Divorce is rarely simple, but when business ownership and private investments are involved, the complexities multiply. Unlike dividing household items or liquid assets, these situations require a nuanced approach and specialized expertise. This chapter aims to demystify these financial aspects of a divorce.

Click here to Download our During Divorce Guide

What do we mean by “private investments”?

Although a general term, we use "private investments" in this context to describe any investment owned within the marriage that lacks a readily available, public valuation. Think rental properties, investments in private equity, hedge funds, or private real estate partnerships. These contrast with public stocks, whose values are transparent and updated daily on regulated markets. Importantly, private investments involve passive ownership, where neither spouse actively manages nor controls the business entity.

What do we mean by a “business ownership”?

Another key consideration is when one or both spouses own all or a significant portion of a private business. Typically, one or both spouses are actively involved in its day-to-day operations and has significant control over the operations of the business.

What is the business or private investment worth?

Value of Private Investments

The good news is, in many cases, the sponsor of an investment often provides estimated values at regular intervals. For example, hedge funds and private equity funds may provide valuations on a quarterly basis. This is also generally true for private real estate investment funds and partnerships. If you or your spouse own these types of investments, the first place to seek out valuation information is the sponsoring company.

If the company does not have estimated values for these investments, you’ll need consider the valuation options in the next section.

Value of a Business

A fundamental challenge in divorce cases is determining the right value to assign to a small business. Divorce attorneys and judges, while skilled in legal matters, generally lack the specialized expertise needed to accurately value a private business or investment. This is where the need for professional valuation comes into play.

Although a deep dive into the complex arena of business valuation for divorce is beyond the scope of this book, certain key terms may be helpful for couples going through divorce. First, one of the most important variables to understand is the correct standard of value to use.

Standard of value generally describes the basis and underlying assumptions used to measure business value. For example, a business may be worth more to a particular buyer or owner with an established network or reputation in an industry than another buyer without those things. This is referred to as an investment value standard. When a specific buyer might pay more for a business, a higher value may be determined when using the investment value standard.

Conversely the “fair market value” standard is generally defined as the price at which the property would change hands between a hypothetical willing buyer and seller, with neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.[1] Depending on the state, either the fair market value or investment standard may be used.

To add even greater complexity, many states refer in both statute and case law to a fair value standard, the definition of which also varies by state. However, generally, fair value standards still follow many of the same methods used to value businesses as those described above. The important point is this: to determine a defensible value for a private business, one must understand the state specific rules of determining value in a divorce.

Separate from the standard of value used, businesses are valued using several methods, and often a combination of methods. Three common methods include: (1) the asset approach, (2) the income approach, and (3) the market approach:

The Asset Approach

This method focuses on the business's net asset value, which is the difference between its assets and liabilities. It's often used for businesses with significant tangible assets.

The Income Approach

This approach determines the business's value based on its future earning potential. Techniques like the discounted cash flow (DCF) method are used to estimate the present value of future cash flows.

The Market Approach

This method involves comparing the subject business to similar businesses that have been recently sold. It relies on finding comparable transactions to establish a market-based value.

These different valuation methods highlight the difficulties of determining business division during a divorce.

First, a business can be (and often is) worth substantially more than the difference between assets and debts as shown on a company balance sheet. Businesses often have significant value that exceeds the value of physical assets, both in the value of expected future business profits and other intangible aspects that do not show up in financial statements.

Second, most owners of businesses have no idea what their business is worth, never mind how each state would interpret and adjust value in the divorce context. As such, it may be expensive to have a business professionally valued. However, often this cost is inconsequential for a spouse in a divorce who places exceptional value in a business they own.

Third, a thorough valuation requires a lot of information, including company financials, documentation, how the company is managed, and assessments of its competitive strengths and risks. Gathering the right information can be challenging in the best of times but can be even more burdensome in the divorce setting.

Finally, valuations are performed at a point in time. Values regularly change based on company-specific outcomes (internal factors) and economic and market-based changes (external factors). The valuation date must be agreed upon as part of a divorce process. Previous valuations may or may not remain appropriate and representative of the current company and the surrounding market conditions.

Other Issues of Business Ownership in a Divorce

Who controls and manages the business during the divorce?

This question must be answered early in the divorce proceedings. When one spouse is the active manager of the business and the other is not, this is less of an issue. However, when a family business is co-managed by both spouses, it is important to understand the options for management of the company and duties of each spouse. Ideally both spouses continue to work together and remain honest with each other, with both seeing themselves as stewards of the business.

Unfortunately, the ideal outcome is not always the reality. You, or your spouse, may find it too emotionally difficult to continue to operate the business together during your divorce. In this case, the first place to start is the company’s operational documents, such as a partnership or operating agreement. These agreements may outline the respective roles and responsibilities of managers and provide clarity on who is responsible for ultimate decision making within the business. If this is not made clear in the documents, you may need to file a request with the court for exclusive control or some other temporary management arrangement.

How is income from the business distributed during the divorce?

Ensuring fair distribution of income during this period is essential. In many small businesses, the profits generated and distributed to owners provide for a significant amount of the income for the marital household. In cases where one spouse retains full control of the business, the non-active spouse may encounter significant short-term financial hardship if they no longer receive a portion of company profits.

In a perfect world, both spouses continue to communicate and come to an agreement early on about how distributions will be shared and how the record will be kept of the company income, expenses, and profits during the divorce process. Again, though, this outcome may be too idealistic. It is common practice for one party to request temporary spousal support during a divorce. If the court grants this request, the profits of the business are considered a resource by the payor spouse when calculating their ability to pay.

In very extreme cases, typically involving cases of financial mismanagement, it may be requested by either spouse that a receiver be appointed for the business. A receiver is a court appointed temporary occupant and caretaker of the business for the court and acts as a medium through which the court acts and makes decisions[2]. The receiver acts as an independent third party that handles the financial aspects of a business, including receiving revenue, paying expenses, and distributing profits. However, court appointed receivership is typically only used as a last resort as it comes with a hefty financial cost.

How will the business be divided when the divorce is finalized?

Common options include:

1. Selling the business and splitting the proceeds.

The benefit of selling the business and splitting the proceeds is avoiding many of the more complex issues such as determining how the business will be managed post-divorce and agreeing on the right value to use for the business.

However, this option comes with obvious negatives. For one, the economic engine for both parties would be eliminated. Even if one spouse may not directly control profits post-divorce, stopping the profits due to a business sale may negatively impact spousal support during and after the divorce. Moreover, selling the business is often inconsistent with the career and retirement goals of the owners.

2. One spouse "buys out" the other with other non-business property.

Under this arrangement, an agreed upon value is assigned to the business. When the separation of assets takes place, the spouse who gives up ownership in the business receives an equivalent amount of non-business marital assets. For example, if a business is valued at $3 million, one spouse could keep the business while the other receives $3 million in cash, home equity, or liquid investments.

This option keeps the separation of assets equitable, providing a clean break between spouses related to managing the business going forward. However, this option is only viable if there are sufficient non-business assets to begin with. Moreover, determining a fair and equitable value for the business is of the highest importance under this option. For example, let’s assume that you agree to a $3 million value for a business, accept an equivalent amount in other non-business marital assets, and the divorce is finalized. If the business is sold for $6 million a year later—it’s very likely the separation of assets was not equitable! Unfortunately, this would only be discovered in hindsight.

3. Continuing to jointly own the business.

This method is a relatively straightforward continuation of the same ownership shares owned during the marriage, or a transfer of partial ownership from one spouse to the other. Each spouse separately remains entitled to their proportionate share of company profits and value received if the company is later sold.

Although simple, this method is used relatively infrequently. Being business partners is akin to a marriage in many regards. When a relationship has deteriorated to the point of divorce, it becomes very challenging to continue to manage a business together. In many cases this outcome simply leads to continued conflict and future legal action. For these reasons, severing financial ties as cleanly as possible during the divorce process is generally a better option.

That said, sometimes this may be the best outcome in a bad situation. For one, there may not be sufficient non-business assets to fairly and adequately shift ownership solely to one spouse while keeping the overall division equitable. In other cases, both spouses are meaningful contributors to the business. If one spouse were to exit the business, the overall impact to business value and profits may be severely diminished. In this situation, it would hurt both parties financially.

As you can see, careful consideration should be given to the goals of each spouse, the legal and financial implications, and overall facts and circumstances to determine the most appropriate path for splitting the business as part of a divorce.

Recommendations for Handling Business and Private Investment Ownership

To summarize the many points made above, consider these recommendations for handling your business and private investments in your divorce:

• Hire the right professionals for advice.

Engage valuation experts and/or merger and acquisitions professionals to accurately determine the asset or business value. Consult a tax expert to understand the tax implications of various division scenarios. Retain a transaction attorney experienced in business valuation and divorce. Start with your divorce attorney or a divorce finance professional to determine what specialists noted above may be applicable to your case.

• Gather the right information.

Obtain operating documents (partnership agreements, shareholder agreements, operating agreements) that outline transfer restrictions and management rights. Request any historical formal valuations and gather historical financial information (tax returns, financial statements). While this may not be all the information needed, this will give you a solid foundation for your divorce team to understand how to proceed and best advise you.

• Think carefully before retaining joint ownership of an asset after you’re divorced.

Joint ownership can lead to ongoing conflict and complications. While this may seem like the simplest outcome today, keeping financial ties may result in continued emotional and financial stress. Ultimately, you may find yourself in another legal battle as a result. Carefully consider the ongoing quality of your relationship and ability to work together.

• Pay for a valuation from a licensed valuation professional.

While it may seem costly, a professional valuation is crucial for ensuring a fair and equitable division of assets. As the saying goes, don’t step over dollars to pick up pennies! Foregoing a professional valuation may carry what seems like a significant cost. However, in our experience, this cost is often a small fraction of the overall value of the business itself. In these cases, consider a professional valuation as insurance for your peace of mind and confidence that you are getting a fair and equitable deal.

Conclusion

Divorces involving business ownership and private investments require a meticulous and professional approach. By understanding the complexities, seeking expert advice, and gathering comprehensive information, you can navigate these challenging situations and work toward a fair and equitable resolution. Investing in professional advice up front can save money and heartache in the long run.

[1] Treasury Regulation 20.2031-1

[2] Pacific Independent Co. v. Workman’s Compensation Appeals Bd., 258 258 Cal. App. 2d 35, 65 Cal. Rptr. 429 (968).

Ready to get Started?

Schedule a call with one of our Certified Divorce Financial Analysts™ (CDFA®) professionals today!

The information in contained herein is intended for educational purposes only, and should not be considered legal advice. For legal advice, you should consult with a licensed attorney and estate planning professional. Investment advice, financial planning, and retirement plan services are provided by Prosperity Planning, Inc., an SEC registered investment advisor. The information contained herein, including but not limited to research, market valuations, calculations, estimates and other material obtained from these sources are believed to be reliable. However, Prosperity Planning, Inc. does not warrant its accuracy or completeness. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or to participate in any trading strategy. If an offer of securities is made, it will be under a definitive investment management agreement prepared on behalf of Prosperity which contains material information not contained herein and which supersedes this information in its entirety. Any investment involves significant risk, including a complete loss of capital and conflicts of interest. The applicable definitive investment management agreement and Form ADV Part 2A will contain a more thorough discussion of risk and conflict, which should be carefully reviewed before making any investment decision.

[1] Treasury Regulation 20.2031-1

[2] Pacific Independent Co. v. Workman’s Compensation Appeals Bd., 258 258 Cal. App. 2d 35, 65 Cal. Rptr. 429 (968).