Divorce presents significant challenges to any family, and when business founders are involved, these personal difficulties can threaten the stability and governance of their companies. The emotional turmoil and legal complexities of divorce often lead otherwise reasonable individuals to act in uncharacteristic ways, potentially creating serious business risks that affect all stakeholders.
Company founders must understand the risks that a business owner's divorce presents to their enterprise and take proactive steps to mitigate these threats before they materialize.
The equity interest of a spouse who founds a company (a "founder-spouse") may be deemed marital property, or a divorce court may decide to divide the equity interest between the founder-spouse and the other spouse. In either scenario, the non-founding spouse could obtain an ongoing interest in the company after the divorce.
The consequences of such a division can be severe for a business. Without proper planning, the often-hostile, non-founding spouse could obtain voting, veto, appointment, or other rights, allowing them to interfere with, delay, or otherwise impair the company's business and governance. For other founders, the split of equity pursuant to divorce could force them into business with a new, unanticipated, and unwanted partner who may have significant substantive rights.
Additionally, this division could breach agreements the founding spouse and the company entered into with investors, lenders, key suppliers or distributors, and others regarding changes in company ownership. Founders often agree amongst themselves and with investors that they will not transfer all or part of their equity before it vests and satisfies other specified requirements. The split of equity pursuant to divorce could be considered a transfer, creating easily-overlooked contractual breaches.
Fortunately, careful planning at the time of a company's formation or thereafter can mitigate or eliminate the risk of an equity split upon a business owner's divorce.
Founders can protect their equity by entering into an agreement with their spouse providing that the equity will be retained by the founder-spouse or will not be considered marital property. The business itself should execute the spouses' agreement as an express third-party beneficiary to give it the right to enforce the agreement directly.
When spouses enter into such an agreement while married, it is referred to as a "postnuptial agreement." Such terms can also be included in a prenuptial agreement prior to marriage.
Whether prenuptial or postnuptial, these agreements can provide the founder-spouse with the right to retain the entirety of their equity interest in the business pursuant to any division of assets in a divorce. In a postnuptial agreement, the founder-spouse must offer some value in exchange for the non-founder spouse's execution of the agreement, or else the agreement will lack "consideration." Consideration is a fundamental requirement of a valid contract and refers to contracting parties' mutual exchange of some value or benefit. This can include giving or foregoing a right, limitations on actions, or other forms of value exchange.
Such an agreement is essential for protecting and providing comfort to the founder-spouse, co-founders, investors, and the business itself. Founders should obtain such an agreement as a required condition of forming and launching their business.
A company's governing documents should complement any pre- or postnuptial agreement. This applies to both corporations and LLCs, the most common business entity types.
In an LLC, the limited liability company agreement should contain backup means of removing voting rights from a membership interest transferred pursuant to divorce. The LLC agreement should provide that such a membership interest loses its voting rights, providing only an economic interest absent the LLC's consent.
The agreement should also include provisions for an optional means of buying out a non-founding spouse's membership interest. Such provisions should address:
In a corporation, voting rights generally cannot be stripped from specific stock if those rights are granted to the class of stock the non-founder spouse holds. However, corporations can and should include buyout provisions in their governing documents.
Valuation represents one of the key terms of any buyout provision. The method and manner of calculating value requires careful drafting and knowledge of applicable state law, and should be discussed with qualified counsel.
Generally, a company will want to value the non-founding spouse's equity interest based on its "fair market value" rather than "fair value," as the former typically results in a lower payout than the latter.
Under Delaware law, "fair market value" means the price that the non-founding spouse could receive if they sold the equity interest to a third party. Fair market value calculations typically include deductions for lack of control, illiquidity, and restrictions on resale, among other possible reductions.
"Fair value," by contrast, simply represents the net assets of the company multiplied by the non-founding spouse's percentage of equity, which yields a higher buyout amount.
The party being bought out is often given a debt obligation with reasonable interest terms to give the company time to arrange financing for the buyout or accumulate the necessary cash.
Founders should consider implementing these protections:
Preparations for the possibility of a founder's divorce are essential for business protection. Co-founders should not have another owner imposed upon them without the benefit of the consent mechanisms and restrictions on transfer that were agreed upon and set forth in the governing documents.
While these conversations may be uncomfortable, addressing divorce risks proactively protects all stakeholders and preserves the business relationships that founders work so hard to build.
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