By: Roy S. Cohen and Jonathan Landesman
Over the last thirty years, we’ve represented dozens of family-owned and operated construction businesses. Some family businesses run like a well-oiled machine with siblings and extended family members working together harmoniously and taking on different roles and responsibilities that play to their respective strengths. Other family-owned businesses sit at the opposite end of the spectrum – with near-constant drama and dysfunction caused by one or more black sheep in the family. Perhaps not surprisingly, most family businesses that we have worked with lie somewhere in between these two extremes, with operations generally running smoothly and squabbles coming to the boil only occasionally.
We have also seen family disputes turn extraordinarily ugly in the blink of an eye, leading to years of expensive and protracted litigation. It is for that reason that we have prepared this short article so that you can learn from the mistakes of others and avoid the common traps associated with business divorces.
The first rule for avoiding problems seems obvious: recognizing the fact that no one can keep working forever. Does your business have a shareholders’ agreement or operating agreement that says what happens to your shares and your family members’ shares when they stop working because of death, disability, or retirement? Failing to have a clear, written agreement on when one owner has the right to buy out another owner, whether that owner holds a majority or minority interest, is a recipe for litigation. This is especially true in family businesses where a retiring owner wants to hold on to his ownership interest and continue collecting pro-rata profits even after he stops working. These issues should be vetted and agreed upon with the assistance of counsel as early as possible—hopefully, years before anyone is remotely close to death, disability, or retirement.
Next, there is the issue of determining the “fair” value of your business. There are a lot of misconceptions out there when it comes to business valuations. Some people will tell you that it’s simply a matter of picking a multiple (two or three) and applying it to your business’s after-tax earnings. Others will swear that the only true measure of enterprise value is a business’s book value as stated in its audited financial statements (assets minus liabilities). The truth of the matter is that there is no “one size fits all” universal method to determine the fair market value of a construction business. In many respects, valuation is more of an art than a science. Adding a level of complexity, once an enterprise value has been determined for your business, the price actually paid to an owner for his shares can vary substantially based upon whether certain discounts are applied, such as a discount for lack of marketability or minority interest in a closely held company. Once again, failing to vet and agree upon all of these issues prior to problems arising is a recipe for costly litigation.
The other recurring issue that is particularly tricky in business divorce cases are expenditures that are frequently called “add-backs.” If you pay yourself an annual salary of $850,000 to be your company’s CEO but you could find a qualified individual off the street to perform that same job for $250,000, the value of your business needs to reflect a $600,000 add- back. Similarly, money paid (or overpaid) to other family members, excess employee benefits, and cash laid out for non-business related expenses needs to be added back to the value of your business.
If you are tired of carrying the dead weight of a sibling or other family member in your business or—conversely— if you find yourself being frozen out of a business by an overbearing, know-it-all family member, you may have more rights than you know. Indeed, even if the business is turning a profit and things are running smoothly, for the time being, don’t wait. You should gather your business’s corporate documents together, including its articles of incorporation, bylaws, and shareholders’ agreements, and consult with experienced counsel before you get caught in the jaws of a business divorce case.