valuations is Essential For All Trusted Advisors?


Values and valuation methods can be agreed in advance of a divorce.  Depending on the circumstances of each case, they may or may not be adopted/enforced by the divorce courts.

Business valuations can address valuations of the entire business and /or percentage interests within the business e.g. a stock interest.  Many business valuators are academics who generally fail to recognize the market forces of a real sale transaction. Washington divorce court valuations differ from general business valuations.

Q: As a business attorney why should you discuss business valuation and buy out of the spouse in a divorce setting? Consider these Scenarios:

  • Two of the shareholders are married to each other (would the shareholder agreement value prevail or the divorce court value?)
  • Shareholders are married to non shareholders (why might the other shareholders care what $ one shareholder has to buy his/her spouse out for? )
  • Shareholders are married to shareholders, some active some not.  

Valuation Methods of a Closely Held Business for Marital Division/Divorce Purposes:


Whether or not the business is considered a community or separate asset, the business should be valued for divorce purposes, unless the parties can mutually agree on a value.   A word of caution before we start: valuation of business assets for divorce purposes does not always follow real world valuations. A good example of this is that Washington State divorce cases have included professional (personal) goodwill if any, of the working spouse as part of the value of the assets—not just the enterprise goodwill. Professional businesses are particularly at risk of this, e.g. doctors, lawyers, dentists, etc. Real buyers would not pay for the personal goodwill of the principal if the principal were to exit the business. This is in conflict with a real world business valuation.

Courts in Washington permit themselves discretion to consider all relevant facts and circumstances.

This generally leaves the courts free to consider commonly accepted business valuation principles as well as their own opinions as to what is fair in a divorce setting.

Trial courts don’t always get it right.

  • Trial court decisions can be overturned on appeal. In fact, in Washington the appeals court frequently states that a trial court must state what method and factors were used in the valuation.

  • If the appeals court determines that it does not have sufficient evidence, it may direct the trial court to obtain additional business value evidence. The trial court may also be directed to readdress the entire property division (all property of the parties), if new evidence warrants. Naturally, the best policy is to present good evidence and arguments on the first appearance at trial.


Some Real World Appraisal Methods:

Market comparison- Using publicly traded multiples to compare stocks within a sector or other information if available of similar businesses sold.

Liquidated value of the net assets- The market value of the assets minus liabilities and costs of liquidation. This is typically not a valid method of valuation for a viable business with good cash flow.

Capitalization of Earnings Method- This method analyzes past earnings, “free cash flow,” under the assumption that historical earnings are a fairly reliable predictor of future earnings. Typically, the past few years’ average “free cash flow” is capitalized to determine the present value of the historical income stream. This approach is frequently used for a viable business with a record of good profits and cash flow.

Discounted Cash Flow Analysis- The discounted cash flow valuation method determines the business value today based on predicted cash flows into the future at a risk adjusted interest rate. This method is most useful when a company does not have an established track record but has a promising future. Note: The Discounted Cash Flow Method estimates future earnings based on management input or the discretion of the valuator. These estimates can vary wildly and can be biased or manufactured depending on the perspective of the information source. This method is frequently used as a divorce related valuation method. As a veteran mergers and acquisitions professional told me, “I have never experienced a buyer that used the discounted cash flow method as a basis for an offer.”

Because valuation is an inexact science, valuators typically use several methods each of which serve as a cross-check on the others. Determining which methods to use and the relative weight to assign each method depends on the nature and financial condition of the company being valued as well as the quality of data available.

Should the Valuation Represent Fair Market Value in a Divorce Setting?


Real world business valuators generally use the “fair market value” standard for appraising businesses defined as follows. The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Washington divorce courts often tend—although their approaches are not consistent and there are notable exceptions—to focus on the value to the spouse who is awarded the business. You will sometimes see phrases such as “fair value” instead of “fair market.” In reaching their decisions, they will consider real world valuation methodology. However, they do not always follow it. Be careful here, there are exceptions to this approach in addition to inconsistencies.


Personal Goodwill and Valuation:


In Washington, the courts include the active spouse’s personal goodwill in business valuations. A true fair market value approach generally only includes the enterprise goodwill and excludes any non-transferable personal goodwill. Note: Washington is in a minority in this approach among U.S states.


Pre-agreed Valuation Methodology:


A Washington divorce court will consider, but may decide not to adopt pre-agreed valuations set forth in corporate documents, for example, share values for exercising “put” options. These pre-agreed valuations are typically irrelevant and not addressed in the valuation of a business in the real world. However, in the divorce world, the court will consider them and may adopt them depending on the circumstances.


Timing the Valuation:


Good or bad? Timing has its benefits. It also has potential drawbacks. Go over them with your client.

Q. What are the benefits/problems?


Pre-Determining the Valuation Date:

  • Many possible dates can be selected for establishing the valuation date in divorces. Courts tend to use the date of trial as the valuation date or may defer to the randomly selected date the valuation was performed.

  • The timing risk:  Anticipated duration of a potential divorce action. If there are children involved or complex financial affairs, plan more time than less.

  • Key financial reporting dates such as fiscal, quarter-end, or calendar year-end as well as a sense for business momentum.

  • Sometimes, if stock values are tied, e.g. by agreement in a shareholder agreement, to an audited annual financial statement, the date of the valuation may be an obvious choice.

  • Ideally, any predetermined timing of the valuation agreed by shareholders should be recorded in the shareholder agreement. This document should be signed by both spouses and/or be referenced in the prenuptial or other marital agreements.

Q.  What are the potential benefits (if any) to other shareholders/the corporation of including a timing provision?

Consideration of Set Values in Buy/Sell Agreements:

Q: List as many reasons as you can think of where the Court or the divorcing shareholder or the other shareholders or the corporation may not want to use a shareholder agreement value  for a divorce buy out  by the shareholder spouse of the other spouse?

(Remember depending on view point the answer may change)

Personal Goodwill of the Active Spouse:


Washington State is among a minority of states in the U.S which include personal good will, not just enterprise goodwill, in valuing a business for divorce purposes. This can make a significant difference to a valuation in our courts. This concept is frequently seen in cases involving professional service businesses, for example, a dentist’s practice. The dentist may argue that the value of her business should be at liquidation value of net assets, because she cannot transfer her own goodwill (future earning value) to a buyer. In Washington, this argument would not succeed. The courts here look to what the practice is worth to her, not to a market buyer, at the time of divorce.


Double Dipping:


Many states have found this analysis to be unfair and have argued that it “double dips,” if spousal maintenance is awarded to the other spouse and the dentist pays for her own personal future earning power embedded in the valuation. They have also argued that it is unfair, because if one spouse works in the community owned business and the other works outside of the business, the owner of the business has to share the personal goodwill while the other spouse has no asset value attributable to his/her salaried job. Whether we like it or not, this is our law in Washington at this time. Not every state thinks this way. In fact, Washington is in the minority.

The spouse that takes the business in a divorce will be attributed a higher valuation in this state than in many others, if the spouse is important to the business. This is good for the non- business spouse and terrible for the business spouse.

What You Can do to Protect the Business Owner:


I have seen many attorneys shrug their shoulders and simply accept the fact that this is the law in Washington and leave the matter at that. What they should discuss with the business owner is the following possible protections (with the usual cautions about cutting edge issues and uncertainty of judicial results).

  • Exclude personal goodwill from marital assets in premarital and marital agreements and business agreements

This is not just of interest to divorcing spouses. Remember, if the business becomes

involved in the buyout of the spousal interest it may have a considerable interest in a lower value. This can happen, for example, when a business is inclined to assist a cash-strapped shareholder to buy out his marital interest.

  • Exclude personal goodwill from agreed valuation methods in premarital and marital agreements and business agreements

Be ready for a challenge to attempted exclusion of personal goodwill in a divorce setting in Washington State. Inclusion, to date, has been a sacred cow. Your counter argument should be that this exclusion is no different than other agreement to relinquish potential rights seen in contract law and even in family law in pre- nuptial and other marital agreements.

Goodwill Brought Into the Marriage:


In Washington you can characterize the goodwill in existence at the start of the marriage as separate property. However, one should be ready for issues such as:

                  • Does any of the pre marriage goodwill still exist?
                  • How do you establish the value of the business at the time of marriage?

Q.  Can you think of ways to protect your shareholder client’s goodwill from prior to marriage?

Active Versus Passive Appreciation of the Business: Characterization:

In a situation where a closely held business is brought to a marriage (separate property), some or all of the appreciated value of the business occurring during the marriage may be subject to division as a community interest, even though the inactive spouse never participated in the business. This depends, however, upon the character of the appreciation.

Q. What can you do to steer your clients in the direction of helping to keep a business separate?

One answer is to pay reasonable compensation for the active spouse’s work. What are some of the others?

V. Buying Out the Marital Interest-Corporate Finance Issues and Divorce

Introduction:

This is worth a conversation with your clients as the results of a divorce of its shareholders can

financially compromise the corporation as well as the divorcing shareholders.

The divorce courts are also very inclined to award the business to the active spouse.

Phantom Stock:

By the term phantom stock I mean to describe the interest a spouse may have in stock while not a named shareholder in the shareholder agreement. Structures that allow a non-active former spouse to participate in future upside (or downside) can be considered. This may not be a bad thing depending on the needs of the corporation/the shareholders/the divorcing shareholder. The type of limitations placed on the phantom shareholder may also be a factor in determining if post- divorce phantom shareholding will be permitted.  A corporate redemption may have unfavorable tax consequences not found in a qualified tax free exchange available to divorcing spouses. A CPA should be consulted for information on this.  From a structuring standpoint, one must consider that every corporate repurchase of stock is a direct hit to the company’s net worth. Closely held business owners need to seriously consider ahead of a divorce, to what extent they wish to allow or preclude phantom stock.

Cash Payout:

The most traditional form of buyout is payment of cash. Often however, other marital assets, such as home equity, are sufficient in value to trade for the value of the business interest. Trading outside (non-business) assets is a very practical way to deal with a buyout without restricting or financially compromising the company.

Structured Payout:

A structured long term payout is full of complications. The holder of the note, the departing spouse, should want or require some form of security or collateral. In most cases, the only viable source of collateral is the stock being sold. Pledging the stock may be an option if the shareholder is not in violation of a shareholder agreement prohibiting using the stock as collateral (pledging) for any purpose.

A stock pledge is generally strategically favorable to the stockholder spouse and not the note holding spouse.

Multiple Shareholder Issues:

The active shareholder may have co-shareholder(s) and does not have the flexibility of using present or future corporate cash to purchase a divorcing spousal interest. If not provided for in a shareholder agreement, the shareholder must find the cash means or tradable asset resources outside of the company to fulfill a buyout. The corporate treasury is simply off limits. Alternatively, the shareholder spouse may wish to sell shares to co-owners as a source of cash. This requires receptive shareholders and a willingness to be diluted.

Tax Traps and Strategies when Buying out Your Spouse:


The following is provided for issue spotting purposes - not to provide tax advice, which needs to be provided by a CPA or other tax expert.

Taxable and Tax Free Transfers of Stock

At the time of this writing, the U.S Internal Revenue Service considers properly structured transfers of property between spouses (and ex-spouses) pursuant to divorce as non taxable events. However, the business person must be very wary that the transfer meets certain requirements. For example, the term “pursuant to divorce” may cause problems. You can fail to qualify in many ways, one of which is just bad timing. A transfer to your ex-spouse after divorce which is outside timelines prescribed by tax law may result in the transfer being deemed “not pursuant to divorce”. The transfer would then be subject to capital gains treatment.

Similar transferring risks can be found when selling a departing spouse’s stock to the corporation (corporate redemption). The corporation is not a divorcing spouse. This can easily lead to the transfer being considered “not pursuant to divorce” even though the transfer was occasioned by the divorce.

Where one spouse cannot afford to buy out the other with other community assets, corporate redemption may come into play. Depending on how the corporate redemption of stock is structured, the transaction may be deemed a taxable event.

This area is so fraught with tax traps that the business person and his/her divorce attorney must work in close collaboration with a CPA or tax attorney who is experienced in structured buyouts. Depending on whether you are the transferee or transferor the structure will have benefits and weaknesses on both sides. You may benefit, or you may lose depending upon the structure. The net loser may always seize this opportunity as a global bargaining chip in the divorce negotiations.

One more warning: For taxation purposes, it may not always be self evident (without expert advice) who is the transferor or transferee. For example, there are circumstances, involving unintentional corporate transfers, where the IRS may deem that a transfer has taken place. This may lead to an unexpected and unpleasant result.

Leveraging the Business to Buy-out the Spouse:

Risk/Benefit Analysis:


Introducing leverage to a company increases the risk of ownership. Careful consideration must be given.

If cash is not enough to fund a buyout, some level of borrowing and leveraging must be introduced.

Simply put, leveraging means increasing business risk. Conceptually, increased leverage reduces liquidity and a company’s financial flexibility.

Financing the Buyout with a Bank:


A leveraged cash buyout usually involves a bank. While banks may seem eager to lend, they are very reluctant to lend for what they consider non-productive purposes. From a bank’s perspective, a stockholder buyout compromises their loan quality with reduced liquidity and increased leverage, i.e. debt/worth ratio. Next they consider the diminished personal guarantees, if any. The departing spouse will certainly want to be removed as a guarantor, and the remaining guarantor will have a substantially injured post divorce personal financial statement. While the bank may accommodate, the ongoing risk to the remaining shareholder (and bank) has been heightened.

The new risk profile of the company must be carefully evaluated to ensure that the company is financially secure in its ability to succeed into the future. If not, any bargain struck at divorce will be a disappointment to the remaining shareholder.

Some Downsides of Funding the Buyout Through a Corporate Redemption:


The other form of buyout is for the company to redeem the stock and hold the associated debt. This transaction leverages the company’s balance sheet and may cause interference with bank and other creditor relations. In situations of an already undercapitalized and financially fragile company, questions of fraudulent conveyance may arise for any significant payments made by the corporation to the selling shareholder. Fraudulent transfers are subject to possible disgorgement. As in pre-bankruptcy transfers, transfers to insiders, including relatives, are given special scrutiny. Any post divorce disgorgement action may result in post divorce litigation with the ex-spouse or the company.

Consider also potential capital gains treatment when involving stock purchases by a non divorcing spouse, i.e. the corporation. A CPA or tax attorney must be consulted when considering any form of buyout.


Subordinated Debt:


Structuring any new seller debt should be done in concert with the company’s major lender. The best time to configure the new debt as “subordinate” to other lenders is when it is newly constructed. You never want to surprise your bank with an unannounced new debt. Subordinating the debt lien will not likely be readily accepted by the selling spouse so having the lender act as the “bad guy” may be more persuasive.

Subordinated debt is generally acceptable to a lender and is often considered by the lenders as a form of equity. This means that the new debt will be considered by the bank as equity and will be subtracted from total liabilities and added to equity. Alternatively, if you do not subordinate to the bank any lien placed on the assets will be in second position to the bank. This new unsubordinated debt will be viewed by the bank as added leverage.

Fully subordinated debt can be repaid according to the terms of the note provided that the senior lender (bank) is in continued agreement with its repayment. If the senior lender becomes insecure, the lender may prohibit remaining payments. This possibility should be recognized as added risk to the selling shareholder. Non-payment, whether voluntary or bank imposed, could trigger an event of default. Default recourse for the note holder should be a remedy built into the stock sale agreement. The agreement should contain consequences and remedies acceptable to both parties.


Seller Financing:

Promissory Note


Another common financial vehicle used to buy out a spouse is seller financing. This form of financing requires that the inactive spouse take a promissory note in exchange for the value of the shares purchased. The maker of the promissory note can be either the spouse or the business.

Personally Funding the Buyout Through a Salary Increase


If the company is wholly owned by the divorcing couple, the active owner will typically increase his/her share holding to 100 percent at divorce. This affords the shareholder the flexibility to increase his/her salary to fund a personal buyout of the former spouse’s shares. Repayment with after tax salary is generally not a cost efficient strategy and should be contrasted with the tax liability of a corporate redemption. Remember, a qualified transition of stock between the parties incident to divorce is tax free.

Impact On Other Shareholders When Buying Out a Spouse:

Buy/Sell Agreements


It is common for key employees to be shareholders of a closely held business. It is uncommon that shareholders will want to be in business with former spouses. For those that do not want former spouses as shareholders, there should be a pre-arranged corporate resolution and a method to buy out a departing spouse, if the divorcing couple cannot arrange this on their own. A buy/sell agreement does the job nicely and should be a subject of the shareholder agreement. While a buy/sell should do the job, many buy/sell agreements do not contemplate funding the buy/sell.

Outsiders as Shareholders

Many shareholder agreements are constructed to anticipate the departure of shareholders for any number of reasons or circumstances. One of the reasons for departure is divorce. Closely held business owners are reluctant to allow “outsiders” to become shareholders. “Outsiders” may be former employees, heirs of a deceased shareholder, or a departing spouse. A departing spouse may be the worst of all circumstantial shareholders, as they can be divisive and disruptive and pack an emotional agenda.

Enforcing a prohibition of outsider shareholder interests can be an expensive proposition for the company. If purchase of the departing spouse’s stock cannot be accomplished between the divorcing parties (which is ideal), the company is confronted with financing a stock redemption. A stock valuation clause should be provided in the shareholder agreement expressed as either a buy/sell formula or as a third party professional appraisal.

Leverage


Introducing leverage into the business to accommodate a divorcing spouse buyout directly impacts other shareholders. Pre-arranged buy/sell agreements, typically embedded in a shareholder agreement, need to be considered when valuing the community’s shareholder interest. A minority ownership interest may not be given the same clout as a majority interest and therefore may not be able to take advantage of a debt undertaking by the company to buy out a minority shareholder interest.

Disruption


Divorces in closely held businesses that include other shareholders can be disruptive and messy. Questions can be raised concerning the quality of financial reporting, subterfuge, cronyism, near and long term business prospects, and can include inquiries (depositions) of active shareholders. Forensic accountants can be retained, business valuators brought in, and a slew of other random information requests can be nonstop. As distant as fellow co-shareholders may want to be, they seem to get dragged into the haggling.

Enforceability


The terms of a pre-agreed buy/sell agreement and departing shareholder buyout procedure is binding on all shareholders. Most often, only the active named shareholder spouse is a signer on the shareholder agreement. Sometimes the non-active spouse is also a signer. Little thought is typically given to these issues at the time, but when the divorce starts the signature may be very significant depending on what your client wishes to do with it. Even where the departing spouse is not active and does not have stock held in his or her name, that spouse, upon reasonable disclosure and opportunity for legal counsel, could arguably, be bound by those agreed values and terms in a divorce. This is a tricky area, largely untested, and may involve a consideration requirement or equitable estoppel argument. Your clients should be made aware that typically there is no certainty as to how a court may view any provision of your shareholder agreement. This is particularly true of divorce courts.

Building Financial Flexibility


With any untimely divorce, the company may be faced with an all cash shareholder redemption requirement at just the wrong time. This could cause financial stress to the company. It is best to anticipate this and provide payment options in the shareholder agreement including a long term payout plan for extra affordability and flexibility. Be sure to incorporate duration, interest rates, and perhaps variable interest rates tied to market indices.

VI. Potential Disruption of Divorce to the Business and Shareholders


Court Intervention and Discovery:

  • Intensive forensic accounting, diligence, protective orders, restraining orders, blocked mergers and acquisitions are just a sampling of court ordered interventions that can cripple the operations of the business.

  • Tactics of a particularly aggressive opposing counsel and/or a distrustful spouse.

  • Allegations of: Are they cooking the books? Or are the other buddy shareholders ganging up on the departing spouse?

  • They may subpoena minutes of the board meetings where much information can be found.

  • These problems are compounded by a judiciary who are not typically business persons.


Confidential Information:


Many businesses operate with proprietary, sensitive, and confidential information that cannot be shared with any outsiders, including opposing party counsel. When pushed to disclose, the business’s attorney will likely move for a protective order. Now the business is engaged in the divorce and has activated the services of their business attorney. Opposing counsel may argue suggesting that the business is hiding information. At this point, suspicion is heightened encouraging further attempts to disclose even more information.


Personal Financial Statements:


Expect that opposing counsel will request or subpoena key business documents. The company’s bank may be subpoenaed for any personal financial statements submitted to the bank in support of a personal bank guarantee.

As a side note: the divorcing spouse’s personal financial statement has great potential to backfire. Most guarantors optimistically value their personal assets. Bankers have learned to expect this. If the value of the closely held stock interest entered on the financial statement is overblown, opposing counsel will use this value as self admission of value for business valuation purposes. This may hold true for other asset values as well.

VII. Business/Divorce Planning Strategies


The following are some excellent planning strategies to limit business disruption during a divorce:

  • Include divorce planning provisions in premarital, marital and business documents, e.g. shareholder agreements.
  • Obtain the signature of every non-shareholder spouse in business agreements which might have an impact on divorce.
  • Keep good records.
  • Provide complete information when requested.
  • Demonstrate a willingness to provide information.
  • Be realistic in valuing personal property on any written document.
  • Appoint, by the court or by agreement, an independent discovery master to keep discovery reasonable and contained.
  • Address discovery proceedings in prenuptial and marital agreements.
  • Appoint a single representative in the company as a go-to person, not the divorcing party, for the business.
  • Consider relationships, other than marriage and terminations of marriage, other than divorce when drafting divorce provisions.