In this article, Trevor Slack, a partner at Griffins and former principal at Charles River Associates, discusses an approach that may be taken in valuing a family business in divorce proceedings.
The approach uses share options as an alternative to situations where the business value is disputed and the business may be either under or overvalued. Share options could be useful as they represent an indirect investment in the underlying business, but do not have the same rights carried by ordinary shares, such as receiving dividends, voting, or seats on the board.
But perhaps more importantly, if the aim of divorce proceedings is to curb extreme claims and minimise conflict, then share options may facilitate achievement of that aim. For this article, we use a husband and a wife as an example of a married couple with the husband as the owner/operator.
Division of a business
Married couples can have a significant proportion of their wealth committed to a family business. However, in the event of divorce, the value of such a business can be a source of disagreement. Because shares in a private family business are not traded on a stock exchange, private business value is not observable. Private business value has to be estimated or determined by a court (or other independent party) when value is needed to divide assets. This can mean that when a husband and wife have conflicting interests, the result can be business valuations which are polar opposites. For example, if the husband is the active partner in the business, his interests can lie in a low business value, while the wife’s interests can lie in a high value. What approaches can be taken so that the opposite ends of a wide, but reasonable value range can be addressed?
Perhaps the most obvious solution occurs when a spouse offers to buy (or sell) shares which they believe are under (or over) valued. However, spousal trading in the shares of a family business could mean that the couple retains direct interests in the business, even when they are in the process of getting divorced. The issuance of non-voting shares could create complications, as voting rights are generally seen to have value. For example, a greater number of non-voting shares may need to be issued to make up for the loss of voting rights. Also, in the case of a 50/50 split of equity in the business, the ‘non-voting’ spouse might expect to have a seat on the company’s board. Therefore both spouses would be involved in board-level decision making, regardless of any non-voting status at the shareholder level. Share options can offer an approach to avoid this scenario.
An overview of share options
Since options are derivatives of shares, their value essentially follows the value of the underlying business. However, options provide a way to retain an interest in the business, but without enjoying the rights attached to the shares. The type of option discussed in this article is known as a ‘call option’. In brief, there are two parties to an option contract. One is known as the option writer (or seller), who owns the underlying shares and. the other is the option holder (or buyer). A call option gives the option holder the right, but not the obligation, to buy the underlying shares from the option seller, sometime in the future. (Put options are the opposite of call options in that they give the holder the right, but not the obligation to sell the underlying share to a counterparty.)
The current value of the underlying share is often used to set the price which the option buyer will pay if/when they exercise the option. (However, this future price can be set higher or lower than the current value of the share.) This fixed price is known as the ‘strike’ or ‘exercise’ price. Thus, if the future value of the share goes above the strike price, the option holder can profit by acquiring the share for the strike price rather than for the higher price in the future period. However, this potential for profit is not normally given away. Hence, the option seller will sell the option to the option buyer. Options have their own intrinsic value, and there are models that estimate this value. Among the most well-known are the Black-Scholes and Binomial models.
Inputs for the Black-Scholes model differ from equity valuation models such as the Capital Asset Pricing Model (CAPM). Both option pricing models rest on the value of an equity share. Thus, options are another approach through which share and business value can be measured. A key advantage of the basic option pricing models is that all of the inputs are either given or readily observable, bar one. The exception is volatility, which can be estimated relatively easily. Importantly, volatility is often seen as a proxy for risk. However, Black-Scholes treats risk in a different way to that used in the CAPM.
For the ordinary shares of a business, risk is bad for value. This is because the expected cash flows of a risky business will be valued less, or discounted more, than if those cash flows belonged to a more stable/predictable business. With options the opposite is true – the more risk a share has, the greater the chance for its value to increase significantly above the current price. For shares that are considered low risk, it implies a lower chance that their value will be significantly higher in the future than what it is now. Thus, ‘high risk’ businesses tend to have higher option values than ‘low risk’ businesses. The decoupling from ordinary shares (and accompanying valuation models) is what makes option models potentially useful in business value disputes.
To show how options might help settle disputed business value, a condition is needed: options can be used as in-specie payments to a spouse. A potential cost is that assets of one spouse would remain integral to the assets of another spouse after a settlement. This, of course, may run contrary to the aims of a clean break / consent order. However, if options were included in the order, they would be specific in scope and time bounded, ie by the life of the option contract.
This is not to say that it would be easy to include options in a consent order. Indeed, perhaps the main circumstances where it would be useful is when there is great uncertainty about the value of the business, and the spouses simply wanted to ‘place their bets’ on the future. However, this situation is outside the scope of this article. The assumptions used to illustrate how options might work are set out below:
If under or overvalued shares become the settlement figures in a divorce, then clearly one spouse is going to benefit at the other’s cost. However, if under or overvaluation exists and options are used, the flow of any wealth transfers between the spouses will be reversed. This is analysed below.
For the wife
If the wife were to accept the husband’s valuation of 500 for the business, she would be entitled to half, ie 250. But if the true value of the business is 1,000, then the wife should have been entitled to 500. Thus, to state the obvious, if a valuation of 500 were accepted, the wife would lose 250. However, the wife could ask for her 250 to be paid in-specie with options, which are valued at 2.50 each. The husband would therefore grant the wife options over 100 shares to arrive at 250 in value (100 options x 2.50 option price = 250). In effect, the wife would have an option over the entire share capital of the business.
If the wife were to then exercise all her options the next day, she would need to pay the husband the exercise price of 500 (5 per option x 100 options = 500). Because the ‘true’ value of the business is 1,000, the wife would gain 500. Two things are therefore achieved: (i) the wife accepts the husband’s low value of the business, thereby avoiding further dispute; and (ii) she ends up in the position she would have been in if the husband had not undervalued the business.
For the husband
What if the husband agrees with the wife’s proposed valuation of 2,000, but can ‘pay’ the wife her 50% share (ie 1,000) by granting options? Since the option price is 10 under the wife’s valuation, the husband would grant the wife options over 100 shares and she would receive 1,000 in value (100 options x 10 option price = 1,000 (in-specie)). Coincidently, the wife again ends up with an option over the entire share capital of the business.
However, the exercise price under the wife’s valuation is 20. Therefore, if the wife were to exercise her options, it would mean she would need to pay the husband 2,000 (in exchange for the 100 shares in the business (100 options x 20 exercise price = 2,000)). The problem for the wife is that the ‘true’ value of the business is 1,000, so she would lose 1,000 if she exercised (1,000 true value - 2,000 exercise price = 1,000). Further, while the business’ value stays at 1,000, it would not make commercial sense for the wife to ever exercise her options. In fact, the business value would have to double to 2,000 for the wife to break even (2,000 true value - 2,000 exercise price = 0, ie breakeven). Thus, if the business’ value never rose above 2,000, then the wife’s options would never be exercised.
From the husband’s perspective, it could be a good deal to accept an overvaluation where he can settle it by granting options. The true value of the business at 1,000 means that the wife is entitled to 500. But settling with options using the wife’s overvaluation means that the husband might never end up paying out anything in respect of the business. This would make the husband better off by 500, as he would have avoided paying the wife her ‘true’ entitlement of 500, despite having initially given 1,000 in value by granting her options.
Using options to settle the value of a family business upon divorce has a number of advantages. First, options enable the husband and wife to both retain an interest in the family business. Secondly, options can allow the partner running the business to do so without actively involving their ex-spouse. Options also avoid complications that can arise with a settlement involving non-voting shares. If a business would have to raise debt or be sold because there is not enough cash to pay out a spouse, options may be a way to preserve the business, but still divide up its value. Lastly, if one (or both) spouses feel that the equity in the business has been under/overvalued by the other, using options could highlight this bias. While this would involve the spouses trading with each other, the benefit would be overcoming bias in family business valuation.
Trevor Slack, a partner at Griffins and former principal at Charles River Associates,
The views and opinions expressed in this article are those of the author and do not reflect or represent any of the organisations with which the author is affiliated.