Taking Charge Before it’s Too Late: Determine a Business’ Fair Market Value Prior to Divorce
Published in Chicago Lawyer Magazine, December 2014
By Daniel Stefani
One of the biggest problems a privately held business owner usually has in a divorce proceeding is the risk that a court will find his or her ownership interest to be worth far more than all or most of the other assets combined in a marital estate. This creates the obvious problem of how the business owner pays his or her spouse an equitable share of the estate, especially since most businesses do not have the liquidity to support an immediate “buyout” of the other spouse.
A typical valuation issue at trial results in a “battle of the experts.” Business evaluations are an art, not a science, and depending on the methodology used by the expert, conclusions of value can differ by many millions of dollars.
A recent 2nd District Appellate Court case subtly exposes an important issue which creates an opportunity for the owner to somewhat indirectly control the valuation methodology in the event of a divorce. Essentially, certain language in an operating agreement could dilute the threat that the trial court will make an unreasonably high finding of value regarding the business owner’s interest.
In In re the Marriage of Schlichting, 2014 WL 4805241 (Ill.App. 2 Dist.), the trial court deemed the wife’s membership interest in an LLC to be marital property. However, the trial court awarded the husband, a non-member of the LLC, all of the wife’s membership interests. The court also ordered the husband to pay the wife money in exchange for the membership.
The wife appealed, arguing that the trial court abused its discretion because the order required her to violate the LLC’s operating agreement. The appellate court agreed with the wife’s position and reversed the trial court. As the court indicated, there are very few cases in Illinois that addressed a potential conflict between a marital dissolution and an operating agreement. In those cases, the court flagged this issue as a potential problem but ultimately avoided a direct ruling. As such, this recent ruling is a case of first impression in Illinois.
Somewhat hidden in the opinion is an issue that all business owners should consider. In the opinion, three paragraphs of the operating agreement were referenced.
Paragraph 16.1 stated: “A [,[ember will not assign, sell, transfer, pledge, or otherwise encumber its [m]embership [i]nterest, or any portion of its [m]embership [interest], without unanimous prior written consent of the other Members.”
Paragraph 16.4 stated: “In the event that a [m]ember dies, declares bankruptcy, or receives a court declaration of incompetence, he or she shall receive the fair value of his or hr membership interest as of the effective date of his or her resignation as may be determined by the accounting firm regularly employed [the LLC], utilizing the customary practices and principles associated with the operation and valuation of the LLC’s assets and liabilities to the date of resignation . . .”.
Paragraph 16.6 stated: “I the event of a [m]ember’s divorce (if [a]pplicable), the same buyout procedure set forth in Section 16.4 shall apply, except that the value shall be greater of said determination [by the LLC’s accountant] or that amount determined by the final non-appealable decision in the divorce [by the court]. In the event the final non-appealable decision [by the court] concerning value is higher than the value calculated in Section 16.4 [by the LLC’s accountant], the divorcing member shall execute a promissory note payable to the [LLC] for the difference in valuation, which note shall be due and payable within ninety (90) days of said order . . .”.
The court found that the trial court violated Paragraph 16.1 primarily because there was not unanimous consent of all of the members for the ordered transfer. These provisions were interpreted by the court as a buy-sell agreement. Illinois law holds that the terms of a buy-sell are not dispositive of value in a divorce but only on indicia of value. Here in Schlichting, Paragraphs 16.4 and 16.6 do an “end around” on this concept, which gives the business owner an ability to somewhat control the business valuation methodology and ultimate conclusion of value.
Specifically, if the divorce court found an excessive fair market value, Paragraphs 16.4 and 16.6 create a corresponding marital liability by requiring a payback to the LLC of the difference between the inflated divorce court’s value and the value based on the chosen methodology by the LLC. The marital liability is “real” and therefore courts could consider the liability as an offset to “their finding of the higher fair market value for the ownership interest itself.”
As such, either at the creation of an entity or later with an amendment, the business owner should consider identifying the most favorable valuation methodology in the event of divorce and insert it in the operating agreement in paragraphs much like 1604 and 16.6 cited here. This aspect of the Schlichting case was not necessarily the main legal issue, but it certainly appears to create an opportunity for all business owners if they ever are involved in a dissolution of marriage.
This case should cause the business owner to take a look at their existing operating agreement and/or buy-sell agreement and amend it now with similar provisions dealing with the event of a divorce. There may be business reasons why such a provision may not be appropriate, but it certainly is something to consider.