The principles discussed in this article apply regardless of whether the business is operated as a sole proprietorship, corporation, partnership, or limited liability company.
Characterizing a Business Interest
Texas is a community property state and only community property is subject to division during divorce.
The first step is determining whether business interest is subject to division during a divorce is characterizing the interest as either community property or separate property.
Community property is all property owned by the spouses that is not separate property.
Separate property is property owned by a spouse prior to marriage or acquired by the spouse through gift or inheritance.
Texas operates under the Inception of Title Doctrine which means that property, including a business interest, is characterized as community or separate property at the time it is acquired.
This means that if the business interest was acquired by one spouse prior to marriage or inherited through probate, then it is separate property.
This also means that if the business interest was acquired during marriage or if a spouse started a business during marriage, then the business is community property and subject to division in the divorce.
Just and Right Standard
Texas law provides that during a divorce, a court shall:
…order a division of the estate of the parties in a manner that the court deems just and right, having due regard for the rights of each party and any children of the marriage.Texas Family Code Section 7.001
Most people consider “just and right” to start with an equal division of the community property and then adjust the division one way or the other based on a number of factors.
A business interest may or may not be divided between the spouses. In certain circumstances, the interest may have more value to one spouse or the other, or the business may be more valuable if operated under the supervision of one spouse or the other.
A court will consider these factors as well as the entirety of the marital estate when making a decision on dividing or awarding the business interest between the spouses.
Methods of Dividing a Business Interest In Divorce
There are a few options for dividing a business interest during your divorce.
First, if there is sufficient property in the marital estate, the court may simply award one spouse the business and the other spouse offsetting property of equivalent value.
This is a likely outcome if one spouse has operated the business exclusively and the martial estate is sufficient to still allow for a just and right division.
Second, the court may order one spouse to “buy out” the other spouse’s interest in the property. This can be accomplished through an award of offsetting property or it could be accomplished with payments over a period of time.
If payments are made over time, it is imperative for the other spouse to seek sufficient security to protect his or her interest in case the business’s fortunes take a turn for the worse.
Third, the interest could be divided between the spouse’s with both of them continuing on as co-owners of the business. At first this option might seem odd or awkward as the spouses are in the process of terminating their marriage.
Indeed, in the case of a smaller business where the owners are heavily involved in operating the business it might seem even more awkward.
But in some circumstances, it may be that the spouses are perfectly capable of working together in business even if they were unsuccessful in marriage.
The final option is that the court could order the sale of the business then divide the proceeds from the sale between the spouses. This option is the least favored option unless there are requirements to sell the interest (such as in a buy-sell agreement discussed below).
The reason this option is least favored is because of the effect it has on the value of the business. A court ordered sale on a short time frame means that any prospective buyers will expect to acquire the interest at a discount.
In addition, the business may not have had sufficient time to best position itself for a sale and maximize its value.
Valuing A Business In Divorce
Valuing any asset during a divorce proceeding can be difficult and lead to significant disagreement between the spouses. A business interest is no different.
There are any number of ways to go about valuing a business during divorce. The correct method will depend largely on the parties, the industry in which the business operates, the operating history of the business, and the ability of the parties to justify their valuation.
One option is book value. This option is relatively straight forward in that you take the value of the business’s assets and subtract the business’s liabilities to arrive at a value.
But this fails to capture the value of goodwill or the value of the business as a going concern.
Another option is to value the business based on a multiple of sales or profit. The difficulty with this option is determining the appropriate multiple to apply.
Sometimes the spouses may agree to hire an independent appraiser to value the business. This can provide an independent third party’s opinion on the value of the business if offered for sale in an arms length transaction.
Even after a method of valuing the business is determined or agreed to by the parties, the process of valuing the business is not over. There may be discounts that should be applied to the valuation to account for facts arising from the divorce or the interest itself.
For example, a minority interest (say 30%) in a business is not necessarily worth 30% of the business’s overall value. This is because of what is referred to as a minority interest discount. Since a minority owner of a business has less control or say in its operations, that interest is often deemed to have less actual value.
Another example of a potential discount would be where the spouse losing his or her interest played a key role in the business. The loss of a key man or woman could cause you to discount the value of the business as a going concern.
The Impact of Buy-Sell Agreements In A Divorce
When individuals go into business with each other, they may execute a buy-sell agreement. The purpose of the agreement is to keep ownership of the business with those individuals or the business itself.
A buy-sell agreement sets forth specific trigger events that require the owner of an interest in the business to sell his or her interest to the other owners or to the business itself (a redemption).
A buy-sell agreement will often provide that the divorce of an owner mandates the sell of that owner’s and/or the spouse’s interest in the business.
A well drafted buy-sell agreement will also set forth the terms of the sale and the price or formula to determine the price that will be paid for the interest.
Assuming the buy-sell agreement was properly drafted and ratified by the owner’s spouse, a court will enforce the agreement. This means that the divorce court will only have jurisdiction to divide the proceeds from the sale.