Article

Dividing up the family business

Jay Shaw Jay Shaw

Using the Family Business to Fund a Relationship Property Settlement

With nearly 150,000 small to medium businesses operating in New Zealand, an ownership interest in a family business features in many relationship property settlements. The interest held in that business can represent a significant proportion of the relationship property, and in some cases it can make settlement proceedings considerably more complicated.

If there are other assets that can be used to offset the value of the business interest, or if the business is to be sold, then the process of allocating assets remains relatively straightforward. Even if there’s no actual sale price available, an independent valuation will provide the value of the business interest that can be used in dividing the assets.

However, if one of the parties wants to keep the business, and it forms a large proportion of the relationship property ‘pot’, it can add a great deal of time and complexity to the settlement process. In those circumstances, what might be needed is to further carve up the business value so that it can be distributed more easily.

To achieve this you will need to conduct a much more detailed assessment of the business, to identify any underlying assets that could be extracted. Depending on the nature and structure of the business there could be several impediments to realising and extracting that value.

If this seems like an arduous and daunting exercise, a specialist in business valuation and forensic accounting will be able to help. They will conduct a thorough evaluation and identify any issues, enabling you to remain focused on the other aspects of settlement proceedings.

Key Issues

There are several issues to consider when extracting assets from a family business in this context:

  • Whether your client has the right to extract funds from the business
  • Whether the business owns any assets that are capable of realisation
  • How those assets could be converted into cash
  • How any proceeds could be extracted from the business
  • What effect the extraction of these assets will have on the value of the business  

1.   Does your client have the right to extract funds?

Not all business interests allow the extraction of funds, so the first step is to establish whether this is the case for your client. This requires very careful examination of any company ownership agreements: even though equity interests of over 50% usually confer this right, the approval of other shareholders might be needed - and this simply may not be forthcoming. (I recently valued a 51% equity business interest where the approval of 75% of shareholders was required for the payment of dividends or distributions. The remaining shareholders were hostile, which meant that there was no reasonable ability to extract funds).

Another way to realise funds is through the repayment of shareholder loans, particularly if they are repayable on demand. However, if your client only holds a minority interest, and no shareholder loans exist, it is unlikely that they will be able extract funds without the agreement of other shareholders, directors and funders.

2.   Does the business own any assets that are capable of realisation?

If your client can extract funds from the business, the next step is to investigate whether the business owns any assets capable of being realised. In practice, this usually means identifying assets that could be realised without impacting the viability of the business.

Once again, this exercise is not always straightforward. For example, I recently valued a business that held a large cash balance, but this was mostly ‘locked up’ because it included seasonal working capital requirements, deposits held, and planned capital expenditure. I have also valued a number of financial services companies, where significant cash balances are held due to solvency criteria required by law - making them unavailable for distribution.

A full understanding of the business is necessary to accurately identify any realisable assets. Highly liquid assets (particularly cash) should not automatically be considered to be surplus to operations. Genuinely surplus assets may include:

  • Land and buildings that are not being used by the business
  • Cash not required by the business (e.g. term deposits)
  • Surplus working capital (not forgetting to consider seasonal requirements)
  • Investments, such as property, shares and other businesses
  • Borrowing capacity (depending on the banks' willingness to lend money to fund a relationship property settlement)

Another important consideration here is timeframe: even where there are assets that could be sold, this process may cause unacceptable delay if the parties are looking for a quick settlement.

3.   How can the business assets be converted into cash?

The next step, if there are assets available for realisation, is to decide how they will be converted into cash. They may be sold or simply transferred out of the business – or depending on circumstances your clients might consider other options such as:

  • Further borrowing (secured against business assets)
  • The sale and leaseback of land and buildings
  • Using external funding rather than cash reserves to fund business commitments
  • Factoring or discounting of any business debts

4.   How can proceeds be extracted from the business?

When it comes to extracting funds following the realisation of assets, the most important issue to consider is the tax implications. At this stage it might be sensible to seek advice from a tax specialist regarding the structure of the settlement.

In my experience, dividends are the most common method of extracting funds, particularly when imputation credits are available. Depending on the business structure there may also be other options, such as the sale of shares or the repayment of shareholder loans.

5.   How will extracting assets impact the value of the business?

Extracting assets or funds from the business will inevitably reduce its value. It is important to take this into consideration and adjust the valuation of the business interest accordingly once any funds have been paid out, to ensure there is no double counting in the settlement.

Summary

An interest in a family business can add real complexity to a relationship property settlement, where one of the parties wants to retain the business and the couple does not have other property of equal value. Extracting assets from the business may be a viable solution to this problem, but this is rarely a straightforward process. There are a number of important considerations, and a very thorough understanding of the business is needed to identify whether, and which, assets could be realised. Expert accounting and valuation advice and a full assessment of the circumstances will help you to reach a practical solution and achieve a fair division of assets acceptable to both parties.

This article appeared in Volume 16 Issue 3 of The Family Advocate.