Early-State Companies and Risks of a Founder’s Divorce: Love is a Battlefield
Divorce is brutal, even at its most amicable. Rending a once-cherished union is like ripping apart atomic bonds in nuclear fission - each releases a primordial, potentially catastrophic amount of energy. Often, the couple’s hurts, resentments, fears, insecurities, and grief have become intractable by the time of the actual legal denouement of divorce. So affected, persons otherwise reasonable may act or lash out against the other in uncharacteristically stubborn, petty, vindictive, or hurtful ways. Company founders need to consider the risks that a business owner’s divorce presents to the company (and, thus, the group); they can take the steps below to heavily mitigate and likely head off such risk.
The equity interest of a spouse that founds a company (a “founder-spouse”) could be deemed marital property, or a divorce court could decide to divide the equity interest between the founder-spouse and the other spouse; in either case, the non-founding spouse would have an ongoing interest in the company after the divorce. The consequences of such a division to a business can be severe. Absent preplanning, the often-hostile, non-founding spouse could obtain voting, veto, appointment, or other rights, allowing him or her to interfere, delay, or otherwise impair the company’s business and governance. Particularly among the other founders, the split of equity pursuant to divorce could essentially force them into business with a new, unanticipated, and unwanted partner who may have significant substantive rights.
In addition, this division could breach agreements the founding spouse and/or the company entered into with investors, lenders, key suppliers or distributors, and others regarding changes in company ownership. For example, founders often agree amongst themselves and with investors that they will not transfer all or part of their equity before it vests and satisfies other specified requirements. The split of equity pursuant to the divorce could be considered a transfer, creating easily-overlooked contractual breaches.
Preplanning at the time of a company’s launch or thereafter can mitigate or remove the risk of an equity split upon a business owner’s divorce.
Protection by Pre-Nuptial or Post-Nuptial Agreement
Founders can protect their equity by entering into an agreement with their spouse providing that the equity will be retained by the founder-spouse or will not be considered marital property (each provision puts the equity with the founder-spouse). The business itself should execute the spouses’ agreement as an express third-party beneficiary in order to give it the right to enforce the agreement directly. When spouses enter into such an agreement while married, it is referred to as a “postnuptial agreement.” Such terms can also be included in a prenuptial agreement prior to marriage.
Whether prenuptial or post-nuptial, these agreements can provide the founder-spouse with the right to retain the entirety of his or her equity interest in the business pursuant to any division of assets in a business owner divorce. In a postnuptial agreement, the founder-spouse must offer some value in exchange for the non-founder spouse’s execution of the agreement, or else the agreement will lack “consideration.” Consideration is a fundamental requirement of a valid contract and refers to contracting parties’ mutual exchange of some value or benefit, even if only of value to the contracting parties. This can include giving or foregoing a right, circumscriptions on actions, or even just a party’s personal gratification.[1]
Such an agreement is critical in protecting and providing comfort to the founder-spouse, his or her co-founders, investors, and the business itself. Founders should obtain such an agreement as a required condition of forming and launching the contemplated business.
Protections for the Company Included in Governing Documents
An early-stage company’s governing documents should dovetail with the pre- or postnuptial agreement. This is true of both corporations and LLCs (which together form most of the entities formed each year).
In an LLC, the limited liability company agreement should contain a back-up means of removing voting rights from a membership interest transferred pursuant to divorce. The LLC agreement should provide that such a membership interest loses its voting rights, providing only an economic interest absent the LLC’s consent. Further, it should include a provision for an optional means of buying out a non-founding spouse’s membership interest. Such provisions should include means to initiate a buyout, time periods for conducting various steps, a means of valuing the interest for a buyout, and a method of payout. In a corporation, one cannot generally strip voting rights from specific stock if those rights are granted to the class of stock the non-founder spouse holds. However, it can and should include a buyout provision.
Valuation is one of the key terms of a buyout provision. The method and manner of calculating value requires careful drafting and a knowledge of Delaware law terms of art, and should be discussed with counsel. Generally, a company will want to value the non-founding spouse’s equity interest based on its “fair market value,” rather than “fair value,” as the former results in a lower payout than the latter.
In Delaware, “fair market value” means the price that the non-founding spouse could receive if he or she sold the equity interest to a third party. It is calculated by deducting the company’s liabilities from its assets and multiplying the difference by the non-founding spouse’s percentage ownership of the company’s equity. This provides the “fair value” of the interest. For “fair market value” purposes, the fair value is subject to deductions in value for a lack of control, illiquidity, and restrictions on resale, among other possible deductions.
As described above, fair value simply represents the net assets of the company multiplied by the non-founding spouse’s percentage of equity, which yields a higher buyout amount.
The party being bought out is often given a debt obligation with nominal interest in order to give the company time to arrange financing for the buyout or set aside cash to effectuate as it is able.
Preparations for the possibility of a founder’s divorce are critical. Co-founders should not have another owner foisted upon them without the benefit of the consent mechanisms and restrictions on transfer agreed upon and set forth in the governing documents.
[1] It is often held that a mere “peppercorn” can serve as consideration. Although some courts look deeper into the validity of a contract with nominal consideration, the peppercorn aphorism illustrates that courts seek to enforce a contract where it was properly entered into freely by competent parties for a purpose that they considered as having value.
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