Unicorns in Divorce: Equitable Distribution of Privately Held Businesses

We regularly represent founders or other leaders of substantial privately held businesses and/or their spouses going through divorce. 

As a starting point, all assets legally and beneficially acquired by either spouse during marriage are subject to equitable distribution in divorce. When either spouse is an owner of a privately held business, how that business interest is valued and treated in the divorce can be the most important economic factor to be resolved. 

Key Considerations for Privately Held Businesses in Divorce

With so-called unicorn companies (i.e., privately held companies whose valuation exceeds $1 billion) grabbing headlines, there are serious issues that both the business owner and non-business owner spouse must consider. Every case and company is different, but from early-stage startups to more established companies that have successfully navigated multiple rounds of capital raises, many of the same considerations will apply. 

Like all issues in divorce, families are best served when these issues can be amicably resolved, as settlements can achieve a level of flexibility, privacy and structure that may not be achievable in a formal court setting. To that end, we regularly engage in direct negotiation and/or mediation to achieve a settlement of these issues. That said, there are occasions when compromise and settlement are unattainable, and the matter will need to be resolved through litigation. 

1. Due Diligence

The starting point for the representation – regardless of which spouse we represent – is to gather the information necessary to understand the nature of the interest owned, whether any part of the business is exempt from equitable distribution, the business, its valuation, and the owner’s cash flow from the business. 

As a starting point, we will need to understand what information concerning the nature and value of the business already exists. Due diligence will focus on the following: 

• Details of the interests at issue in the divorce: For all interests at issue, we will need to understand when and how the interest was acquired, the nature of the interest, any restrictions on the interests, and whether it is fully vested or subject to conditions or future employment.
• Past transactions and capital raises: We will need to understand and gather documentation concerning:
  • Have there been prior sales of any interest in the business? When, to whom, what percentage of the business, and at what price? Sales within the last 3-5 years will be of particular importance. 
  • Prior capital raises: From seed capital from friends and family to Series C funding from private equity or venture capital firms, each capital raise will need to be examined to understand the value set for the business. In doing so, we will need to know the differences, if any, between the nature of the interest being valued in the divorce and the nature of the capital raise, including the differences if any between common stock and preferred.

• Prior valuations: Prior valuations provide a great starting point and should be gathered for the past 5 years, including: 
  • 409A Valuations: 409A valuations are prepared for certain privately held businesses by independent valuation firms at a variety of times, including for capital raises and for equity compensation. The valuations are intended to determine the fair market value of the common stock of a privately held company prior to an initial public offering as of a specific date. The valuations may adjust the price for preferred stock established by a prior financing round to arrive at a value of the common stock for the business. Often, the valuations will provide a helpful roadmap that details the history of prior capital raises, prior transactions for the company, and details of the types of equity of the company.
  • Any other valuations: Valuations may be performed by third-parties, the business itself, or the business owner for a variety of reasons. You will need to understand what valuations have been performed, by whom, for what purpose, and using what standard of value. 
• Other business records: Each case and business is different, and different cases will be resolved with very different levels of due diligence. That said, working with valuation experts, we often will need to gather records including financial statements, business plans, and projections of the business. 

Of course, this information is more readily attainable when we represent the business owner. That said, the non-business owner spouse is also regularly entitled to receive this information either by way of informal exchanges or by way of formal discovery demands.

2. How is the business interest valued in divorce?

Different states apply different valuation standards in divorce. New Jersey generally applies a “fair value” standard for business valuation. Other states, such as New York, generally apply a “fair market value” standard. This can have a meaningful difference in valuations, as generally speaking “fair value” does not consider discounts that would be available for consideration under a “fair market value” approach. That said, there may be issues to consider on this front depending on the nature of the interest and stage of the company. 

As part of the valuation process, the following are among those that will be addressed: 

• When were the interests acquired? 
• Were any of the interests acquired prior to marriage?
• What is the nature of the interests?
• Is the interest fully vested?
• What is the appropriate standard of value?
• What is the appropriate valuation methodology? 
• When was the most recent sale of any interest, and what were the terms?

3. How is the business interest divided in divorce?

In working to settle the matter, one consideration may be whether the interest will be divided in-kind between the parties (and if so, how that would be accomplished), whether there will be a buyout of the interest where the owner spouse will buyout the non-owner spouse for his or her equitable distribution (and if so, the terms for such a buyout), or whether there will be some combination of the two approaches. Generally speaking, an in-kind division may not be available should the matter proceed to court, but parties can negotiate a variety of approaches in a settlement. This can involve direct ownership of certain interests or a constructive ownership where the business owner continues to be the title owner of certain interests for the benefit of their spouse. For buyouts, considerations will necessarily include the timing of any such payments taking into consideration the overall liquidity of the marital estate. Other considerations will include the security for any payouts and the payout terms.

For a buyout, the parties of course will need to agree upon an amount to be paid for the interest. When such an agreement cannot be reached, a court will be called upon to determine the value of the interest and the appropriate percentage to be paid to the non-owner spouse for that value. In equitable distribution states such as New Jersey and New York, as opposed to community property states such as California, a court has considerable discretion to determine an appropriate percentage award based upon the general equitable distribution factors as well as those specifically related to the business, including whether and how the business interest will be considered for support, potential tax consequences, and a variety of other potentially pertinent considerations. For business interests owned prior to marriage or acquired during the marriage by way of gift or inheritance, different considerations will need to be made concerning what portion of the interests, if any, are subject to equitable distribution and what portion are exempt. 

4. Privacy and Protection of Confidential Business Information 

When identifying and valuing interests of privately held companies, there will be an exchange of documents and information that is highly confidential. As part of this process, it is often necessary to enter into a confidentiality agreement the terms of which may need to be resolved before confidential information may be exchanged. It will also be important to discuss with your counsel how such information may be used as part of any divorce proceeding, the potential for public disclosure, and the nature of protection that can be sought from the court to seek to protect such confidential business information as part of the process.

Experienced Legal Counsel for Divorces Involving Privately Held Businesses

The equitable distribution of a privately held business is often the most significant financial issue in a divorce. An experienced family law attorney will know how to guide you through the process, ensuring your rights are protected and your business interests are properly addressed.

Skoloff & Wolfe, P.C. represents clients in all matters of family law including Divorce, High Net Worth Divorce, Child Custody, Child Support, Separation, and Mediation. Leaders and the spouses of leaders of finance, law, entertainment, sports, real estate, and members of America’s prominent families, rely upon the attorneys of our family law group. From start to finish, we work side-by-side with our clients to identify reasonable objectives and achieve the best possible result.