Planning for a divorce while you’re still happily married may seem both pointless and emotionally draining. But ignoring the possibility of a breakup can wreak havoc on your business. Let me tell you about a recent phone call I had from an Inc. reader who for obvious reasons will remain anonymous.
He founded his company, an automobile-service business, during the mid-1980s. It experienced tremendous growth at the same time that his marriage, unfortunately, was deteriorating. Also unfortunately, he had failed to predict either how successful his company would become or how ugly his marital breakup would get. He hadn’t taken even the most basic precautions to ensure the business’s survival in the event of a divorce.
When the marriage went down, so did the company, for all the predictable reasons. The couple lived in a state with community-property laws, which meant that–in the absence of any type of divorce planning–all their assets were divided 50-50. Not surprisingly, most of their assets were in the company. To come up with the cash to pay the divorce settlement, our reader had to sell his business.
But the story doesn’t end there. With offers from two potential buyers to choose between, he was forced to accept the lower bid because it was for cash on the spot. The judge agreed with his ex-wife and her attorney, who argued that it wasn’t fair for her to have to accept whatever financial risk might be attached to the higher bid, which had provisions for an extended payout.
Unpleasant and emotionally charged as it may be to contemplate, divorce planning should be an integral part of overall business and personal financial planning for business owners. And it’s not only the breakup of your own marriage you need to worry about. If the survival of your company is a priority, as it is for most business owners, you need to safeguard it against any number of divorces, including those of partners, investors, and, most threatening of all to your company’s stability, your adult children.
The first thing to consider is where you live. That’s because if you do nothing, state laws will determine the allocation of property in a divorce settlement. Nine states are community-property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), in which essentially all assets and liabilities acquired during a marriage are split 50-50. Those include business ventures. In equitable-distribution states (the other 41, plus the District of Columbia), the courts divide assets and liabilities accumulated during the course of a marriage according to specific family circumstances and state guidelines, with the split generally falling somewhere between 50-50 and 75-25. (An entrepreneur might be able to keep a settlement down to 25% of a company’s value, depending on the judge, the lawyers, and the expert witnesses.)
Most owners of privately held companies would be hard put to come up with cash equal to a quarter or a half of their business’s value without, at best, wreaking havoc on their company’s operations or, at worst, having to sell part or all of their business. That’s why it’s smart to put agreements in place that will both be fair to your spouse, should your marriage break up, and ensure your company’s survival. Your lawyer’s bill for the simplest document will be in the range of $500 to $1,000. The more elaborate and detailed the agreement, the higher the fees. Because your financial situation is likely to change as the years go by, you’ll want to include a requirement that you and your spouse renegotiate and update your agreement at specified intervals. The particular strategies you should think about implementing depend on your own special circumstances. Here are some typical situations:
I’m the sole owner of my business and still unmarried, but I’m close to setting my wedding date. I’ve read that to protect my company I should have a prenuptial agreement. Frankly, that’s the last thing I can imagine bringing up at this stage of our relationship.
You’re right. Prenups are not easy to talk about. Even if your mate-to-be is willing, you have to maneuver your way between two equally unappealing options: focusing so much on your company’s best interests that you wind up alienating your future mate entirely, or worrying so much about his or her feelings that you turn the prenuptial agreement into a virtually worthless exercise.
But however uncomfortable the subject may be, don’t delude yourself into believing that you need to be another Donald Trump in order for a prenup to make sense. The key point is to include a plan in which the spouse who is not active in the business will receive a financial settlement rather than stock in the company in the event of a divorce. Whatever the size of your business, and whether or not you’re profitable yet, it would be beneficial to have an agreement that also details how the value of your corporate assets will be divided should you part ways.
Even better would be an agreement that covers the other key elements that could be sticking points. It should include an agreed-upon method to determine your company’s value in the event of a divorce. (To ensure getting unbiased results, some people specify that two or three independent appraisers be hired, with the couple agreeing to rely on their average estimate. Expect to pay $5,000 to $10,000 per valuation, though valuations can run as high as $25,000 to $30,000.) When companies are valuable–and it does make sense to assume yours will be someday–you should also be sure to include an extended payout, perhaps lasting as long as 5 or 10 years, in order to shelter corporate cash flow from the shock of a one-shot divorce payment.
I’m happily married and the owner of a thriving company. My spouse doesn’t work in the business. We signed a prenup years ago. In the unlikely event that we split, I don’t need to do anything else, do I?
If you and your spouse have adhered to all the provisions in your prenuptial agreement, you’re probably fine. That means sticking precisely to the agreements, including those that specify whether you should separate or commingle bank accounts and other financial matters. Otherwise, a judge could declare certain provisions of your prenup null and void and work out an entirely different asset split.
There are further precautions you can take, however. For one thing, do everything you can to segregate all corporate-related assets (such as stock ownership) and liabilities (such as bank loans to support the company) in the name of the spouse who is actively involved in running the business. Ideally, the family’s joint financial assets, such as the ownership of a home, a car, or an investment portfolio, will be distinct from those relating in any way to the business.
We know, we know. The business undoubtedly constitutes the bulk of your family’s assets. But it will be simpler to adhere to the blueprint spelled out in a prenuptial agreement if corporate assets are kept separate from the family’s personal assets. To be on the safe side, ask a lawyer to evaluate your prenuptial agreement and recommend changes or updates. Then talk to your accountants (both personal and business) about how to best go about separating the assets.
It never occurred to me to sign a prenuptial agreement. But since my spouse is actively involved in running the company, can’t we just assume that we’ll both have its best interests at heart if our marriage should fall apart?
You should take the same precautions when your spouse is a business partner that you would with any other business partnership. The strategy of choice is a buy-sell agreement. A good buy-sell agreement doesn’t need to be long, but it does need to cover some essential issues. Our recommendations: Both spouses should agree to several restrictions concerning the ownership of their company’s stock. It must be held only by people who are actively involved in the business. If either spouse leaves the business, his or her stock must be sold back to the partner who remains active. Neither spouse can sell shares to anyone else without the other person’s permission. And finally, in the event of a divorce, one spouse must leave the business and agree to sell his or her stock back to the active owner. And if you want to be extra safe, include a clause to cover a situation in which you and your mate separate but do not actually wind up in divorce court.
Next–just as with a prenuptial agreement–you need to plan for an orderly and fair transfer of the company’s stock, should that become necessary. Like a prenup, a buy-sell agreement should specify how the stock will be valued.
Michael and Cathy Brown, who are co-owners of Boston-based accounting firm Brown & Brown, designed the valuation technique in their buy-sell agreement themselves. “We’ve got a ‘push-pull’ clause, which says that in the event of a divorce or either of us leaving the business, we’ll flip a coin to determine who will set the stock price,” explains Michael. “If she sets it, I get to decide if I want to buy or sell.” He adds, “This kind of an arrangement keeps everyone honest, because if she were to jack it up too high, she might wind up having to buy me out at that price, rather than getting to sell it at that.” A push-pull agreement might not suit you, but you and your spouse will still want to work out some type of strategy for deciding who stays with the business in the event of a divorce. Also include the requirement for an extended payout period, as long as five years or so, to avoid cash strains on the remaining spouse or the business. Usually, couples who go the buy-sell route opt to sign an additional employment document as well, which includes some type of noncompete safeguard.
I haven’t done any divorce planning, but my spouse isn’t involved in my company. Isn’t that enough of a protection?
If you can come up with the cash to handle the 50-50 split in a community-property state, or if you live in an equitable-distribution state and can afford to fork over a minimum of 25% of your company’s value, maybe you want to leave well enough alone. Because, frankly, if there’s one thing more emotionally laden than a prenuptial agreement, it’s a postnuptial agreement that covers the same ground (a projected split of assets, a method for valuing the company’s stock, and a prolonged payment schedule). The only difference is that a postnuptial document gets signed after–sometimes long after–the honeymoon is over.
One suggestion is to set up the postnup to focus only on the company’s stock, with all other marital assets to be divided according to a judge’s decision. Or you might also agree to segment personal assets that are important to your spouse, perhaps because they represent his or her accumulated earnings, a personal inheritance, or even a favorite piece of property.
If it seems absolutely impossible for you and your mate to agree on how corporate and marital assets should be split, maybe it pays to leave that one issue up to the judge, should you ever wind up in divorce court. But you’ll still help protect the long-term survival of your company if you can at least agree on such matters as how the business will be valued and how long the payout will be extended.
If the notion of any kind of postnuptial is too much to contemplate, you may do better with a variant on the buy-sell theme. Your goal should be to structure an agreement that requires all shares of stock owned by a nonactive spouse (or awarded to that spouse by the judge) to be bought back by the active ex or the company. Again, the buy-sell should also specify the valuation method and payout scheme to be relied on.
My company is successful, and I’ve started taking steps to pass along stock to my children as part of an estate-planning strategy. Should divorce planning be part of my overall strategy, too?
Absolutely. Once you start giving stock to your children, your company is as vulnerable to the problems that might arise from their future divorces as it is to the possibility of your own divorce.
Richard Rampell, a certified public accountant with Palm Beach, Fla., accounting firm Rampell & Rampell, has a story he likes to tell when asked whether it pays for an entrepreneur to take precautions against an adult child’s divorce. “There was a successful restaurant founded by two brothers,” he recalls, “and they eventually passed on some of the stock to the second generation, especially to one child whose husband was active in the business. Then that daughter’s marriage fell apart. And things got ugly.”
The former son-in-law wound up with some of the stock. “We were retained by him to do a valuation of his stock,” Rampell says, “as well as to look at whether any of the founders were skimming money out of the business that should have gone to him and other shareholders. The founders wound up paying much more than they would have liked to in order to remove that hostile minority shareholder from their business.”
The most effective estate-planning strategies almost always involve the transfer of minority stakes. The danger is that such stock could end up in the hands of a combative former in-law or even be sold to outsiders in order to facilitate the payment of a divorce settlement.
The solution is not simply to skip stock-gift strategies and avoid estate planning. Successful privately held companies can be destroyed just as easily by the costs of an unplanned-for estate-tax bill as they can by proceedings within a divorce court. The trick is to plan for both contingencies at the same time.
The easiest way to do that is, again, through a buy-sell document. The issues are exactly the same, no matter whose divorce you’re worried about: When must stock be sold back to active owners? How will that stock be valued? How will the stock be paid for?
Michael Brown recommends not only making a buy-sell agreement but also issuing only restricted stock. Restricted shares “say right on them that they can’t be sold or passed on to someone other than the original recipient,” Brown says. A divorce-court judge would be legally required to respect that.
What if my estate-planning arrangements are more complicated than just giving some outright gifts? Can I coordinate divorce-planning goals with the use of trusts or other methods?
If you and your attorney have set up a legal structure to accomplish estate-planning goals without passing ownership rights to your offspring, you may already have in place protection against second-generation divorce.
Allan J. Landau, a senior partner at the Boston law firm Sherburne, Powers & Needham, notes that “so-called spendthrift trusts work particularly well in this regard. If you put company stock and perhaps even other assets in trust for the lifetime of your child and he or she has no control over those assets–because it’s a trustee who makes all decisions about the interest and principal–no one, not a divorcing spouse nor any creditor, can get at the trust’s assets.”
Landau recommends that you give your children the right to name and remove the trustee. “That gives them some degree of control, while still achieving your objective of minimizing estate taxes and protecting against the risks of a marital breakup,” he says.
Is there a way to manage my company’s future growth that will make second-generation planning less cumbersome?
Lawyer Jerome Deener, senior partner at Deener, Feingold & Stern, in Hackensack, N.J., recommends the use of limited-liability companies (LLCs), which could make sense if you’re diversifying into new business lines or making acquisitions that could just as easily be spun off into separate corporate entities. (It’s complicated to switch to the LLC corporate structure with an existing business operation.) If you follow the strategy of setting up an LLC, confine your gifts to LLC shares rather than stock in your existing C or S corporation.
LLCs work nicely because the rights of their owners can be tightly controlled according to a management agreement that restricts stock transfers. You can build all kinds of instructions into the writing of the agreement, such as the requirement that no partner be able to transfer his or her ownership interest to anyone without the consent of all partners. In such cases, a divorce-court judge would be unable to award ownership of the stock to an ex-spouse who was not an original recipient.
It goes without saying that this type of agreement would also require all partners (even if that means just you and your spouse) to vote and agree to pass shares along to children as part of an estate-planning gift. And if your LLC is structured to include multiple owners, among them nonfamily members, you do need to feel fairly certain that they’ll go along with your basic program (voting yes on gifts to family members and no on transfers of children’s stock to ex-spouses in the event of a divorce). If not, you might be better off skipping the LLC strategy entirely.
One final caveat: don’t delude yourself into thinking you can avoid the risks that accompany second-generation divorces simply by restricting your lifetime gifts to assets other than stock. CPA Rampell has another story he likes to tell on this front: “A client of ours owned a retail chain, and when she started doing some estate planning, she decided to keep the company stock to herself but to give the company’s real estate assets–the property on which her stores were based–to her kids. When one got divorced, she found herself forced to negotiate with a hostile ex-in-law on one of the stores’ leases…and eventually wound up having to relocate that store because those negotiations just got too expensive.”
To avoid a similar downside result, take the same precautions recommended earlier on all estate-planning gifts that could affect your company’s future. That might mean housing those gifts within an estate-planning trust or requiring recipients to sign a legal document, along the lines of a buy-sell agreement, that would require them to transfer the gift back to you as the company owner if they get a divorce. (As always, specify how the transfer will be valued and paid for.)
Are family divorces the only ones I need to worry about? And if not, what precautions do I need to take?
It’s difficult to come up with a complete scoreboard of all the marital breakups that could conceivably make your life as an entrepreneur miserable. But here’s a short list: Your business partners’. Your investors’. Your key employees’ (if you’ve given them stock or even warrants).
“Anyone who has seen the havoc that a hostile minority shareholder can cause would never again hesitate to take some precautionary measures,” says Michael Brown. “We often are hired to perform a forensic accounting evaluation of all the ways that an owner is taking money out of the business. It can get as elaborate as examining every American Express bill, every car-lease arrangement and other ownership perk.” The rationale behind that type of foraging is simple: your minority shareholder is worried about a situation in which you’re taking too much money out of the company through various perquisites rather than concentrating on building the company’s value and thus the shareholder’s investment. “You just don’t want to leave yourself open to that by failing to restrict stock that passes out of your hands,” Brown advises.
Lawyer Landau recommends considering an agreement–whether between business partners, a company and its equity investors, or others with stock or option holdings–that says in the event of a divorce, stock automatically becomes nonvoting and must be offered for sale to the company at a specified price or valuation formula.
If you don’t have a divorce-proof shareholders’ agreement in place, make it a high priority to negotiate one that will bind everyone who’s holding your stock. You’ll all need to sign it. But it may be easier to persuade your minority partners to sign it than you expect. After all, they’ll be better protected, too, since such an agreement will safeguard their own holdings as well as the company’s future if you’re the one to wind up in divorce court and a judge tries to give away 50% of your shares.
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