/>iWhen a married couple enters into a divorce proceeding, they generally expect to end things in a final decree that fully divides all of their marital assets. But when they fully own or have a large interest in a closely held, private business, for a number of reasons they may find that it benefits them to continue co-owning all or a portion of the company for some time period after their divorce becomes final. It is not surprising that a business partnership entered into between divorcing spouses can be rife with problems. This post therefore focuses on steps that each of the spouses can take to protect their interests while also continuing to maximize the value of the company in which they have a shared ownership interest.
There are a number of reasons why it may be beneficial for ex-spouses to continue in a business partnership after their divorce, including (i) to achieve the most favorable tax treatment, (ii) because the value of one of the individual interest held in the business cannot be fully realized at the time of the divorce, (iii) because the sale of an interest in the business by one spouse could lead to a substantial downturn in the business, or (iv) because both ex-spouses like the business and they do not want to relinquish their continued ownership in the company.
Once the ex-spouses decide to continue co-owning an interest in a business together, for this partnership to have any hope of working well, they should consider the following steps to put a workable structure in place. Specifically, the ex-spouses will want to (i) require the company to adopt a clear governance structure, (ii) specify a compensation strategy that determines how each of them will be paid, including dividends and distributions, and (iii) negotiate and implement a buy-sell agreement that sets forth a defined contract governing a future partner exit. Placing a set of rules and mutual safeguards in place will permit both parties to protect their investment and also minimize the potential for future conflict.
The Control Dilemma in Post-Divorce Partnerships
When a couple considers becoming business partners after their divorce, the most basic issue they need to confront is who will control the company after the divorce is final. It will be a recipe for disaster for them to adopt a joint management approach where they must agree on all business decisions on a 50-50 basis. Divorcing spouses likely have a low level of trust between them and requiring them to exercise joint authority will very likely lead to an impasse putting the company into stagnation or chaos. By the same token, allowing just one of them to make all of the business decisions for the company exposes the non-decision maker to an unacceptable level of risk in regard to the operation of the business.
The practical solution to the issue of control is to provide one partner with control over the day-to-day operations and routine decisions made on behalf of the business, but with an important set of exceptions. Specifically, the parties need to negotiate a clear set of veto rights by the non-controlling ex-spouse on matters that would impact the company’s long-term value. These are what can be referred to as “protected decisions,” and they are typically included in the governance documents for companies that are owned on a 50-50 basis. The protected decisions that may be subject to veto rights may include (i) the sale of the entire company or a sale of the company’s major assets, (ii) any large purchases made by the company above a certain amount, (iii) bringing new partners into the business that would cause a dilution of ownership rights, (iv) taking on substantial new debt by the company, (v) changes to the compensation paid to either of the parties, (vi) whether to issue any dividends or not and in what amount, and (vii) the hiring or firing of key personnel at the business. All of these specific veto rights are subject to negotiation during the divorce and before the couple actually become business partners.
Another practical suggestion is for the couple to consider appointing either an entirely independent board for the company or to appoint a designated arbitrator to resolve disputes. They could then turn to the board or the arbitrator to address any conflicts arising between them that relate to the operation of the business. These outside parties then serve the role of preventing the parties from experiencing a conflict between them that could lead to litigation. For example, if the non-managing partner exercises a veto right over a business decision the managing partner party believes would seriously harm the business, the managing partner could require that the exercise of the veto be subject to a prompt arbitration.
Establishing Reasonable Compensation and Distributions
Once the couple have resolved control issues in managing the business, their next major challenge is to determine the financial returns that they will each receive from the company. The spouse who is actively managing the company will rightfully expect to receive compensation for these services, but the non-manager may also desire to receive distributions or dividends issued by the company on a current basis if the business is generating profits. If the compensation paid to the managing partner is too large, that will likely reduce the amount of distributions, so there is definite potential for tension here between the ex-spouses.
The way to resolve this conflict is similar to the previous management discussion, with a pragmatic approach to the problem. More specifically, the parties’ divorce settlement will need to document not just their co-ownership of the business after the divorce, but it will also need to present negotiated formulas for executive compensation and for future dividends/distributions. The compensation levels will be tied to the company’s future financial performance taking into account both revenues and profits, and experts can assist the parties in developing formulas for the total amount of compensation that is reasonable to pay to the managing spouse.
Similarly, experts can also propose dividend/distribution formulas based on the earnings of the business earnings (EBITDA) taking into account the amounts that the company will need to retain for working capital and potential future expansion. At a minimum, the company should be making distributions sufficient to cover the income tax liability of both co-owners – neither one should have to pay taxes on income that is not distributed. But a dividend/distribution formula will call for the company to distribute some additional amount above the tax distribution based on a formula that includes working retaining capital and expansion capital – perhaps 15% to 25% of the company’s total profits can be distributed to the ex-spouses on an annual basis, without causing any negative impact to the company.
Establishing these clear parameters on compensation and distributions/dividends in the divorce documents will help to avoid future conflicts and meet the financial objectives of both co-owners. These negotiated boundaries achieve the necessary balance that allows the company to continue to flourish and the ex-spouses to continue to coexist as business partners.
As a necessary corollary to the contract parameters set forth that govern compensation and distributions, the divorce documents need to provide for financial transparency to the non-manager. To ensure that the compensation level and dividends are based on information that is both accurate and up to date, the divorce settlement will need to require the company to provide the non-manager with consistent financial reports, likely on a quarterly basis.
The Final Lap: The Divorce Settlement Should Include a Partner Exit Plan
Even with all of the careful planning in place, most post-divorce business partnerships are temporary arrangements that are in place for a limited period of years until one or both of them wants to separate. At that point, a business divorce will become necessary, and the ex-spouses therefore need to anticipate and plan for the business divorce in the future when they are completing their marital divorce and creating their post-divorce business partnership.
The situations calling for a business divorce can arise when the business does poorly, when one of the ex-spouses wants to retire, becomes ill or remarries, or when the managing individual wants to grow the business requiring major reinvestment and the non-manager is content with the current situation and blocks the company from taking steps needed to grow. But if there is no partner exit plan in place, the non-manager who desires to depart from the company will be stuck holding what amounts to an illiquid, unmarketable interest — it has considerable value, but it cannot be monetized. On the other side of the ownership, the manager may desire to redeem the interest held by the non-manager, but if no contract right exists that permits the manager to require a redemption, the partners remain together unwillingly.
The partner exit plan should be set forth in a buy-sell agreement (BSA) that provides the ex-spouses with a defined path for them to exit the business. The agreement will therefore provide for all of the following: (1) the specific circumstances under which either ex-spouse can trigger the BSA, (2) the manner for determining the value of the departing individual’s interest once the BSA has been triggered, and (3) the terms for payment of the departing partner’s interest because the purchase price typically involves payment being made over a period of years and there may be collateral provided to protect the departing co-owner in the event of a monetary default. The payment terms have to be realistic and not cause undue economic stress to the company.
The mechanism for triggering the BSA will be the subject of negotiation at the time the divorce is finalized. The agreement may include a “shotgun” provision that enables either side to trigger the buyout but allowing the ex-spouse receiving the purchase offer to either offer to accept it or, instead, to purchase the interest held by the other party. This type of provision is designed to achieve fair pricing because the party making the offer must be willing to accept the same price in return for his or her own interest in the business.
Conclusion
When divorcing couples consider the possibility of continuing as partners in a company after their divorce, they need to take steps to head off potential conflicts as business partners. They can avoid disputes by creating a clear governance structure, by addressing the amount of compensation and distributions to be issued in the future, and by negotiating and signing off on a buy-sell agreement that provides a path to exit in the future. When these provisions are put in place at the time of divorce, the couple are positioned to meet their business objectives with reasonable hope for success as they embark on a post-divorce partnership.
