What happens when one of your business partners gets divorced? Unless your Operating Agreement states otherwise, chances are you are now in business with your Partner and their ex -spouse. It’s a well-known fact that half of all marriages end in divorce, yet it is staggering as to how little by way of planning goes into this statistic when it comes to setting up a business. Let’s take a closer look at what a business owners’ options are when it comes to divorce among partners.
Consider the following scenario:
“I am a partner in a dental practice. One of the other partners is getting divorced. My partner had no prenuptial agreement and has been married over 30 years. His wife worked to help put him through college and dental school. She then stayed home to raise their kids. She never finished her degree and has not worked for the better part of 2 decades. I think it is safe to say she is going to get half of everything that is his… including his ownership in our practice or the cash equivalent. My partner doesn’t have the cash to pay her off in a lump sum. In the meantime, we also don’t want her to be in business with us. We respect our partner and would like to help him, but we don’t want to cripple our practice or dig into our personal pockets to buy her out. The other issue is we are expanding (hence the importance of cash flow), and we don’t want to delay or give up those plans, but we sure don’t want to have to include our partner’s ex either. Our partner’s wife’s divorce attorney is already requesting our business financials since we started the Practice. The whole process is making us very uncomfortable. I checked our Operating Agreement, but it doesn’t mention what to do in the case of a divorce. How does this normally work out? We can’t be the first partnership to have to deal with this type of situation.”
Unfortunately, no, you are not the first partnership to face this problem. It would be much less of a problem if you had planned for it sometime in the last 30 years, but since we do not have a time machine (you don’t, right?), let’s delve into how this situation may play out. As is often the case in life, and particularly so when you are dealing with something emotionally charged like a divorce, different people handle things in greatly varied ways. And, how this spouse (I will call her “Mrs. Co-Owner” here) addresses this situation will likely go a long way toward determining the outcome. The best-case scenario is that the value of the interest in the dental practice is just one part of an overall financial picture of the divorce and your partner (“Mr. Co-Owner”) can barter other things (home, retirement funds, increased spousal support, etc.) in exchange for maintaining sole-ownership of his share of the partnership. Usually, this works. And, if it does not work, it is typically because there just aren’t enough other assets of the marriage to “fund” the buy-out.
Fortunately, Mrs. Co-Owner probably doesn’t want to be a partner in the dental practice anyway; rather, she would much prefer the cash value of the interest instead. Consequently, the partnership could make an offer to Mrs. Co-Owner to purchase her half of Mr. Co-Owner’s interest in the practice. To do this, typically an expert in valuing businesses is hired to determine the worth of the partnership, and the partnership then offers to purchase Mrs. Co-Owner’s half share based on that value. Mrs. Co-Owner’s divorce attorney will likely hire their own expert to “check” the accuracy of the partnership’s expert’s conclusion, and a negotiation ensues. Once the value is agreed, the partnership typically pays Mrs. Co-Owner for that value. This could be lump-sum, or even payments over time, depending upon the means of the partnership and the desires of Mrs. Co-Owner.
The issue you raise is almost always solved in one of these ways. However, if Mrs. Co-Owner will simply not “play ball”, the partnership may have to rely on the relevant jurisdiction’s partnership Act for guidance. Most jurisdictions have similar laws (based on something called the Uniform partnership Act), but I will briefly discuss the New Mexico version here. The New Mexico Uniform partnership Act specifies that the only transferrable right of the partnership is the opportunity to receive profits from the partnership. As a result, if Mrs. Co-Owner was granted half of Mr. Co-Owner’s partnership interest by the divorce court, she is only entitled to a “half-share” of the partnership’s profits. Mrs. Co-Owner does not get to make decisions or force the partnership to do anything else. The partnership can carry-on (expand as described) and Mr. Co-Owner will just split his profits with his ex-wife for as long as he remains a partner. Finally, the partnership could dissolve entirely. This process is complicated, but it suffices to say that dissolution is not a particularly great outcome for anyone, including (maybe especially) Mrs. Co-Owner, so that option is unlikely to be chosen.
Wait! It turns out there is such thing as a time machine. What should I and the rest of the Partners do prior to the divorce winds blowing?
First, be really careful; things rarely go as planned when you employ a time machine (or, at least that’s what the movies/TV/books always tell me).
As for the business, whether your business is a partnership, corporation, limited liability company, or some other form of artificial entity, there are devices available that can address the procedure to be followed in the future event of the divorce of a fellow owner, which can avoid having to become co-owners with the soon-to-be ex-spouse at all. Essentially, each of these solutions is implemented through a contractual arrangement between and among the owners (this type of document is commonly known as an operating agreement, partnership agreement, or corporate by-laws, depending upon the type of entity involved), and typically looks like one of the situations outlined above, but with prescribed procedures for each part.
The owners often agree that, in the event one of the owners becomes divorced, this owner is technically subject to removal from the entity and subjected to a forced buy-out. This forced buy-out often specifies the price at which the owner’s interest is to be purchased, and typically the same price is utilized for other events of an owner dissociating themselves from the entity. More accurately, the method for determining the price is more typically outlined (related to revenue or profits, for example), than an actual amount, because this allows the value to scale as the business grows. And, the agreement will typically specify how that price will be paid (lump-sum or over some time-period), in order to adjust to the business’ means to pay. The “departing” owner often then must either obtain their spouse’s portion of the interest (usually in exchange for the value of half of the purchase price) or give the business an opportunity to buy out his/her interest on the terms mandated by the agreement. In this way, the owners have charted a path to navigate through the (almost inevitable, from a statistical standpoint) divorce among partners in a manner that is utterly survivable for the business.
There are many other ways in which business planning like this may be structured, but the key point to take away from this discussion is that having a knowledgeable attorney properly organize your business before something unexpected happens is far preferable to dealing with that unexpected thing as it is happening. After all, while it is understandable that you and your partners are not thinking about your potential divorce(s) decades away when you are excited about starting a long-anticipated business (like a dental practice), an experienced lawyer will think about it for you.
Does your Operating Agreement make considerations for divorce among the Partners? Would you like to consult with an attorney regarding options? Give us a call today. (505) 715-5700. Visit our website at L4SB.com.