There is no doubt that family businesses form a key part of the UK economy, with 86% of UK businesses being family-owned. These businesses can be generations-old, and the business owners can often regard the company as a legacy that will continue long after they die. This year, in recognition of Family Business Week 2023, we explore how family businesses are dealt with in the event of a divorce.
A divorce can be a particularly significant cause of anxiety for owners or owner-managers of family businesses. Many will wonder, what will happen to the family company? Will the legacy end? Will the company have to be liquidated to fund a financial settlement and if so, how will the income be replaced? What happens if the spouses both work for the company?
The family courts regularly deal with these sorts of questions. The starting point in all cases is always the same:
Many make the mistaken assumption that on divorce, the family business will effectively be ‘ring-fenced’ from the other assets – that is not the case. The court will look at the business in the context of all of the assets and seek answers to the questions above.
When determining the value of each spouse’s interest in the business, the court may order a formal valuation of the company by an expert accountant who is instructed jointly by the parties, but that is not always the case. For example, where the business is simply an income stream for the family and would have no real independent value, then a formal valuation is less likely to be necessary.
In cases where it is determined that a formal valuation is needed, the method of valuation becomes important. There are different approaches that a court can take, with the most common being:
Both the methods above are an ‘art not a science’ and experts can provide a range of values for a company, based on different factors. If parties cannot agree on a value then the court would need to make a determination on the issue, although it should be noted that when faced with a dispute on the value of a business, different judges can have different approaches (see the below discussion of the Wells v Wells 2002 case).
Once the business as a whole has been valued, the expert would then look to establish the value of the relevant individual shareholding/s. This is where matters can become complex. For example, in cases where one spouse owns, say, 25% of the voting share capital of a company, it might be the case that the expert would apply a discount to their shareholding (known as a ‘minority discount’) to reflect the fact that they do not have the ability to significantly influence the decisions made by the company. The company documents (in particular articles of association and shareholders’ agreement) are important when considering the value that ought to be attributed to individual shareholdings as they can sometimes contain clear provisions for how shareholdings ought to be valued.
Once the value of each spouse’s shareholding in the company is established, one spouse may argue that they made ‘non-matrimonial’ contributions which have increased the value of the company, and this ought to be recognised by the courts in a final settlement. For example, perhaps they established the company prior to the marriage. Alternatively, perhaps they consider that the value of the company increased due to their post-separation efforts. These are arguments that a court would consider carefully, and it may be that the overall ‘value’ of the company is adjusted to reflect this ‘non-marital’ contribution. One way in which this can be done is on the ‘straight-line basis’, which means that the value of the company is reduced proportionately to reflect one parties’ non-matrimonial efforts (either by setting the company up X years prior to the marriage, or working to increase the company’s value X years post-separation) and then that reduced value is deemed a matrimonial asset to be divided between the parties. This was the approach taken by the court in the case of Martin v Martin 2018. However, this is not the only approach courts can take in this situation.
The case of Wells v Wells 2002 grappled with this issue in depth. In this case, the court found it extremely difficult to attribute a value to a poorly performing family business. It was argued that it would be unfair to leave the husband with all the shares (which were inherently risky assets that were difficult to attribute a value to) and allow the wife to retain a larger portion of the ‘liquid’ assets. Following this case, it was determined that when dealing with a family business, the court may:
Of course, option one above is far from ideal where parties wish to end all ties with each other post-divorce, and in fact, it goes against the ‘clean break’ principle, which is enshrined in family law. The reality is that in some cases there is little option save for both parties to retain shares in the company and share the ‘risk’. One way in which the impact of this may be mitigated is for the party who wishes to retain the day-to-day control of the company to adjust the ‘class’ of shares held by the other spouse to ensure they do not have voting rights attached. This will mitigate the level of influence that their ex-spouse can continue to exercise over the business.
Another issue that can often arise is where the parties have very little by way of liquid assets because most of their wealth is tied up in the family business. ‘Offsetting’ as per option two above can be difficult, or even impossible, in such cases. In those circumstances, the court may need to resort to creative ideas to extract liquid funds from the company for the spouse who will no longer be involved with the company. It is extremely important that this is carried out based on expert advice as to the mechanism and the tax implications. There are many ways in which this can be done, for example, by utilising the companies’ cash account (for example to pay a dividend, fund a buyback or capital reduction or pay a bonus provided in each case that it is legal and does not seriously impact cash flow) or potentially by an agreement that in the future, if and when the spouse who will continue to own the business sells his interest, a portion of the proceeds shall be paid to the other party. Other methods include payments of spousal maintenance from the business-owner to their ex-spouse which represent a longer-term ‘pay out’.
It is incredibly important for a matrimonial lawyer to work alongside the company lawyers/accountant/a tax advisor when dealing with these issues. For example, when grappling with the issue of extracting funds from the company, to mitigate against unexpected tax consequences and also to ensure that the documents which govern the company are fully complied with during the negotiation process and when terms are reached or imposed by the court. For example, it can sometimes be the case that these documents prohibit the use of the directors’ loan account for certain purposes. It is also important to bear in mind the duties a director owes to the company, with one of the most important duties being to act in the company’s best interests. It may be difficult for a divorcing director to establish that it is in the company’s best interests for large amounts of cash to be transferred to their ex-spouse.
Further issues can arise with family-owned businesses when one or both spouses are employed at the company. Post-divorce this may be highly undesirable and the method of extricating one spouse from their position needs to be carefully considered and employment law advice will need to be taken. Consideration will also need to be given as to whether spousal maintenance needs to be paid to the ’leaver’ until they find alternative employment.
There are steps that spouses involved in a family business can take to try and smooth matters and minimise disputes over their company in the event of a divorce.
For example, they can enter into a pre-nuptial or post-nuptial agreement which sets out how the business will be treated in the event of a divorce (both the business itself and the income derived from it).
Another way to minimise disputes would be for the shareholders’ agreement to specify the method by which a company ought to be valued in the event of a divorce. Where these documents are both in place, care should be taken to ensure that they work alongside each other.
The Penningtons Manches Cooper family team has significant experience in representing clients who are owners or owner-managers of family businesses or spouses of such individuals. If you would like any further information, please contact our family team.