Matters Column

Can you ‘divorce proof’ your family-owned business?

May 3, 2013
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A significant risk facing family-owned businesses is almost uniformly unaddressed: the risk that the company gets embroiled in the divorce of one of its shareholders. Companies have strategic plans and all manner of contingency plans, yet leave themselves exposed to the risk of significant harm in the event that the company gets caught in the crossfire between divorcing spouses, one of whom owns an interest in the family-owned, and privately held, business.

Can you think of any circumstance where a company leaves itself vulnerable to divulging all of the following?

  • Financial statements and tax returns for the last five years.
  • Details of the company’s product mix and emerging markets.
  • The company’s customer mix and channels of distribution.
  • The company’s past capital investment and future capital investment plans.
  • All of the company’s future forecasting.
  • The company’s banking and lending relationships and details of all loans.
  • Compensation information for all members of management.
  • History of distributions to shareholders and production of all K-1s.
  • Identification of any potential personal expense run through the business.
  • Revealing anything that the company views as its “secret sauce.”

All of the above items, and more, are produced and robustly debated in a divorce action between parties who own an interest — even a minority interest — in a closely held company. Can you imagine that a company would not take proactive steps to avoid these problems when the risk is greater than 50 percent?

Yet that’s exactly what companies do — namely, nothing — despite the reality that more than 50 percent of marriages end in divorce. In a family-owned company with four shareholders, each of whom has a 50 percent chance of divorce, this means there’s a greater than 90 percent probability the company will encounter a shareholder divorce.

But hold on: Certainly all of the information about the company will be protected, right? Surely access to the company’s confidential information will be strictly limited to a very few people?

The answer is: “Yes, but …” only for a limited period of time. The company’s confidential and proprietary information will be protected by a Protective Order during the case, but all bets are off if the case goes to trial. At that point, the company’s most personal and private information is figurative laundry hanging in the public square. Trials are inherently public events, and those pre-trial Protective Orders end when battling spouses take it to the mat in a full-blown trial.

So who benefits — and who pays — for the risk that the company’s proprietary and confidential information is spread around the public square?

In the litigation “game of chicken,” the risk of public disclosure of a company’s confidential information will always favor the non-owner spouse. The shareholder spouse, on the other hand, is motivated and probably pressured by the company to resolve the case and protect the company’s information.

Which brings us to valuation. 

As horrible as it is for a family-owned company to be embattled in the divorce of a shareholder, with its management and administrative staff distracted by producing all of the “guts” of the company’s financial and proprietary information, add to the mix the fact that each party to a divorce hired his/her own business valuation expert to value the stock. And the experts don’t agree. In fact, they’re often planets apart in their valuation. 

With widely divergent valuations and a sea of numbers, then factor in the risk that the court might not “get it right” in terms of valuing the stock if the case goes to trial. This is particularly concerning given that trial courts have great latitude in terms of valuing assets, specifically stock in privately held companies. In short, if both valuations come into evidence (and they typically do), it is almost impossible to reverse on appeal a trial court’s valuation finding if it’s within the range of proofs.

So what if the court gets it wrong? What if the value is too high? What if the shareholder cannot afford to pay the value determined by the court?

This is frequently a problem because stock in privately held companies is illiquid. Nonetheless, the divorcing shareholder spouse is typically ordered by the Court in the Judgment of Divorce to come up with cash within a certain period of time to pay an equalization payment to the non-owner spouse.

But what happens if the divorcing, now divorced, shareholder cannot come up with the cash? Is the stock at risk?

You bet it is. The non-owner spouse will have the same rights as any Judgment creditor, including the right to attach, and sell, assets — including the stock in the family-owned business. And if corporate governance documents of the family-owned business do not prevent it, the company can literally end up with a new shareholder, including the unthinkable:  the ex-spouse of the now former shareholder and member of the family owning the business, perhaps for generations. 

Does all of this happen? Almost never, but only because the case is forced to resolution to avoid the risk of such cataclysmic results. You can imagine, however, the angst and turmoil experienced by the family members who run the family-owned business who repeatedly ask “how can that happen?” when they experience first-hand the business risks incidental to a shareholder divorce.

While the above risks are almost uniformly ignored by family-owned businesses, they shouldn’t be. The good news is that the above risks can be controlled through the creation of corporate governance documents that protect the confidentiality of the company’s information, keep any valuation-related dispute out of court and control the valuation process.

Proactively addressing these issues with an attorney versed in corporate law, business valuation and family law can potentially save your family-owned business a great deal of uncertainty, expense and frustration.

Paul A. McCarthy, J.D., MBA, is an attorney at Rhoades McKee PC. He can be contacted at mccarthy@rhoadesmckee.com.

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