This news service talks to Northern Trust about the kind of complexities arising when business owners and their spouses break up, and the sort of structures and methods that can be used to make the process less painful and disruptive than it needs to be.
There are several ways that couples can structure business and other interests to ensure that however acrimonious a split is, it does not destroy what has been built and protects third parties.
Co-owning assets after divorce: If the divorcing couple needs to continue to co-own assets for a period of time, there are two potential options:
1. A partnership (LP/LLC)
-- But this may or may not be allowed under the terms of the operating agreements of the business.
2. A trust with an impartial trustee like a corporate as a trustee
-- This might be an option, especially if the asset doesn’t permit transfer to a partnership.
-- Both parties can contribute their interests to a trust, with an impartial trustee acting as an intermediary to hold shares of the business in an agreed upon manner. The trust can include other safeguards to ensure both parties’ interests are protected until a buyout (or outright sale).
-- For example, a third party (impartial trustee) can oversee and monitor the operating spouse to make sure the covenants are being kept and the financials are prepared correctly.
A term that needs to be understood is that of the "buying spouse". Such a person is the spouse that intends to remain in the business after the divorce, and looks to buy out their spouse’s interest as part of the settlement. The selling spouse is the one who will be bought out.
When co-ownership post-divorce is not a viable option (either logistically not permitted or parties refuse) a structured sale through a deferred payment, or an earn-out, can be considered. In a deferred payment, the buying spouse (who will hold the assets moving forward) pays the selling spouse a large sum payment up front with a remaining portion of proceeds paid out over time, with potential interest (a.k.a. a seller’s note). One issue w/ this option is that both parties still need to agree on value upfront and that might be difficult.
Another term that arises is the "earn-out". This works in the same manner with the buying spouse paying an upfront lump-sum to the selling spouse (potentially at a discount), followed by earn-out over a number of years (e.g., 3 to 5) based on the assets future performance (revenue growth, cash flow). Pros and cons to earn-outs include:
They offer upfront liquidity for the selling spouse, as well as a discounted price for the buying spouse. Also, the overall purchase price is tied to future performance (when uncertainty hopefully subsides), which helps to give both parties some degree of comfort.
It is traditionally difficult for a selling spouse to “police” earn-outs. This may create concern that a buying spouse may achieve $1 short of the earnout
With a clawback, an initial price is established and the buying spouse buys the selling spouse out of his/her interest. However, the transaction is subject to to a “clawback”. This means that if the business sells within a stated period of time, (e.g., two or three years after divorce), the buying spouse agrees to share all, or a decided upon percentage, of future sale proceeds that exceeds the valuation (or sales price between the two spouses) at the time of divorce.
On the plus side, they provide immediate liquidity to the spelling spouse and there is no ongoing co-ownership issue. The buying spouse sells to selling spouse at a discount since selling spouse has opportunity to participate in any upside without having to do any work him/herself.
However, on the downside, it might be hard for spouses to negotiate the discount rate to initial value, as well as the percentage amount of upside that buying spouse is to share with selling spouse. Similar to an earn-out, a “clawback” must be carefully drafted/negotiated, and the selling spouse will need to closely monitor the business to ensure everything plays out properly.
As these examples demonstrate, dividing business interests because of a divorce is a complex business, and organizations such as the group at Northern Trust are likely to be kept busy in coming months, and years.