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 post aims to demystify some of the key considerations when navigating these financial aspects of a divorce.
What do we mean by “private investments”?
Although a very general term, in this context, we use "private investments" 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, we’re also focusing on passive ownership when we use this term, where neither spouse actively manages nor controls the business entity.
What do we mean by a “business”?
"Business " here describes situations where 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.
The (Multi) Million Dollar Question.. 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 start is by inquiring with the sponsoring company to ask for the most recent valuation information.
If values for these investments are not available, other avenues to determine the correct value to use must be explored. Such avenues are like those described below under “Value of a Business”.
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 what is covered here, we feel that it may be helpful for divorcees to understand certain key terms that apply. 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 that are used to appropriately 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. As a specific buyer might pay more for a business, often a higher value is determined 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, 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 of what we discuss here 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. A brief description of each follows:
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.
Why does any of this matter? These points underlay the importance of understanding a few things.
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, and consideration must be given to the value of expected future business profits and other intangible aspects that do not show up in financial statements.
Second, valuing a business is complicated. 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 to the overall value that could be lost by one spouse in a divorce that accepted a value that was inequitable.
Third, a thorough valuation requires a lot of information. Such information includes quantitative information such as company financials as well as qualitative information such as how the company is managed and its competitive strengths and risks. Gathering the right information can be challenging in the best of times and 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) as well as economic and market-based changes (external factors). It is imperative that the valuation date is agreed upon as part of a divorce process. If valuations have been performed in the past, it is important to consider whether such value remains appropriate and is representative of the current company and market conditions.
Other Issues of Business Ownership in a Divorce
Beyond valuation, several other critical issues arise:
Who controls and manages the business during the divorce?
During the divorce proceedings, decisions regarding business operations must be addressed. Sometimes, where one spouse is the active manager of the business while the other is not active, this is less of an issue. However, often the business is a family business that is co-managed by both spouses.
In these cases, it is important to understand the options for management of the company and duties of each spouse. The ideal outcome is where both spouses continue to work together. They are honest with each other, and both see themselves as stewards of the business where maintaining smooth operations is in the best interest of all stakeholders.
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 as partners 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, it may be necessary 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 the case of 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 and associated profits, this can create a significant short-term financial hardship for the non-active spouse if they no longer receive a portion of company profits.
Once more, 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 is kept of the company income, expenses, and profits during the divorce process. Again, though, this outcome may be too idealistic. It is common practice that during a divorce temporary spousal support is requested and granted by the courts. In these cases, 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 which 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:
- 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 how the business will be managed post-divorce and agreeing on the right value to use for the business.
However, significant cons for this option may also exist. For one, the economic engine that creates income 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 maintenance. Moreover, selling the business is often simply inconsistent with the career and retirement goals of owners.
- 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 that will not retain ownership in the business receives an equivalent amount of non-business marital assets. For example, if a business is determined to be valued at $3 million, one spouse could keep the business while the other receives $3 million in cash, home equity, or liquid investments.
The main benefit to this option is that it keeps the separation of assets equitable, and there is a clean break between spouses as it relates 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.
- 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 pursuant to the divorce from one spouse to the other. Each spouse separately generally 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. Remaining business partners is akin to a marriage in many regards. Where the relationship has deteriorated and resulted in an ended marriage, it becomes very challenging to continue to manage a business together. In many cases this outcome simply leads to continued conflict and potential further legal action later. For these reasons, it is in the best interest of most to sever financial ties together as cleanly as possible.
That said, in certain cases 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. Also, in certain 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 case, it would hurt both parties financially.
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:
- Recommendation #1: Hire the right professionals for advice.
Engage valuation experts and/or M&A 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.
- Recommendation #2: 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 a full list of information needed, this will give you a solid foundation for your divorce team to understand how to proceed and best advise you.
- Recommendation #3: 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.
- Recommendation #4: 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 towards a fair and equitable resolution. Investing in professional advice up front can save money and heartache in the long run.
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).
