In this edition of Ask General Counsel, we are discussing an issue that far too often impacts business owners – the potential devastating impact of divorce and, most importantly, preventative measures that all businesses should implement to protect their business.
The best way to ensure smooth corporate operations is to anticipate risk and events at the outset of an enterprise. Unfortunately, the same positive energy that can help launch a great business can also interfere with people’s willingness to discuss negative future events, even if it is in the best interests of the business to do so.
Divorce can be a difficult time for an individual equity holder, but, if a company has not planned ahead, that equity holder’s divorce can have significant ramifications for the company’s operations and future. The best way to prevent a divorce from affecting an equityholders’ business is before a divorce happens. This can be done by structuring ownership to avoid confrontations and incorporating certain key provisions into the organizational documents (e.g. bylaws, shareholders’ agreements, or operating agreements) to control the transfer of equity within a business.
Transfer and Buy/Sell Provisions in Shareholders’ Agreements and Operating Agreements
Equityholders in a business can negotiate with each other to establish a series of rights, restrictions or obligations regarding equityholders going through a divorce. Shareholders’ agreements (for corporations) or operating agreements (for LLCs) can include provisions that:
- Block the transfer of equity to the ex-spouse of an equityholder.
- Allow the other equityholders or the company to repurchase units of an equityholder going through a divorce.
- Prohibit management powers from being exercised by unauthorized equityholders.
- Agree beforehand upon the manner of valuation of equity upon divorce.
By planning ahead of time to prohibit unauthorized transfers and/or allow for repurchase, a company can prevent having to admit an inexperienced business associate, and an ex-spouse can be sure that their equity will be able to be sold even if no market exists for them at the time.
Spousal consents are common requirements for shareholders of closely-held corporations and members of LLCs and are generally used in conjunction with an operating agreement or shareholders’ agreement. A spousal consent is a document signed by the spouse of an equityholder to ensure that (a) the spouse is aware of transfer and other restrictions placed on such equity and (b) will not claim an interest in the company (in particular, in the management of the company) upon the death or divorce of their equityholding spouse, among other issues. They are particularly useful in heading off objections to repurchase and transfer restrictions in a company’s organizational documents (where such spouse would not otherwise be a party to such agreement or have knowledge of its provisions). They may also contain provisions that:
- Clarify that any community property interest in the equity is subject to the shareholders’/operating agreement.
- Authorizes the equity-holding spouse to act on behalf of both spouses with regard to such property (e.g. in permitting corporate amendments or sale of the equity).
- For LLC members, state that a spouse may receive the economic benefits of their spouse’s equity but not be admitted as a member of have management authority in the case of a death or divorce of such spouse.
- Acknowledge provisions allowing for or requiring repurchase of equity from a spouse of a deceased shareholder/member.
Form spousal consents are usually decided upon by the equityholders and attached as an exhibit to the applicable organizational document. These documents are more likely to be deemed enforceable by having their terms incorporated into or mirrored in a validly executed prenuptial or postnuptial agreement that strictly conform with state requirements. As such, you should consult with a qualified family law attorney before relying on or assuming the enforceability of a spousal agreement.
Equity Splits – Planning Your Business for Success
One of the most frequent issues arises around closely-held businesses owned primarily or exclusively by a couple who are married to one another. Not only can emotions run particularly hot when both owners are simultaneously going through the stress of a divorce, but, in companies that have not anticipated such issues, significant management problems can emerge during a divorce. Below are some commonly occurring scenarios among business-minded married couples, but can apply to any closely-held business entity.
- The 50/50 Split – Unequal Is Usually Better. Frequently, spouses will start a company together and split equity in the company equally, with each spouse receiving 50%. Upon divorce, decision-making quickly arrives at a deadlock, as neither party has majority control and cannot direct the company to act. Often, the only solution in such a situation is to have one partner buy some or all of the equity from the other partner to resolve the deadlock, or to seek judicial intervention and/or dissolution of the business entity. This can lead to cessation of an otherwise profitable business – as well as cause a huge loss in value as property is quickly liquidated for below-market prices and employees are laid off. For this reason, we almost always encourage couples who are starting a business to give one partner majority control. That partner should be willing and ready to take sole control of the business in the event of a divorce. If this eventuality is discussed beforehand, often the minority equity-holding spouse can obtain a promise or contract for some other item of value to “equal out” the distribution of wealth between the spouses without having to compromise the continued life of the business.
- Ownership to Qualify for Set-Aside Contracts For Small Businesses. Other times, a spouse who is not a member of a historically socially-disadvantaged group or veteran of the armed forces will gift majority control to their spouse to take advantage of federal or state contracting programs, such as the Women-Owned Small Business (WOSB) or Service-Disabled Veteran Owned Small Business (SDVOSB) programs offered by the Small Business Administration (SBA). That spouse often regrets this decision when, upon a divorce, their spouse is able to force them out of their own company; or, alternatively, the majority owning spouse may be less interested in continuing the business post-divorce. Often, it is better to have the person who is most willing and able to continue the business be the majority owner, even if this disqualifies a business from special interest designations.
Divorces often precipitate attempts by one spouse to oust or minimize the business involvement of the other spouse. Certain minority-rights protection provisions can maintain fairness and preserve the business interests of all parties involved. While the following are useful in any business situation, they are particularly applicable between co-owning spouses.
- Amendment requirements can ensure that any amendment proposed that unfairly affects one member over another (e.g. by destroying the rights of one class or holder of equity but not another) require the approval of the unfairly affected party.
- Anti-dilution protections can allow a minority member to purchase their proportional share of newly issued equity so that they can’t have their interests intentionally diluted by the majority member.
- Board participation irrespective of the relative size of ownership can be written into an operating agreement.
- Supermajority approval requirements for particular important transactions can be written into operating documents.
- Rights to review the company’s books, records and statements can be limited or expanded.
- Tag-along and drag-along rights can ensure that one member is not cut out of the economic benefits of a larger corporate transaction.
This article was researched and written by Evan St. John, Senior Corporate Associate with General Counsel, P.C. If you have questions, you can contact Evan at email@example.com.
For more information about how to protect your business prior a divorce, contact General Counsel, P.C. Corporate attorneys at General Counsel, P.C. are experienced in all aspects of tailoring shareholders’ agreements, operating agreements, and other ancillary contracts to ensure smooth functioning of your business enterprise. Contact us today so we can help you protect your interests. Telephone: 703-556-0411; Email: firstname.lastname@example.org; or use this Contact Us Form.