By Donna L. Maul and Daniel H. Adler
As a business owner, you can choose your partner or co-owner. But what business owners often overlook are the spouses sitting in the wings, who could impact your business or partnership even if they are not titled owners or partners. If your co-owner/partner’s marriage hits the rocks and divorce follows, it can have significant, unwelcome, and unanticipated consequences for ongoing business operations and interests.
Given that many marriages end in divorce, which may lead to serious business fallout, failing to plan in advance for this possibility early in your entrepreneurial journey could become a costly oversight. Whether you are launching a new business/partnership or have operated one for years without previously considering this issue, it is important to understand what can happen if your co-owner or partner divorces and what steps you can take to protect the business from disruption and unnecessary entanglement in the divorce process. Specific agreements can be drafted between business partners and co-owners that will be binding on, and potentially limiting to, a spouse’s equitable interest if divorce occurs.
Your Co-Owner/Partner’s Interest May Become an Issue in Divorce Proceedings
The division of property in a New Jersey divorce is governed by the doctrine of equitable distribution, under which marital assets are divided fairly, although not necessarily equally. Assets owned by a spouse before marriage are generally considered separate property and are not subject to equitable distribution. However, any increase in the value of those assets during the marriage may be subject to distribution in a divorce, resulting in financial consequences.
As a result, appreciation in the value of a business from date of marriage to date of Complaint for Divorce may become an asset of the marital estate, even if the business itself was established before the marriage. If your co-owner/partner started or acquired their ownership interest after marriage, their entire interest could potentially be subject to equitable claims in the divorce. This creates the possibility that a spouse who has never worked for or otherwise participated in the business and who has little knowledge of its operations could receive an ownership interest, a security interest, or force a buyout that places financial pressure on the company.
From Disruption to Disaster
Without safeguards, a co-owner/partner’s divorce may quickly become your problem. The divorcing spouse can claim that the ownership interest is marital property and demand a share of its value. This often requires a formal business valuation by a forensic accountant. These valuations can be expensive, and dueling experts routinely reach wildly different numbers because of their view of the business’s intangible “goodwill” and their use of different acceptable approaches to value the business.
Although rare, a court could order the sale of the business to facilitate the division of assets, or the non-titled spouse could create outside pressure. But more often, the danger to the business is subtler: a divorcing partner/co-owner may have to sell or liquidate their interest to fund a settlement. They may force an untimely buyout, drain company resources, or cause the company to need additional capital, bringing on new investors that the original owners never wanted. One owner’s marital divorce can therefore lead to a business divorce among the partners/co-owners, resulting in oppression claims, dissociation fights, and deadlock once a resentful or cash-strapped owner starts fighting over the business’s value.
But there is good news. Thoughtful advance planning and well-drafted protective agreements can significantly reduce or avoid the collateral damage of a co-owner’s divorce.
Buy-Sell Agreements With Divorce Triggers
A comprehensive buy-sell agreement is your first line of defense against the unwanted consequences of an owner’s divorce. The agreement should contain provisions that specifically address the event of an owner’s divorce and often require the divorcing owner to buy out any interest that might otherwise be transferred to a spouse. Alternatively, they may grant the company or the remaining owners the right to purchase that interest pursuant to a predetermined formula.
The agreement should clearly provide that a divorcing owner may not transfer ownership interests to a spouse as part of a divorce settlement. It should also establish a valuation methodology in advance, whether based on book value, a multiple of earnings, periodic independent appraisals, or another agreed-upon approach. When entering into a buy-sell agreement, each owner’s spouse should execute a spousal acknowledgment, expressly acknowledging the agreement, including their transfer restrictions and buyout mechanisms, and consent to be bound by them. This practical step can meaningfully strengthen the enforceability of these provisions against a spouse in a New Jersey divorce proceeding.
It is also important to plan how a divorce-triggered buyout will be funded. Unlike death or disability triggered buyouts, which are commonly funded through life insurance or disability buy-out insurance, divorce-triggered provisions require alternative funding sources. Installment payment structures, dedicated sinking funds, or pre-arranged third-party financing are options that should be considered or expressly addressed in the agreement. A buy-sell provision that cannot be practically funded when triggered provides far less protection than it appears to on paper.
Prenuptial and Postnuptial Agreements
It might feel a bit intrusive and overreaching to ask or compel a co-owner or business partner to enter into a pre- or postnuptial agreement for the purpose of shielding your shared enterprise from a divorce. However, you may make such agreements a condition of ownership, or of receiving additional equity in the company. An effective prenuptial or postnuptial agreement can expressly segregate a business interest, minimizing the impact of a future divorce upon the business partnership as separate property, or limit spousal rights in the event of future divorce, thereby keeping it outside the scope of divorce proceedings.
Strategic Business Structuring
The legal structure of a business from inception can also provide additional layers of protection when a co-owner/partner divorces. LLC operating agreements and corporate shareholder agreements can include transfer restrictions, rights of first refusal, and consent requirements that prevent involuntary transfers to non-owners, including former spouses.
Businesses may also consider creating different classes of ownership interests, with voting rights and management authority reserved for specific classes. Under such an arrangement, even if a spouse were awarded an economic interest in the business, that interest would not necessarily enable participation in management or interfere with daily operations. Care must be taken, however, as the creation of multiple classes of ownership interests may not be available for every business type, such as an S corporation, which permits only a single class of stock.
If these issues have not yet been discussed among co-owners/partners, whether they are single, happily married, or somewhere in between, now is the time to address them. The discussion should not be framed as skepticism about anyone’s marriage, but rather as prudent, strategic business planning and risk management that protects the partners and co-owners equally in the event of future divorce. Because these issues sit squarely at the intersection of corporate law and family law, effective protection requires a coordinated approach involving counsel experienced in both disciplines so that the business’s governing documents and any matrimonial agreements are designed and aligned to work in concert with one another.
If you would like to discuss issues relating to business ownership and divorce, please contact Donna Maul at DMaul@Ansell.law. If you require a business planning consultation, please contact Daniel Adler at DAdler@Ansell.law.