Community Banking Advisor: Psst . . . Is your client headed for divorce?

If some of your borrowers are headed for divorce court … take heed. Why? Because if a couple co-owns a company, it might place the loan at risk. Here are some issues you should consider if a client is preparing for divorce court.

A one-man show

Sometimes one spouse controls the business, and the other spouse pursues outside interests. A key question in these cases is how much of the private business interest to include in the marital estate. The answer is a function of purchase date, prenuptial agreements, length of marriage, legal precedent and state law.

Goodwill is another point of contention. If a business has value beyond its tangible net worth, how is intangible “goodwill” split up? All goodwill is included in (or excluded from) the marital estate in some states. But about half the states divide goodwill into two pieces: business goodwill and personal goodwill. The latter is excluded from value in these states.

Accurate valuations and reasonable payout periods are important. Settlements that disproportionately favor the noncontrolling spouse can drain company resources and cause financial distress. If the parties can’t reach an equitable settlement, it’s also possible for the court to mandate a liquidation, which threatens business continuity.

When the company buys out a spouse, Treasury stock might appear on the balance sheet. Or you might see an increase in shareholder loans if the owner-spouse borrows money from the business to pay divorce settlement obligations.

The matter of maintenance payments

The noncontrolling (or nonmonied) spouse also may receive alimony and child support from the controlling shareholder. Maintenance payments typically are based on the owner’s annual salary, bonus and perks.

Unscrupulous owner-spouses may try to change compensation levels in anticipation of divorce. Depending on the type of entity they own, a lower wage level may benefit them in negotiations for spousal maintenance and child support.

Also be aware that what divorcing borrowers say on the stand about unreported revenues, below-market compensation and personal expenses run through the business could lead to negative tax consequences. Publicly admitting these tax avoidance strategies puts both spouses and the business at risk for IRS inquiry.

The loss of a key person

Many private businesses are run by both spouses, whose complementary skill sets make for a hard decision: Who’s going to run the business after the divorce? In limited cases, the spouses may want to continue to run the business together. Like most stakeholders, if co-owners decide to split up personally, but maintain their professional relationships and continue comanaging the business, you may be rightfully skeptical. Usually, however, the parties can’t imagine working with each other. Such a scenario requires a buyout and a noncompete agreement.

Buyouts should occur over a reasonable time period and can include an earnout — wherein a portion of the selling price is contingent on future earnings — to avoid undue strain on the business. Future success is uncertain when a business loses a key person. It’s fair for both shareholders to bear that risk. If they don’t, the remaining owner, and your bank, could be at risk.

Even if your ma-and-pa business borrowers aren’t currently contemplating divorce, consider what might happen if they did. Proactive family businesses have a buy-sell agreement in place before personal relationships sour. Factors to consider include valuation formulas and methods, valuation discounts, earnout schedules, postbuyout consulting contracts, noncompete agreements and payment of appraisal fees.

A sticky situation

Divorce can truly ruin lives and a couple’s livelihood. And as a lender, you might be concerned that you’ll lose a valued client in the process. The good news is that you can always recommend a financial advisor to help divorcing couples, or your bank itself may provide such services. Either way, you’ll likely protect the loans from default and delays.