Buy-Sell Agreements in a Divorce (Part 1)

Ervin Cohen & Jessup LLP
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My prior articles have discussed how to monetize one spouse’s equity interest in a privately held company that has no other owners.  However, many businesses are started by two or three partners contributing their ideas, capital and “sweat equity” into their new company.  To protect against any of their ownership interests being transferred to someone outside the company, they will often sign a shareholders agreement (for corporations) or operating agreement (for limited liability companies) which greatly restrict any transfers.

One common feature in such agreements can complicate the marital division of assets in a divorce.  A typical provision will give the other owners a right to step in and buy any shares or membership interests of a divorcing owner that would otherwise pass to his or her ex-spouse.  A key question then becomes: Under the terms of the agreement, what price will be paid for those shares or membership interests?

The most common alternatives are:

  • “Book Value,” a number which is usually well below the actual fair market value since it is based on only the “hard assets” and existing liquidity of the company, ignoring the substantial goodwill value as a going concern.
  • A stated multiple of earnings which, however valid it might be when the agreement is signed, may not reflect true value several years down the road.
  • “Fair Market Value” as determined by the Board of Directors or Manager “in good faith,” which invites an under-valuation by the remaining owners.
  • Fair Market Value as determined by an independent business appraisal expert, the validity of which depends on the appraiser’s expertise in the particular type of business and the criteria used in the valuation.

What can the attorney representing a non-company spouse do if the agreement appears to set an unfairly low value for the equity interest which is part of the marital division of assets?  Can the provision be successfully challenged and replaced with an alternative basis for determining the value of that interest?  A 1994 California case, In Re Marriage of Nichols, 27 Cal. App. 4th 661, established a useful three-part test for a trial court to consider in determining that issue:

(1)      the proximity of the date of the agreement to the date of separation to ensure that the agreement was not entered into in contemplation of marital dissolutions;

(2)      the existence of an independent motive for entering into the buy-sell agreement, such as a desire to protect all partners against the effect of a partnership dissolution; and

(3)      whether the value resulting from the agreement’s purchase price formula is similar to the value produced by other approaches.”

Most shareholders or operating agreements with buy-sell provisions should meet the first two prongs of this test, since they typically are entered into at the outset of business formation for the valid purpose of preventing the transfer of one partner’s ownership interests to an outsider.  The third element of the court’s test therefore becomes critical.  My next article will discuss the factors to consider in questioning whether a particular provision is likely to reflect the fair value of an equity interest.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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