Businesses are now a prominent feature in most divorce matters, especially where a business was set up before the marriage, an individual has worked within the business throughout the marriage or where the couple have contributed to the business and have been involved in one capacity or another. The general statistics suggest that nearly 50% of marriages end in divorce. It is therefore prudent to divorce-proof your business.
It is a misconception that any interest the other spouse has in a business will automatically transfer to them on a divorce. Often a court may require a business to be invaded to meet a spouse’s financial need, which can be done by way of deconstructing the business or raising financial capital using the assets of the business as collateral. Whilst the family court will have regard to the interests of third parties, including shareholders or trustee beneficiaries, this does not inhibit the orders available to a judge in achieving a ‘fair’ outcome.
The court’s powers are wide-ranging, and a number of outcomes are possible, including the transfer of shares from one spouse to another. The court can require that the business is partitioned allowing each spouse to retain a part, that they sell the shares to raise capital or have the business sold (in part or in its entirety). It can also order one spouse to pay the other a lump sum which effectively compensates the other spouse for their share or entitlement.
Of course, there is no ‘one size fits all’ approach and a court will have regard to the nature, age and liquidity of the business, reliance on business for future income, the needs of the parties and the standard of living enjoyed by the parties.
A pre-nuptial and post nuptial agreement are one of the most effective ways to protect a business.
Structural corporate considerations can be put in place to strengthen a business against the consequences of a divorce, including phantom agreements or compulsory transfer provisions.
A phantom agreement can produce phantom shares. This tends to be an agreement between a company and a recipient (i.e. an owner or someone working within the business) to provide phantom shares, which act like shares in that they can increase and decrease in value, without actually granting any shares in the business. Phantom shares can be in lieu of stock options and are often used within the context of a cash bonus plan. Phantom shares can, but do not usually, pay dividends, and upon vesting, can be taxable.
A phantom agreement can be created to give a spouse a financial interest in a business. Alternatively, it can be put in place, specific to an individual’s interest prior to the marriage. Such an agreement can include a condition on vesting to the effect that if the marriage broke down, such shares would not vest or would revert to company as a phantom option. Both spouses will need to carefully consider the tax position. Further considerations can include jurisdiction, particularly where you are dealing with an international couple or business interests overseas.
Articles of Association and shareholders agreement
These are key documents when establishing a business. A compulsory transfer provision within a company’s Articles of Association and or Shareholders Agreement may deter a court from making share transfer orders on divorce as it would raise concerns about implementation and enforcement. That said, this would not prevent a court from making such orders or being creative in finding an alternative solution – this could indirectly impact the other shareholders or trustees to enable compliance of such an order.
Such Articles of Association and/or shareholders agreement can require shares previously transferred to a spouse to be ‘bought back’ by the business in the event of a divorce.
There are times where compulsory transfer of a spouse’s shares may not be in the business-owning spouse’s interest or that of their family (especially in the context of family owned businesses). So, it may be wise to state within any Articles of Association and shareholders agreement that the shares be passed down to the issue of a senior family member or ancestor, thereby preventing the transfer away from the original bloodline by a divorcing spouse. Consideration may wish to be given to whether such shares would be transferred pro-rata to the other shareholders.
If the former spouse’s shareholding is a minority shareholding, a business may be comfortable with them retaining their shares for their lifetime and receiving dividends, sometimes to offset claims of maintenance or to provide a stream of income. In this case, a spouse tends not to have any board representation rights or veto rights. It should be highlighted that a minority shareholder will have the right not to be unfairly prejudiced.
If a compulsory transfer provision is being contemplated, thought will need to be given as to how the share value is to be determined, including a mechanism for the valuation process, if not agreed.
Normal circumstances, where articles or shareholder agreements have not dealt with these issues, can focus on a fair value for a business which is a going concern, with no discount for a minority shareholder. The articles should be reviewed to confirm if a minority discount should be applied or if a low value could be ascribed to the shares if the spouse, not being an employee of the company, could constitute a ‘bad leaver’. If you want to do this, you would need to make specific provision for it in the Articles. It may also be worth considering who would acquire the shares by way of pre-emption rights out of the remaining members.