EQUITABLE DISTRIBUTION OF THE FATTENING CALF
In olden days, which is to say about 20 years ago, divorce clients would see their lawyers and discuss the family business as just that, the family business. It could have been an insurance company or a funeral home or a hardware store. It would need to be valued based upon the standards of Revenue Ruling 59-60 using the various income and asset based approaches endorsed by the business valuation community.
Back in those days private equity was in its nascency. The idea that the little family business in Leola, Pennsylvania would one day be rolled up into the assets of a multi-million dollar private equity fund or packaged as part of an initial public offering on NASDAQ would seem to be pure fantasy. This writer enjoys playing in the business valuation field and often will try to estimate a value based on the tax returns of the subject business. In recent years, that has become a quarrelsome task with the client that goes like this:
LAWYER: So, looking at averages the EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization) and applying a 3% growth rate and a 20% capitalization rate, I suspect this business will be valued around $1,500,000.
CLIENT: WHAT? I don’t know what you are looking at, but my spouse has been shopping the business with two private equity firms and I’m hearing that this business is going to sell for at least $5,000,000.
I recently tried a case where the experts differed in the valuation of a service business with wife’s counsel at $18,000,000 and husband’s at $12,000,000. A year after the case was decided, word circulated that the business had sold for 3-5x those values, depending on which appraiser’s value you selected.
While that matter was pending we represented an entrepreneur who had created a business seven years ago with the sole purpose of growing it to sell out for a huge premium. He had been shopping the business for several years with the private equity world and his spouse had been fully acquainted with the entire process. What I learned in that process is that the private equity folks find various industries or trade sectors that they believe can be sold for vast premiums over any number that a business valuation expert could defend. I also learned that once they settle on such a business sector the private equity folks look for targets. They tell the target businesses that they may be able to sell for a huge premium but they need to see the business growing sales by large percentages. In our case, the target was told the business could sell for 1x revenue but the revenue had to exceed $20 million. Otherwise, the target was deemed too small to be part of the private equity package.
In a sense, these are “pig in a poke” arrangements. There is no real offer, just discussion premised upon revenues or cash flows not yet in existence. There is no clear evidence that the private equity firm will make the offer in a defined period or can close on the sale at the circulated price. But these discussions with possible suitors can cause huge problems in equitable distribution. The spouse not in control of the business is not going to accept a settlement premised upon $1,500,000 valuation when there are discussions of a sale at 3-5 x that amount “in the wind.” So, we have a stand off- often because of discussions about an illusory price premised upon illusory revenue projections. The “correct” solution in circumstances such as these is probably to divide the ownership interests in the business in kind rather than effecting a buy-out. Unfortunately, that solution comes fraught with its own problems related how the business is managed in the meantime. The other challenge is whether private equity will remain interested in the target business or industry. A year ago there was immense interest in acquiring fulfillment facilities near major interstate highways. This drove real estate values at such intersections way up. Then Amazon announced it really didn’t need as many fulfillment centers as they first projected. Result: massive decline in interest for these locations. Similarly, a few years ago there was immense interest in the telemedicine business. In the middle of that interest, Amazon announced it might get into the telemedicine business. Very few private equity investors saw big gains to be had competing against Amazon. Again, Amazon moved on, but the pandemic drove the retail pharma business into the health diagnosis business. Private equity is a fickle thing and there is no goal except maximizing returns.
CLIENT: I get what you are saying but I would rather die than see this business valued at $1,500,000 only to see it sell two years later for $5,000,000 with my spouse pocketing $4,250,000 while I get a lousy $750,000. That ain’t gonna happen.
This is the classic dilemma. Let’s assume attorneys who are reasonable and want to get something done. They understand that the spouse who owns the stock wants to pay $750,000 and hope to bring in the big payday with no further obligation. The other spouse says it will be a cold day in Hell before that result occurs. The parties can litigate but if the court gets the case and understands it, the result is probably 50/50 on the stock and “Let the games begin…” The problem to begin with that result is that no one has control; something the private equity buyers will view as a poison pill. If you leave one spouse with a controlling interest without further limitation this invites the “controlling” spouse to play many kinds of games with things like salaries or asset sales intended to loot the business.
I had this problem about 35 years ago and my solution was to hire a mergers and acquisitions lawyer to advise me. My instructions to that lawyer were; give me a term sheet you would write for an agreement between the spouses that would allow the controlling spouse to make the best deal but not gain an unrealistic advantage. That would include day to day management controls until the “ship comes in” and avoiding a setting where the business sold for $3,000,000 but the controlling interest spouse was paid a $2,000,000 severance or some other “B.S.” payment that diluted the real transactional price.
To make such a deal, BOTH parties have to be real. Controlling spouse needs to agree his compensation is essentially fixed until the “ship comes in” and the business is sold. As time passes a spouse who is not working in the business will have to see their interest diluted. Otherwise, the spouse working day to day in the business has no real incentive to grow it and attract the wealthy buyer. Issues like debt, spin offs, asset sales will need joint agreement no matter how the stock is allocated. After three years either spouse can force a liquidation but it’s not mandatory. A liquidation would likely be a kind of suicide but each spouse might choose to buy the other out rather than see a hole drilled in the bottom of the ship only to watch it sink in a liquidation.
This solution is fraught with peril. But where two people who own a business that is really worth $1,500,000 agree that they want to get $3-5 million, risk is inherent and has to be accepted. There remain huge premiums to be had in selling the right business to the right buyer. But both spouses need to be smart enough to form a deal that allows that transaction to evolve and to accept the fact that when in the hunt for “big money” there is inevitable risk of serious loss or a fight that will drive buyers away.
Some readers might suggest this a ripe place for mediation. I can’t disagree with that. But we live in a world where mergers/acquisition attorneys are writing lots of these deals with contingent or delayed payouts for a business interest. I want that kind of thinking “in the room” when we talk about deferring sale of any major asset because the corporate lawyers often see problems ahead in any deferred transaction which a family law attorney might easily miss.
