Maintenance payments by entrepreneurs: why we’re getting it wrong

When a married couple gets a divorce, in most cases one of the spouses ends up paying the ex-spouse maintenance. Individuals who are entrepreneurs often end up paying their ex-spouse the wrong amount of maintenance. This is due to cash flows being disregarded or not given sufficient consideration. So how SHOULD the courts calculate maintenance?

The entrepreneur’s financial means

You might think it is straightforward to ascertain an entrepreneur’s financial means: it is simply a matter of looking at his income and the company’s profits. But this is incorrect. An entrepreneur’s financial statements are merely a snapshot of his financial situation in a particular period. The court cannot solely determine how much maintenance an entrepreneur is able to pay in the event of a divorce on the basis of the financial statements.

Profits during the three years prior to divorce

One of the basic principles (established in 1994) for calculating a company’s profits is that one needs to use business profits when determining financial means. This is still misinterpreted in legal practice. The recommendation was that lawyers and judges needed access to financial statements from the last three years of a company in order to determine the company’s profits.

In practice, this recommendation has taken on a life of its own, with the result that courts take the average profit for the last three as the baseline. This is what judges still ask for when determining an entrepreneur’s maintenance obligations. In practical terms, this means there is far too little consideration of whether the entrepreneur can actually afford the maintenance payments. Even if the average profit is pretty good, there may not be any money available to pay maintenance. When determining maintenance in an entrepreneur’s divorce, as well as past profits, the annual cash flow in recent years and the expected cash flow must also be determined.

Determining cash flow

In order to determine how much maintenance an entrepreneur can afford to pay, in addition to the company’s profits, ideally the court should draw up an overview of cash flows from operating activities, investment activities and financing activities. This should quantify current and projected cash flows at the time of calculation, clearly indicating how much money is available for maintenance payments without relying solely on past accounting profit or taxable profit.

Analysing cash flow

There is a lot of effort involved in producing cash flow statements, but alone such statements are not enough. The court will have to analyse cash flows so that cost items which do not actually produce a cash flow can be corrected. In other words, the cash flows have to be “normalised”.

Capital expenditure and repayments around the time of the divorce

An entrepreneur may have elected to make certain investments and/or repayments which will affect cash flow. Investing too much around the time of the divorce, raising too little finance for those investments and/or repaying too much on loans when there is no need to do so from a business perspective: these are all scenarios which may call for a correction of cash flows.

It is also important to know how much money the ‘Director and Majority Shareholder’ has taken out of the business, how much he owes the business and how things will look in the future. In addition to investments and director’s drawings from the business, contributions to a self-managed pension fund are another factor to consider when correcting cash flows. The same goes for depreciation.

Why? Well, what if profits are good but the ‘Director and Majority Shareholder’ owes the business a lot of money? In the cash flow system, a debt on current account is an outgoing cash flow. No money will come into the business, yet money will leave the business because the company has to pay the entrepreneur a dividend.

Forecast for the post-divorce period

The final piece in the puzzle is a forecast for the next few years. The importance of forecasts is greatly underestimated, yet they are a major factor in determining what an entrepreneur can afford.

Conclusion

To conclude, when determining maintenance an entrepreneur can afford, the court must look at several things. First of all, the court must observe the financial statements over the last three years. Next to that, it is essential to prepare the most detailed cash flow statement possible, complete with a forecast. Only then can the court form an accurate picture of the means – or potential means – at the entrepreneur’s disposal. Past book profits are no help at all here; the court needs to determine the (free) cash flow.

And remember that maintenance payments must never be more than the amount the free cash flow allows. This would jeopardise the company’s very future – which is certainly not in the interests of either party in a divorce.

We understand that the topic of maintenance can be difficult.

Please do not to hesitate to contact us should you have any questions or if you need advice sorting out your maintenance arrangements.

 

Update article: December 2017