In the first episode in our “Businesses and Divorce” series, Brian Walters and Jake Gilbreath discuss what happens when a business is involved in a divorce case in the state of Texas. The partners talk about some of the more complex issues that can come up during these cases, their experience handling these type of situations and provide some general advice for anyone who might be going through a divorce involving a business.
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Your hosts have earned a reputation as fierce and effective advocates inside and outside of the courtroom. Both partners are experienced trial attorneys who have been board certified in family law by the Texas Board of Legal Specialization.
Jake Gilbreath:All right, welcome back. Thanks for tuning into ‘For Better, Worse, or Divorce’ podcast. This is where we provide you tips and insight on how to navigate divorce and child custody situations. I’m Jake Gilbreath, I’m here with my partner Brian Walters, and today is the first episode in our “Divorces and Businesses” series. We’re going to discuss what happens when there’s a business involved or when the spouse owns a business, or spouses own a business together, and it’s involved and they’re going through a divorce. So we see this quite a bit. Brian, you and I, get hired a lot when there’s businesses involved, and it could be something as small as sole proprietorship or just one person who’s running a business and maybe have an employee here or there, to much, much more complex businesses, and businesses that maybe gross $50,000 a year to businesses that gross 50 million, 500 million a year, or what have you.
And they all look somewhat similar, but then obviously they get more and more complex depending on the business. But first, Brian, most importantly, if I own a business, or my spouse owns a business, or we own a business together and we’re talking about divorce or I’m thinking about going through a divorce, what can I do as a business owner, or married to somebody who owns a business, what can I do to prepare for the divorce?
Brian Walters: Well, if you think that’s going to happen, I think there’s a couple of things that you’re going to want to do. You’re going to want to make sure your books are in order, that you’re doing your accounting, your taxes are being filed properly, you’re not three years behind on them. There’s not any funny business with the books. There’s not any cash being pocketed. There’s not any expenses being run through the business that are probably not properly done. I’d also want to make sure that all of my regulatory filings were in order, whether that’s with the Secretary of State, we’ve already mentioned the taxing authorities, both for the State of Texas and the federal ones, any local ones, DBAs, make sure your corporate paperwork, your corporate minutes, all of those things are in order. I think that makes a lot of sense.
And I’d also try to be conservative with the business as you enter that point, try to put aside cash, pay down debt. We’ll get into why I think that’s important in a little bit. But those are some of the initial things I would try to do. And I guess lastly, don’t do anything that might be misinterpreted by somebody as underhanded or attempting to gain an advantage in the divorce, because even if that’s not the intention, it may come across that way and be turned into an issue, which I think would be unfortunate.
Jake Gilbreath: I think generally speaking, I tell people keep doing what you’re doing with the business. And that’s the same as far as paying yourself. I’ve had people ask me and say, “Well, I pay myself, or I pull $30,000 a month out of the business, I serve 20,000 a month out of the business. Should I stop that? Should I continue that?” In most cases, the advice is going to be just keep doing what you’re doing because it’s just going to make it messier and more complex if you change things up. But like you said, Brian, make it as clean as the business can be. And that includes the books too. We’re business owners ourselves, we put a lot of work and effort into making sure our books are in order and everything’s up-to-date. And when I say a lot of effort, we have really talented people that work for us that do that, work with us and do that.
Maybe you haven’t updated QuickBooks in six months or a year, or you’ve been meaning to get your personal expenses to your CPA and you just haven’t. It’s nice to get all that updated, because one thing that is or could be happening in the divorce is the business gets valued. So can you talk about that, Brian? What are the options? What am I preparing for? If I’ve got a business, I own a business, and I’m going through a divorce, what’s going to happen with the business in the divorce?
Brian Walters: Good question. And that’s a pretty complex, broad question. So the first question is who owns the business? Do you have partners? Is it in one spouse’s name, or both spouse’s names? Or what corporate format is it? Is it a partnership, or sole proprietorship, or a LLC or whatever the case is? Is it a C-corporation, is it an S-corporation? And the next part is the character of the share or the ownership by each spouse, is it community property or separate property? And those are complex legal questions that are very important. And in some cases, for example, if it’s 100% the separate property of a spouse, you might actually have some different answers to some of the things we mentioned earlier about distributions and salaries and those type of things. So that’s the first thing that needs to be done. And once you’ve figured that out, then you can go from there.
In the example where there’s other owners of the business besides one or both of the spouses, you’ve got to be really careful because now you’ve got fiduciary duties, either spouse or potentially the community, or any number of things, what’s fiduciary duties to the other owners, and so you’ve got to be careful with that. But let’s just take the simple example where each spouse owns 50% of a corporation and it’s all community property. In that case, you’re going to need to make a decision at some point about, well, what’s going to happen. Is the husband or the other spouse, who’s going to end up with the property? Or are you going to continue in business together? Or are you going to just sell it to a third party and take the cash? So that’s the big fork in the road after you determine the entity ownership specifics.
Jake Gilbreath:And I’ve had people ask the 50/50 example that you gave, why don’t we just continue to own this together? Or even if the spouses own 25%, why don’t we just split it 12 and a half percent, 12 and a half percent, and go on down our merry ways, that way we don’t have to devalue it, or anything like that. That can be done. I’d be curious if you have, Brian, I don’t think I’ve ever seen anybody actually do that. And generally I tell people, “If you can’t stay married together, what makes you think that you can run a business together?” And then, of course, if you’re the spouse and say y’all own marriage, the community just owns 50%, and then there’s a partner, so okay, well, let’s just stay business owners with this partner. Well, what if that partner is buddies with one of the spouses and then all of a sudden you find yourself getting outvoted on everything because you are minority interest and then your ex-spouse is buddies with the other partner or other partners?
It just creates all sorts of messes. I don’t know if you have, Brian, I’ve never seen anybody actually do it where they co-own a business. I’ve seen them do if they have an investment maybe, you have an investment in a startup or something like that.
Brian Walters: That’s what I was going to say. I think there’s two situations that, let’s say, that the business was strictly they own 100 apartment units and they have a property management company that administers them, in that case, you could potentially stay partners together. You’d still need the typical things you need with any business partnership. The issue’s always somebody wants to exit, they want to sell all or part of their shares, how do we do that? Which is what happens in a divorce a lot of times, but that’s a situation where there’s not day-to-day running of the company, you’re both fine with it, it kicks off cash, you don’t really have any work to do, I could see those kind of folks staying in business, and I have had a couple of those happen. There’s some other ones where there’s no choice but to sell, for example, a law partnership.
Neither one of our spouses are attorneys in Texas, only attorneys can own parts of law firms, and so even though it’s a community interest that we have, we can’t stay 50/50 partners with our spouses for our ownership of it because our spouses aren’t lawyers. So there’s no choice but to do some type of big buyout in that particular situation. But most of the time, you’re right, someone’s going to either buy the other spouse out or they’re just going to sell it to a third party, either that half share or the entire company to get someone out of the company.
Jake Gilbreath: It’s like a house, we’re probably not going to own the house together after divorce. In theory, we could, but we’re probably not going to, so we’re either going to sell it or somebody’s going to take it at a value. By the way, you’re talking about law practices, your spouse can’t, non-lawyers, the same as medical practices, which we see a lot, a non-doctor can’t own a medical practice, so a lot of times the doctor’s spouse is the one getting the practice, and then it’s a question of what’s the value. So what’s the value of my business? There’s a long discussion, and we talk about it on our website a lot, and it’s obviously more complex than just a 20-minute podcast. But just generally speaking, Brian, how do you figure out the value of the business, and why is it not just I’ll pull my balance sheet, here’s the assets, here’s the debts, pull out a calculator, and there’s the value?
Brian Walters:It’s often a lot less than one would think as far as we calculate that in Texas, because we have a difference between what’s personal goodwill and enterprise goodwill, which is technical terms. But basically I like to say that it’s like, well, what happens if you both died, or whoever’s running the business died, what is the business worth? Let’s say I was a solo practitioner as a lawyer or a solo doctor or a solo CPA or consultants or something like that, and I’m made X number of dollars per year, let’s say I made $500,000 a year, well, you can go online and you might find that businesses are often valued at somewhere between three and five times the trailing profit. So let’s say four times, so is my business worth two million dollars, four times 500,000? The answer is really no, because that’s essentially my salary, it’s my personal goodwill, that’s what is being brought into it.
And if I died, if I have a solo law practice, there wouldn’t be one, no one’s going to hire a dead lawyer. And so there’s, in that case, really no value to the business other than my name, which is my personal goodwill, to simplify things, versus the alternative where the business is, let’s say, the real estate example, it’s 10 million dollars’ worth of rental real estate that’s managed by some other company that’s kicking off three million dollars a year. Well, the value of that would be very different because it doesn’t matter if I’m alive or dead, there’s real estate that’s paying us money, I’m not managing anything. So those are two extremes, and they would have very different valuations because of just the nature and type of the business, even though they might be making a similar amount of money.
Jake Gilbreath: I don’t know about your experience, Brian, usually this personal goodwill discount, because backing up, businesses are valued as an ongoing concern, right?
Brian Walters: Right.
Jake Gilbreath: It could be the value of the balance sheet. Oftentimes it’s an ongoing concern. So you see the experts using, it’s called the income approach or discounted cash flow approach, let’s look at what this business has made, apply cap rate, apply discounts, and then… Think about Shark Tank, it’s like you said, Brian, it’s three to five times X of what your profit is. It’s not just the money you have at the bank and the assets you have. But I’m like you, Brian, it’s like you say, what happened if I got hit by a bus, how much would you pay for this business?
The way I describe it in court or to judges and the juries, it’s if I’ve got a business and you’re handing me a check, and I’m handing you the keys to the business and I say, “Okay, here’s the keys. By the way, I’m not retiring. I’m going across the street and I’m going to compete with you, and I’m calling every single client and seeing if they’ll leave with me, and I’m calling every single employee and seeing if they’ll leave with me.” Would you pay the same amount for the business as then you would if I was retiring or signing a non-compete? Probably wouldn’t.
It’s like you said too, Brian, the example of the medical practice, if it’s the dental practice of Jake Gilbreath, you’re probably not going to pay a bunch of money for that, particularly if Jake Gilbreath is going across the street and opening the real dental practice of Jake Gilbreath competing with you. But if it’s Austin Dental Practice, which is a name I just made up, so I hope that’s not an actual business in town, but if it’s Austin Business Dental Practice, I may not care who the dentist is running that thing or who the dentists are, I may or may not. So it’s going to have a different value. Brian, how big of swings can this cause? Well, first of all, who’s determining the value overall, including the personal goodwill discounts, is that you doing that? And then how big of a swing can this discount and other discounts cause in the valuation?
Brian Walters:I’m going to answer the last question first, huge swings. And the example I was giving earlier, it’s difference between something being worth zero and being worth millions and millions of dollars depending on the nature of it. So who determines it? Well, ideally the marketplace, if it was a big enough company, you’d have it listed on the stock market and we’d be able to say it’s worth this much, but that’s not most companies. So the second alternative is if the decision is let’s just put it up for sale to some other third party, then the answer would essentially be whatever a willing buyer is willing to pay for it. But that doesn’t happen in most cases, and so most of the time we have to have an evaluation made by the court, and the court’s going to rely on experts who have training in the field, and they’re going to apply principles that are commonly accepted. There’s a number in the state that do it.
By the way, as a business owner, you can give an opinion as to your own view of the valuation, that might be colored, might be biased, it might be accurate. There’s a lot of truth to it sometimes. And the answer is, of course, we really don’t know because, like you said, it’s discounted cash flow in the future and nobody knows what the future is going to hold, but we have to make best guesses, and so we have experts who do that and apply all kinds of complex discounts and calculations, and those type of things to come up with the number. Frequently you’ll have the husband and the wife will each hire their own expert. They’ll come up with two different competing values. Sometimes you’ll agree on somebody that you trust to just do it one time and have a number. My experience has been that most of the time when they’re competing experts that their numbers are relatively similar to each other. They’re different often, but it’s not a huge difference. But what are your experiences and thoughts on that?
Jake Gilbreath: Same. Obviously your lawyer needs to be hiring an expert. It needs to be an expert that knows what he or she’s doing. Unfortunately, just like lawyers, doctors, just like any profession, there’s some people that frankly don’t know what they’re doing, or do a bad job at it. And that can really be a disadvantage to the clients, and really the family as a whole because it can cause disputes where there shouldn’t be disputes. In an ideal world, because we’ll talk about discovery in a second, I always say the more open book you can be when you’re doing a business valuation, the better. And having both experts talking and working together is a lot of times better. It’s counterintuitive to think why would I want the information my expert has being shared with what the other expert is looking at?
First of all, you have to under the rules of discovery. But second of all, the really good ones, what they do is they talk, they share information, they make sure they’re looking at the same data, because how confusing is that for a judge or a jury if it’s wife’s expert I valued this business as of June this year, and the other spouse’s expert says, “Well, I did it as of December, and I looked at old financials, I looked at new financials, I looked at this version of QuickBooks, I looked at that version of QuickBooks, I talked to this key per point person, I talked to that key point person.” That’s not helpful.
So the experts talking, so you have really good experts on both sides, they talk and they look at the safe data, and a lot of times they’ll come to you and they say, “We have the same number for what we think the projected income is for this business. We actually have the same cap rate. We actually have the same discount for lack of marketability,” but wife’s expert says it’s X personal goodwill discount, husband’s expert says it’s Y personal goodwill discount, and we can’t agree so you guys have to go litigate that. And so rather than litigating for a judge or a jury these complex numbers here or there, let’s spit out this number and some judge who’s trying her best to follow this but may not have the background in it, that’s really hard to do. That’s hard for me as a lawyer to do. I see these all the time.
But if you get it down to, hey, it’s just this one issue, judge, their expert says 50% personal goodwill discount, our expert says it’s a 20% personal goodwill discount, you got to make that determination, and then the rest you just plug into a calculator, it spits out the numbers. That’s the way to do a dispute and a divorce where it’s the most cost efficient, and you get your issued litigated, and you get a rational decision as opposed to we just all vomit information on a judge or a jury and say, “You pick a number,” because it’s not going to give the judge the information she needs. On that, Brian, talk about the issue of discovery when there’s a divorce, which is one of my least favorite conversations to have with clients, particularly the business owner, of the amount of discovery that can happen when there’s a divorce in a business.
Brian Walters:And it’s an open book system that we have essentially. The discovery just means both sides have the right to discover or learn about what’s going on. Now, there’s a couple of exceptions. If a business is clearly the separate property of one side or the other, I would say that you’re probably not going to get much information, and for good reason because it’s not really terribly relevant. But generally speaking, both sides, their experts or just individually through their lawyers are going to have the right to know about the business. And that’s pretty extensive information, it’s certainly the financials, it’s certainly the books, bookkeeping, that type of thing. But it can go farther than that. One significant asset for a business may be accounts receivable. And we’ll often hear, “Well, yeah, we have three million dollars in accounts receivable, but we’re not going to collect most of it.”
Well, is that true or not? Is it worth three million? If it was an accounts receivable out, invoice out to Exxon that was legit and Exxon paid your invoices, that’s probably worth three million dollars. If it’s six year old accounts receivable in a dental practice, it’s probably not worth much. So we’d need to know that type of thing. Same things with accounts payable, you say you owe a bunch of money, do you really? Are you really going to pay it? Can you negotiate it down? Those type of things. And you’d want to look specifically at the various assets of the business. If a piece of real estate’s on the books for X number of dollars as an asset, is that really the case? Do we want to get it appraised? All of those type of things. I don’t think you’re going to have unlimited access to it. You’re probably not going to see all the emails between the salespeople and their salespeople that they’re working with.
There’s some limits to it, but it’s going to be pretty much an open book. And that’s why we started off by saying keep things clean and open, because even if it looks shady and it’s not, it’s going to probably be presented that way and you’re going to have a judge who’s suspicious. It’s human nature that if you know you’re going to get divorced and you know you’re going to end up with the business and you know you’re going to have to pay your spouse out, it’s human nature to want to lower the value of the business. And so they’re going to be suspicious about that.
Jake Gilbreath: And it’s frustrating for the business owner. I can’t tell you how many times, because it’s probably a majority of the time that the poor business owner I’m representing, and I get it, he or she’s telling me, “Why are we doing this? I can tell you guys what this thing is worth. I know what this is worth, and I’m telling you it’s worth 500,000, or a million, or zero. I’m telling y’all we’re crashing and burning here. Why do I have to do all this discovery?” It’s hard because the spouse on the other side who’s naturally going to be distrusting of you and has a lawyer in his or her ear saying, “Trust, but verify,” it’s frustrating turning over all of the information when you as the business owner a lot of times legitimately could tell us what it’s worth, you have to go through this process.
So it’s frustrating, but we certainly help clients with that, be it a way of limiting the discovery or help them do it efficiently, back to the experts talking, a lot of times it seems counterintuitive, but I’ll have the client with the business, and if they do QuickBooks online, you say, “Give the other side access to QuickBooks so they can run whatever reports they want to do. Or if it’s plugged into the wall of QuickBooks, then put it all on flash drive, give it to them.” Not fun. To be real frank, with my business owners that I represent, it’s not a fun process, but we can help you through it. And the more you can give information to the other side, it’s going to help the divorce move on.
Because my clients, a lot of them think that they can convince their spouse of what the business is worth, and sometimes they can, but a lot of times they are thoroughly unable to convince their spouse of anything, because they’re going through divorce, and, like you said, that’s human nature. That doesn’t make anybody a bad person. It’s just the nature of things. So just to wrap up quickly, Brian, an obvious question, and we talk about it a lot on this podcast, but why is it important to have not only a lawyer when you’re going through this, but a lawyer who actually has experience in dealing with divorces with businesses?
Brian Walters: It’s a good question. And you and I just did a podcast where we said some people don’t need one, don’t need a lawyer, or can probably get by with a pretty basic skilled lawyer. This is not that situation. This is the opposite. This is the equivalent on if you have kids of having, let’s say, a child with a very specific needs or a parent with severe issues, you need a good lawyer and you need not only a lawyer, but one that knows what they’re doing because this is really specific information, and I’m continually surprised at lawyers who don’t understand money or business or taxes or these type of things. It’s startling to me. And maybe it’s because they don’t have the kind of practice where they have the sophisticated clients with these issues. I don’t know. But it’s one of the areas where there’s a real difference in what your lawyer can do for you.
So I would think you should definitely retain one in this case. And that’s probably not the only expert you’re going to use, you’re probably also going to need a evaluation expert, maybe even a forensic accountant, which might or might not be the same person, to deal with the kind of issues you’re going to have. And in this case, and possibly a business law attorney, if there’s questions about the business formation or the character or the paperwork or all those other kind of things, it’s pretty complex. It’s good news, bad news. That would be the case because you have a valuable business, but more money, more problems sometimes.
Jake Gilbreath: That’s true. And in the consult, just ask. You’re talking to us or talking to whoever, say, “This is the business I have. Have you seen that before? First of all, have you done a divorce with the business involved and have you seen this type of business?” I think that’s a fair question. No different than if you were talking to a doctor and saying, “Have you seen this condition before? Do you specialize in this? Tell me your experience?” The consultation’s not just us interviewing the clients. A lot of times it’s the client interviewing us to make sure that we have the experience to deal with this, because, like you said, it can be shocking how poorly these can be handled if it’s somebody that doesn’t know what they’re doing.
So that’s a broad overview of the way businesses work in the divorce. We’ll talk more about this on a series, but for this episode that’s all we have for today. We’ll be back in a couple of weeks for another episode on this subject in the series. As always, if you like what you heard today, please do us a favor and leave a review. We appreciate all feedback, especially when it helps us better the podcast or gives us ideas for topics or questions that y’all have. If you have any questions or suggestions, reach out to us at email@example.com. I’m Jake Gilbreath with Brian Walters, and thank y’all for listening.
For information about the topics covered in today’s episode and more, you can visit our website at waltersgilbreath.com. Thanks for tuning in to today’s episode of For Better, Worse, or Divorce, where we post new episodes every first and third Wednesday. Do you have a topic you want discussed or a question for our hosts? Email us at firstname.lastname@example.org. Thanks for listening. Until next time.