For many divorcing couples, a closely-held business is the most valuable marital asset. In most cases, it is likely that only one spouse will remain with the business, raising this key issue: How can the interest of the “Departing Spouse”, after its value is determined by independent appraisal, be turned into cash?

My earlier article summarized three principal choices which should be considered. Often, the “Remaining Spouse” proposes a modest down payment for the Departing Spouse’s interest, with the balance to be paid in installments over 5 years or more. The rationale is that the company’s cash flow can support these installments (along with the Remaining Spouse’s living expenses and support payments to the Departing Spouse) without the disruption and uncertainty caused by a third party financing or a sale of the business.

While this leaves the Remaining Spouse with complete ownership and control of the business, it amounts to a risky “investment” by the Departing Spouse in the continued success of the business. So, a family law attorney should carefully consider the range of terms that an outside debt or equity investor would require from the Remaining Spouse, including:

1. Installments: The Departing Spouse should argue for monthly, or at least quarterly installments. The Remaining Spouse may argue for annual installments, but the cash flow of the business should allow more frequent payments.
2. Interest Rate: At one extreme, the Remaining Spouse may propose an under-market rate. However, this is a high-risk debt and the interest rate should reflect that risk. The Departing Spouse should get at least a commercial bank rate, and depending on the Note’s length and the risks of the business, should argue for the higher rate that a mezzanine or other alternative lending source would require. The rate should be based on the current market, can be fixed or floating, and may be in the form of the prime rate (or LIBOR) plus X%. The Departing Spouse might even argue for compound interest, rather than a simple per annum rate.
3. Late Payments: In commercial and high-risk loans, it is common to have both a higher default interest rate that continues until the default has been cured (e.g., an additional 5%) and a late charge equal to 5% of the installment that was not timely paid.
4. Mandatory Prepayments: The premise for the Remaining Spouse paying over time is that the business can only afford the agreed installments over that prolonged period. So, if the business then generates more significant cash flow, it is only fair that prepayments on the principal balance be required. For instance, the Promissory Note might provide that 50% of “Available Cash Flow” (i.e., less outstanding payables, etc.) must be used for mandatory prepayments. To ensure that cash is not taken out of the company to defeat this requirement, the Note should also provide that no distributions, or increased compensation and bonuses, can be paid to the Remaining Spouse without the Departing Spouse’s consent.
5. Acceleration on Sale: The Note should provide that, if all or any significant part of the business is sold, 50% of the net proceeds must be used to pay down the Promissory Note. This provision requires thoughtful drafting to ensure that the sale documents do not allow the Remaining Spouse to avoid the intent of this requirement.
6. Security: The Remaining Spouse’s obligations under the Promissory Note should be secured by a pledge of his/her stock or other equity in the company. While this is not adequate security in an economic sense (since events causing a default on the Note likely mean the business is in trouble), it does provide the Departing Spouse with some safeguard leverage.