For many married couples in California and other community property states, a closely-held business is the most valuable community asset. And whether or not they’re in a community property state, both spouses may be active co-owners, or a spouse who’s outside the business may still have some ownership rights. In most cases, it is likely that only one spouse will remain with the business following their divorce. So the key issue becomes: How can the interest of the “Departing Spouse”, after its value is determined by independent appraisal, be turned into cash? The answer is further complicated by the fact that the business is not just an asset to be divided, it is also the principal income source for the “Remaining Spouse” and for spousal and/or child support payments to the Departing Spouse. From a business lawyer’s perspective, three principal choices should be considered:
Installment Buyout. Often, the Remaining Spouse will propose a relatively modest down payment for the Departing Spouse’s interest, with the balance to be paid in installments over 5 years or more. This leaves the Remaining Spouse with complete ownership of the Company, provides cash flow for his or her living expenses and support payments to the Departing Spouse, and avoids the disruption and uncertainty involved in a third party financing or sale of the business. Internal Revenue Code Section 1041 permits this as a tax-free transfer incident to a divorce, avoiding capital gains tax for either spouse (though the Remaining Spouse will not get a step-up in basis on the acquired interest). However, this scenario effectively doubles the risk of the Departing Spouse. A decline or failure of the business jeopardizes both the continued payment of installments on the property settlement and continuing support payments, since the Remaining Spouse’s ability to pay each depends on cash flow from the business. The relatively modest down payment will not provide the Departing Spouse with an adequate buffer against this double risk. And if the Company runs into financial troubles, a security interest in its equity or assets will not be adequate protection, though the threat of enforcing that security does give the Departing Spouse some leverage over a slow-paying Remaining Spouse.
Third Party Financing. A second scenario is for the Remaining Spouse to arrange third party debt or equity financing to make a lump sum payment to the Departing Spouse or, at least, a much larger down payment with a far shorter and smaller installment note. This provides the Departing Spouse with a cash “nest egg”, mitigating part of the above-described double risk, and also produces a Section 1041 tax-free transfer of the Departing Spouse’s interest (again, without a step-up in basis). There are, however, some complications to this choice. First, there is the delay, uncertainty and cost of obtaining third party financing or investment, and potential disruption to the business through the customary due diligence and negotiation process. Further, the resulting debt payments to a lender or distributions to an investor may hamper the Company’s future success and the Remaining Spouse’s cash flow. Also, the third party lender or investor will likely require some management input and control, which may impede the Remaining Spouse’s flexibility in managing and growing the Company.
Sale to Third Party. The third principal choice is to find a strategic or financial buyer for the business, with the net sales proceeds split between both spouses. This may become necessary if the Remaining Spouse cannot raise third party financing, or decides the time is right to “cash out” from the business. While this alternative theoretically provides both spouses with a lump sum cash payment for the business, it has some major disadvantages. First, there will be capital gains tax on the sale, materially reducing the net proceeds to each of the spouses. A sale is likely to have more cost, uncertainty and disruption than a financing. And it is possible, even likely, that the buyer will not make a 100% cash payment at closing, due to such common deal elements as: an escrow of some of the purchase price to secure seller indemnifications; an installment note for some of the purchase price; a possible earn-out component based on sales or net profits following the closing. Also, unless the Remaining Spouse receives a long-term contract from the buyer, he or she will need to find new employment for living expenses and support payments.
So far, we have discussed the principal choices where the business is wholly-owned by one or both spouses. Further complications arise if there are one or more other partners-owners in the picture. In those situations, the divorcing spouses are only splitting part of the overall company ownership; unless they collectively own a controlling interest, an unwilling partner may prevent the choice of either third party financing or sale of business. Further, founding partners often enter into a Buy-Sell Agreement which, among other things, provides that if one of them becomes divorced, the other(s) can buy out any community property interest of the spouse. Such agreements often set a below-market buyout price, such as “book value”, which likely will be subject to legal challenge by the spouse on a variety of grounds.
The above is simply a summary of some critical issues and choices a family lawyer will face where a closely-held business is a valuable marital asset. Any particular business and divorce will have many variables which are “moving pieces” in analyzing the choices for the spouse you represent. Depending on the size and nature of the business and the circumstances of the couple, an experienced M&A business attorney may be essential to maximize your client’s chances of realizing the fair value of his or her ownership interest.