Business ownership can be a lucrative career endeavor and create a substantial percentage of a family’s net worth. Business on Main spoke with certified family law specialist Steven Knowles, partner of Knowles Collum LLP and seven-time recipient of “Southern California Super Lawyer” status from Super Lawyers magazine, about how business assets are divvied up in divorce settlements.
Business on Main: What are some of the ways a divorce can negatively impact a privately held business?
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Steven Knowles: Oh, my goodness! Fundamentally, it can absolutely destroy a business. There are many a business that have not survived a divorce because the owner-spouse is unable to raise the capital to buy out the other spouse, which may not be available during these recessionary times. Incurring a lot of debt to buy out a former spouse can also bring a business to a point that it might not survive.
Is there a way to divorce-proof a business?
Yes! Get a premarital agreement. If the business is owned prior to marriage then a prenuptial agreement can confirm that the business is forever the owner-spouse’s separate property.
Do these agreements hold up in court?
For the most part, yes. Increasingly, judges are recognizing that spouses are entitled to the benefits of contract law. Like any agreement, however, prenuptial agreements are subject to certain tests to ascertain their validity and enforceability. Today, most agreements include “severability clauses,” which simply means that on the rare occasion that a portion of the agreement is disallowed, then the balance of the agreement is upheld.
Most startups in the U.S. are formed by two or more partners. It seems that the failure of one partner’s marriage can impact the stability of the business. Can the purchase and sale terms of a partnership agreement prevent a divorce-related forced liquidation or forced buyout until a future date when the business is more established or liquid?
The answer is no — you can’t force a former spouse to stay in a partnership. But it is possible for the divorce-related buyout terms to follow the process that had been set forth in the partnership agreement.
Let’s talk about cohabitation. Suppose an entrepreneur in a long-term relationship starts up a business that turns out to be the next Facebook. Can the non-business owner make some claims?
Provided there are not children involved, mere cohabitation in itself creates no per se legal rights. It is possible for people who live together to agree to have joint property and joint-support obligations, but then the relationship is no longer founded in family law principles. Of course, the remedy for uncertainty is [to] simply develop a cohabitation agreement which expressly states that the business owner has no support rights or obligations to the cohabiter.
You practice in a community property state. Is there a big difference between how a business owner might be treated by courts in a community property state versus an equitable distribution state?
Good question. The practical application of the laws, while sounding very different, really is not.
How a business is valued can dictate the cost of buying out a former spouse. Small companies often take steps to legally reduce their net income-tax liabilities, which in turn might contribute to a lower overall business valuation that is beneficial to the business owner. How do the lawyers sort through these issues?
First, in order to assess income from a business, the inquiry does not stop at net taxable income. What shows up on a tax return doesn’t have that much relevance to cash flow generated from business operations for professional valuation purposes. Second, there are many different methods for valuing a business — only some of them depend entirely on income.
Are valuations based on a snapshot in time? If so, perhaps recessions are a good time for business owners to get divorced — when business value might be suppressed?
Yes, that is true. At least in California, it is improper for a court to project future income in doing a business valuation. Valuations are based on historical analysis. Even though one might argue that we are getting out of the recession, it doesn’t matter for business-valuation purposes.
Do attorneys have considerable latitude to advocate a methodology that serves their clients’ best interests, or do judges tend to favor one valuation methodology?
No, judges don’t favor one methodology over another. I should say that most lawyers are quite unsophisticated in terms of their knowledge of business-valuation methods, and thus it is really up to the professional business valuator to lead the way. Depending on the nature of the business, a business valuator may choose one or more different methodologies to reach conclusions of business value.
What are some common mistakes business owners make in their separation agreements that might come back to haunt them in the final divorce settlement?
I would say the worst case is a material nondisclosure. The results can be devastating to business owners who deliberately try to pull a fast one on the spouse or negligently fail to disclose some material aspect of the business because of, for example, sloppy record-keeping.
How should a business owner select legal counsel for a divorce proceeding?
In terms of client service, responsiveness is perhaps the most important criteria of a good lawyer. You have to return phone calls and e-mails and respond to client questions.
But business owners won’t really know how responsive a lawyer is until after an engagement letter is signed. What then?
Ask background questions. I think stability is an important credential. You don’t want a lawyer who, quite frankly, has a history of frequent changes in law firm affiliations. I’m also a strong believer in education. As a hiring attorney, where someone went to undergraduate college and law school is a good indicator of competence and sheer brain power.
Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of TakeCommand, a community service organization that offers the largest centralized database of startup and small-business funding sources in the U.S.
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