Divorce and Illiquid Assets: Strategies for Moving Forward

Valuation disputes in divorce can be complicated and contentious, but the right expertise and creativity can help resolve the issues.

Navigating high net worth divorce is often complex and demanding, with the valuation and division of assets requiring an array of legal and financial experts. When illiquid assets are involved, this dynamic can be exacerbated.

Divorce and illiquid assets: an even wider “spread”

Even with the help of outside valuation experts, complex assets with opaque valuations are always ripe for conflict given the natural “spread” that develops between each spouse and what they believe to be their value. Times of uncertainty — the recent pandemic, for example, but also more moderate events — can widen these spreads, and the time and conflict associated with resolving them.

Private Business Interests

Private business interests are a prime example. When there is uncertainty about the future business environment, divorcing couples have more reason to question the financial assumptions used to determine their company’s value. Will temporary changes in customer behavior become permanent? Will capital expenditures be needed to innovate toward changing preferences or comply with new regulations?

All of these unknowns impact a subjective determination of value, leaving greater room for conflict. Whereas the exiting spouse will naturally worry about an overly depressed valuation, the spouse remaining in the business will worry that he or she is paying too high a price given such uncertainty.

This valuation conflict is not insurmountable. However, often, it is critical that both parties work closely with their team of legal and financial advisors to consider creative solutions. For example, recently we have explored or helped clients execute the following strategies in collaboration with their attorneys and other advisors.

Trusts with impartial trustees post-divorce

When valuation issues remain unresolved and buyout terms cannot be reached, both parties might benefit from maintaining their interests until temporary disruptors are better understood or have dissipated. In this situation, they can contribute their interests to a trust, with an impartial corporate trustee acting as their intermediary to hold shares of the business in an agreed upon manner. Further, the trust can include other safeguards to ensure both parties’ interests are protected until a buyout is possible.

Support trusts

Similarly, in cases where determining income available for support is part of the valuation process, support trusts can help. In this situation, a portion of the business can be used to fund a trust for the benefit of the supported spouse. The trust would receive its share of income from the business and an impartial corporate trustee would make distributions to the supported spouse.

Further, depending on the final settlement agreement, the trust terms can include a support modification schedule to allow distribution adjustments based on the business’s actual income. This assures the supporting spouse that payments can be reduced if business slows, while assuring the supported spouse that regular payments will be made. Per the support order, the trust can also include a termination date and contingency provisions — such as for the death of either spouse or the remarriage of the supported spouse.

In all cases, but especially with closely held businesses and trusts, it is important to consider the tax implications of every planning strategy. Tax advisors play an integral role in structuring these trusts so that the tax liability is allocated appropriately between the parties. Also, both parties and their advisors must consider situations in which overfunding or underfunding of the trust occurs.

Creative buyout structures

If co-owning the business interests in trust is not an option, creative buyout structures could be explored. While in practice such solutions are highly customized, the examples below highlight the types of structures that might work, depending on a number of variables unique to the individuals, business and overall marital assets:

• Multiyear earnout:
  The “buyer” could pay the “seller” a lump sum upfront followed by an earnout over multiple years tied to the future performance of the business. While agreeing on an upfront payment may still prove difficult, the ability to share in future upside could ease the concerns of the selling spouse. The selling spouse may also be willing to accept an overall discount in exchange for upfront liquidity and certainty.
• Clawback provision:
  The sale could include a clawback provision, which would be triggered by a future sale to a third party. With this option, the “buyer” could agree to share a portion of future sales proceeds exceeding the business’s valuation at the time of divorce if the business sells within a set period of time (e.g., within two-to-three years after the divorce or according to a sliding scale over a longer time period). Careful parameters (e.g., independent audits) would need to be set around this type of agreement to protect the selling spouse, but the clawback provision could be enough to move discussions forward.
• ESOP:
  In a more limited number of situations, the company could establish a leveraged employee stock ownership plan (ESOP) to provide an exit strategy for the spouse who is leaving the business. This option provides a few main potential benefits. First, it could provide valuable liquidity to the spouse remaining in the business while assuring the departing spouse that an impartial valuation outside of the divorce has been reached. Second, the shares acquired by the ESOP would be allocated to the plan participants as the ESOP loan is repaid, providing a valuable employee incentive. Third, the annual company contributions to the ESOP to cover debt service would be tax deductible as retirement plan contributions.

Solutions Across Other Types of Illiquid Assets

While the above examples focus on business interests, custom solutions can be found across other illiquid asset types too — including commercial real estate and private partnerships — if the right expertise, creativity and advisor collaboration are combined. At Northern Trust, we are committed to drawing from our unique expertise in both complex assets and trusts and estate law to coordinate with other advisors and find unique solutions for our clients.

For help building your financial plan during divorce — or the financial plan of one of your clients — please reach out to one of our advisors.