This post is about one of my 45-second pitches at my BNI Chapter, BNI City Business. You can read the introduction to this collection here.

2 November 2023. A return to Exit Planning 101: The 5 D’s. This week, Divorce. The meme seemed a perfect fit (actually, the meme came first). A very muted reaction in the room, so maybe this isn’t as funny as I thought.

One of the drivers for preparing your Exit Planning before you are ready to exit are what get referred to as The 5 D’s: Death, Divorce, Disability, Disagreement, and Distress. As a business owner, if you prepare your exit plan well in advance of needing to exit, you get to de-risk these five factors that could otherwise kill your business. Another way to consider this is that if any of these five factors hit your business, would the business survive? Your exit plan is your survival strategy.

Divorce

You are a small business owner, and your partner announces they want a divorce. What happens to the business? This might seem like a cold setup for the issue, and it is. For many, separation (and divorce) is a gradual growing apart. For others, it is an unexpected, sudden event. On top of working through the dismantling of your lives together, you need to keep the business running without knowing how the business will be split in any settlement. A well-thought-through exit plan can help.

I’m not a lawyer, however I understand that in most situations your business (or shares in a business) will be considered part of the marital property subject to division. This division of shares has the potential to destroy a lot of value in the business.

If you and your partner both work in the business, the end of your relationship can be destructive. Do you still want to be working together? How will operating decisions get made? How will the business cope if one or other of you leave the business? How does employment law impact this situation? There can be a long list of issues you need to address, and to make it worse, you are both dealing with the emotional impact of the separation.

Most business owners only have a vague idea of what their business is worth. You may need to get the business independently valued to enable one of you to buy the other out. You also need a plan to deal with debt and securities (e.g., director’s personal guarantee). If your business debt is secured against your marital home, for example, how does this work if one of you get the house, and the other gets the business?

In many small businesses, the single largest intangible item of value in the business is the owners’ non-compete and non-solicitation restrictions. Do these restrictions still apply if one of you gets bought out and leaves the business? If not, the value of the business could drop significantly.

Similarly, when the business gets valued, what value is placed on these trading restrictions of the remaining owner? Let’s say you get total ownership of the business, but then decide to sell. What is the business worth? There is likely to be a significant difference of value between what a buyer will pay with a non-compete in place, versus without. If I am buying your business, and you can set up across the road, steal the staff and customers, I am not likely to be willing to pay a lot. Most business valuations assume the existence of enforceable non-competition restrictions, which is a burden a vendor needs to accept to get the price they are seeking. But in the case of a divorce, this burden can fall unevenly on the parties, and raises the question of equitability in a settlement.

Consider the case of Chris and Wendy. They have been married for eight years. Wendy is a licenced plumber, and they run (and both work in) their own plumbing firm. Wendy is on tools, and Chris does the sales and administration. The business is nothing without Wendy. The marriage falls apart. What is in the best interests of each of the parties?

In this situation, I have informally proposed to the Wendy of the case to immediately leave the business and establish a new business. This locks in place two factors of value: (i) the new business is owned solely, and is not marital property, and (ii) directly impacts the value of the marital asset to the point that it can eliminate disputes over ownership and value in the separation. In most cases, they don’t, and then get screwed in the settlement.

Even if Wendy stays with the business and Chris leaves, how should Chris’s 50% shareholding (assuming an equal split) be valued? This is nowhere as easy as it looks. In most cases, the answer is not simply 50% of the value as at the date of separation.

More Than Just the Divorcing Couple as Owners

In some ways, having a stake in a business as the marital property can simplify things, but not always. It is less likely that both work in the business. Getting the business valued as a going concern is likely to be straight forward, and therefore placing a value on the share parcel owned by the couple. Let’s say that Wendy and Chris jointly own 25% of a software company. The Fair Market Value of the business is determined to be $1,000,000, a fact upon which all parties agree. How much should Wendy pay Chris for their half of the 25% shareholding? $125,000 would be the obvious answer. But this is not what that 12.5% shareholding is worth. Small businesses do not have a liquid market for the trading of their shares, and there may be restrictions on sale imposed by the company’s constitution or Shareholders’ Agreement. The value of 12.5% of a small, closely held business is well under its proportion of Fair Market Value. We need to apply discounts for lack of marketability and a discount for lack of control. The shares may need to be discounted 50-80%.

For Wendy to see any value at all from these shares, there may also be a requirement for her to remain an employee of the business. This is imposing a post-settlement limitation on Wendy that doesn’t (and can’t) be imposed on Chris. Is this fair on Wendy? Wendy might want to move to another city or country after the dissolution of the marriage, but can’t make this work financially. How should this shareholding be valued?

In general, I encourage my clients (after appropriate consultation with their lawyer) to include a ‘Divorce Clause’ in their Shareholders’ Agreement to cover this situation. Such a clause spells out what happens to the shareholding in the event of a shareholder getting a divorce. It may also define the basis of valuation for the shares. This is designed to provide the business with certainty. Your business partners may be unhappy that they now have a new (non-working) shareholder who is possibly antagonistic in the event the shares in the business get split 50/50.

Divorce is messy at the best of times. Being a small business owner adds a few wrinkles. Your exit plan should have worked through this type of issue to provide the business with clarity, and that plan is needed well before it is needed.