Facing the Music in a Divorce

By Janet Bamford

When there's a business in the family, a break-up that pits his appraiser against hers can lead to big problems. But there are steps to get around the worst of them.

With its trendy line of teen fashions, Esprit de Corp, the San Francisco-based company that Doug and Susie Tompkins founded 22 years ago, had been growing rapidly when their marriage hit the rocks. Susie was chief fashion designer; Doug was chief executive officer. Together they built a business that had U.S. sales of $420 million in 1988.

But the business began to stumble when the cofounders filed for divorce last year, after a long and very public estrangement. Esprit's sales growth slowed down, and the company was forced to do some serious cost-cutting. The couple disagreed bitterly over the future direction of the company. Susie thought the firm should go after older customers; Doug wanted to stick with the teenage and young adult market. Because each was a 50 percent owner, their dispute led to a stalemate in the business.

In April of 1988, in an effort to alleviate some of the tension, they added three outside directors to the board and in May relinquished control of the company to a new CEO. But that still didn't solve matters. Last July the two reached an agreement that gave Doug the right to buy his wife's shares at a price determined by an outside appraiser. lf he fails to do so, Susie or outside buyers get a crack at full control of Esprit through an option to buy Doug's shares.

The Tompkins case is an extreme example of the disarray that can result when there's a divorce in a family business. Theirs is the classic "apache dance" divorce in which both parties fight it out to the finish, even if it means that the business is the victim.

"A family business is an intricate balance of interpersonal and business relationships," says Sam Lane, a Fort Worth, Texas, family business consultant. "A divorce by definition will upset that balance and it's important to realize that it has not only an emotional impact but an impact on the business as well."

The largest single impact on a family business comes with the property settlement that a divorce brings. In a community property state like California or Texas, assets acquired during a marriage are equally divided in a divorce. In an equitable distribution state like New York or Pennsylvania, a judge considers each spouse's contribution to the business and living needs. In either case, each spouse is going to be entitled to a portion of a couple's joint assets — and the single largest asset is often the business.

How much of the business rightfully belongs to each spouse depends on many factors. "It depends on what role the spouse may have played in the creation of the assets or in the preservation of them," says Dwight Schweitzer, a Hartford, Connecticut, attorney who handles divorces. "Very often a small business was started by a husband and wife. It has gone on to become successful and the wife was probably employed by the business in the early years. She wants to use her stock as leverage to ensure that she gets a fair settlement in the divorce."

Even when a spouse isn't a stockholder or hasn't been involved in the management of a business — even when a business predates the marriage — that spouse still usually gets a piece of the business. "A wife might argue that even if she wasn't involved in the business, she was home raising the children, and providing the opportunity for the other spouse to do that work," says Phyllis Bossin, a Cincinnati attorney who is vice-chairman of the American Bar Association's family law section of the marital property committee. When the business was established before the marriage, the spouse is considered to have contributed to its increased value during the marriage.

When both spouses have been active in building and managing the business, one usually bows out in a divorce. After all, if a couple can't get along well enough to stay married, they probably can't run a business together. "Most courts like to terminate a couple's relationship," says Bossin, "and sever them in a way that isn't going to require ongoing contact and ongoing conflicts. That just leads to future litigation."

In one recent settlement, the husband turned over control of one of the largest black-owned businesses in the country to his ex-wife. Johnson Products Co., the Chicago-based manufacturer of hair-care products and cosmetics for black consumers, was founded more than 30 years ago by a husband-and-wife team, George and Joan Johnson. In October 1989 they announced that as part of their divorce settlement, George Johnson would resign as chairman, and his ex-wife, who was the treasurer, would become chairman. Their son was appointed chief executive officer of the company. (Neither the company nor the Johnsons would comment on the arrangement.)

Sometimes the split occurs in the second generation when a son or daughter in a family business is divorced. In such cases, the daughter-in-law or son-in-law may still be entitled to a portion of the spouse's shares in the business, whether or not he or she is directly involved in management.

In most cases, a judge will order that a family business be valued (along with the rest of the couple's assets). One spouse would then receive a cash settlement equal to half the value of the shares owned by the husband and wife. The settlement can be a lump sum or an amount paid out over time. The process sounds straightforward, but it is usually anything but. "These can be thorny issues," says Schweitzer. "Valuing a closely held business is an art."

"There is always a dispute over the value of a closely held or family-held business," says Bossin. "You wind up getting in a battle between appraisers and accountants."

The process of valuation can be disturbing to business owners. "A lot of concern arises at the beginning that they be allowed to continue to operate the business without a lot of interference," says Bossin. "Usually at the beginning of a divorce there is a fairly large request for production of documents: tax returns, profit-and-loss statements, balance sheets. A lot of times the other attorney wants to know what's going on if a lot of personal expenses are being written off through the business." In addition, if a spouse's lawyer suspects that a business owner may be trying to shuffle or hide assets, the attorney may try to obtain a court order preventing the business from selling certain property or assets.

In coming up with a value on a company, there is an additional danger. "You always have the possibility that the appraisal will be used later on for tax purposes," says Gerald Le Van, a New Orleans-based family business consultant (and Family Business contributor). "If the IRS finds that someone has attached a higher value to the business than the family says, they will certainly take a look at it."

In the worst case, if a business doesn't generate enough income to allow one spouse to buy out the other, the business may have to be sold to satisfy the cash settlement. "One husband and wife ran a collection business together," says Phillip Sidwell, an Atlanta psychologist who counsels family businesses. "It was a second marriage for both, and the husband had been the sole owner of the business before they were married. After they were married he gave her 50 percent of the business to show her he loved her. About five years later they got a divorce. Well, there was no way she wasn't going to demand payment for her 50 percent of the business but he couldn't afford to buy it. The company didn't have a fat war chest. It caused the company to close," says Sidwell.

Ironically, sometimes keeping a spouse fully informed about a company's financial affairs helps to keep the settlement demands reasonable. An unrealistic view of what a company is worth can lead a spouse to believe he or she is being cheated. "A wife may think her husband's share of the business is worth $2 million when in fact it's only worth about $500,000," says Sam Lane. "If it's a nasty divorce and she becomes skeptical and thinks they're trying to screw her out of her money, then, well, away they go."

"They may have an unrealistic view based on gossip," adds Georgia Urbano, a vice-president in the private business advisory service of the U.S. Trust Co. of New York. "They may have been informed by all sorts of colloquial sources—like friends who've owned similar businesses."

A well-crafted shareholders' agreement can be a help in valuing a business. "A lot of people go into business without thinking about the consequences of their business becoming successful and having a high value," says Urbano. "But somewhere along the line their accountant or lawyer will point out to them that it is prudent to have an agreement." In a shareholders' agreement, a provision allows owners to buy each other out under certain circumstances, such as divorce, and the agreement would detail the process by which a business would be valued. The formula could be a multiple of earnings typical of the industry," says Urbano. "Another common formula is book value with certain assets revalued to market value, such as real estate or property used in the business which may have been depreciated for tax purposes." The important thing is to have an agreed-upon method. A shareholders' agreement may also detail a payment schedule. Prenuptial and marital contracts usually try to cover much of the same ground (see "Warning: The prenuptial agreement is full of holes," See below).

A shareholders' agreement isn't a panacea, however. "While they are binding between shareholders, it is legally difficult to bind someone who is not a shareholder, like a spouse," says Urbano. Still it is a starting point. "If you have a predetermined process, you have a defensible position," says David Bork, an Aspen, Colorado, family business consultant.

The toll that a divorce exacts from a family business isn't just a financial one. A break-up disrupts company management, affects employee morale and can disillusion the children of a broken marriage, who may be in line to take over the business.

David Bork recommends that clients who are in the midst of divorce proceedings surround themselves with astute outside advisors to help with major decisions. "During a divorce," says Bork, "don't try to make important business decisions alone. You're going to do something that is out of whack."

Nonfamily employees can also get caught in the middle of an acrimonious divorce. "It can produce a lot of tension within an office," says Phyllis Bossin. "A wife may be good social friends with some of these people, particularly if she has worked there. People wind up in the middle. If there's a romance, for example, between the owner of the business and someone else, it is difficult for other employees who know that it is going on and who also know the spouse." Employees may be uncomfortable if they witness arguments. They worry about the future of the company. The business owners should reassure employees that the business will survive. "If couples can choose the site of the fights, don't fight in front of employees," says Le Van.

Adult children can also get caught in the middle. "If Dad trades in mother for some 30-year-old dame, it divides the children," says Léon Danco, the head of The Center for Family Business in Cleveland. "It pits them against the mother or the father and each other."

Of course, not all divorces are nasty. In so-called Strauss waltz divorces, a couple is unfailingly polite and civilized in making the necessary, if regrettable, arrangement to end their marriage. One Midwestern businessman told Family Business the story of his divorce on the condition that he not be identified. He and his first wife had started a publishing company 10 years ago. "In the early years she had more to do with the company than I did," says the businessman. During the first year, before it was clear the company was going to succeed, she ran the firm while her husband held on to his day job. At some point they decided they weren't made for each other, but agreed to stay married long enough to see their children reach college age. They did so, and then decided on the details of the divorce in an afternoon. They spent another afternoon with their lawyer, an old family friend, who represented them both in the divorce. Both were remarried within a year, but the families remained friendly. The ex-wife remained on the board of directors of the family company for nine years until she and her second husband moved from the area to a retirement home.

Strauss waltz divorces are more the exception than the rule. When they succeed, it is usually because the couple has agreed that the whole is greater than the sum of its parts. "They have a tacit understanding that it is in their interest to work together," says Schweitzer, "simply because the business as an ongoing entity is more likely to provide for their needs in the future than if they try to divide the entity and sell off the pieces."

Perhaps the best advice comes from Léon Danco. He suggests that the wise couple will treat both their children and their family business with compassion during a divorce. "If the combatants accept the fact that the business has a life, a meaning, and a purpose that are just as real as their children's, they will try to minimize the acrimony."

—J.B.

Warning: The prenuptial agreement is full of holes

Prenuptial agreements are fairly common in second marriages, and are becoming more common in a first marriage when someone is marrying into a family with a prosperous family business. The agreement between a prospective husband and wife sets certain limits on the financial settlement should they divorce. "I have heard of people who have tried in prenuptial agreements to require their spouse to waive all of his or her interest in the business in the event of divorce or death or to agree to be bound by the shareholders' agreement," says Georgia Urbano, an attorney with U.S. Trust of New York.

But there is a widespread misconception that a prenuptial agreement can guarantee that a spouse-to-be won't end up with a share of the family business.

Unfortunately, say lawyers, prenuptials don't always hold up in court. "Prenuptials aren't insurance," says Urbano, because "so many holes can be poked into them."

Sam Lane, a Fort Worth family business consultant, agrees. "I think a prenuptial agreement should at least set out an understanding ahead of time. It's probably worth doing, but it's not a guarantee that it'll all work out the way the prenuptial says," notes Lane. "If the divorced person has a good lawyer, then a lot of items come up for discussion and they usually end up with a settlement at least."

A few safeguards can strengthen a prenuptial agreement:

 

  • Both parties should be represented by their own lawyer. Attorneys say this is fairly obvious but is often disregarded.
  • The agreement should be signed before the wedding. Shoving a contract in front of a bride the night before the wedding is likely to be considered coercion in a court.
  • Each party must fully disclose all assets they own and their value. "Sometimes the wealthier spouse will not want the other to know how much is involved," says Urbano. "But it's easy to come back and say, 'No one told me what I was giving up, and I was not represented by my lawyer.' A judge might feel sympathetic."

The topic of prenuptial agreements is a notoriously difficult one to broach with a prospective spouse. Many people feel that such an agreement sows mistrust between a husband and wife and sets up a marriage for failure. Two tips may make it easier to sell prospective spouses on prenuptial agreements. Have a consistent policy that all members who marry into the family agree to a prenuptial contract. Making a new in-law feel as if such an agreement is routine will help avoid the impression that he or she is being singled out for mistrust. Second, it may be easier to have the family business attorney send a letter to each of the engaged couple suggesting a prenuptial agreement. A third party taking the initiative can ease the situation.

Most businesses are started after a marriage, and while it is possible for a marital contract to be drawn up later in the marriage, they are extremely rare. "It's tough somewhere down the line in the marriage to say [to your spouse], 'I'm doing so well I think it's time you signed some of your rights away,' " says Bossin. "This doesn't usually go over too well."

—J.B.

Article categories: 
Print / Download
Issue: 
February 1990

Other Related Articles

  • Dueling Perspectives: Private company share structures

    Business families have a variety of options for structuring shares in their company to meet the needs of the family and the business. We asked George Quarles, a third-generation owner of Quarles Petro...

  • Redefining ownership as shareholder stewardship

    Thirty years ago, I was faced with a typical family business crisis. My father, the founder of our family-owned industrial fabrics company, Seaman Corporation, had passed away prematurely at the age o...

  • Amping up structures to prepare for the future

    In the late 1980s, Charles A. Collat Sr. asked his four children if they knew what it meant to run a family business.“Being young and naive, we said, ‘Absolutely, we know what it means to run a fa...

  • Getting a grip on holding companies

    Philip Clemens, retired chairman of the 125-year old Clemens Family Corporation pork-processing company in Hatfield, Pa., knows firsthand that a holding company structure can play a pivotal role in th...