Stock Options and Divorce

Parties contemplating divorce frequently can agree to sell a car or home and divide up the receipts. However, with assets that cannot be sold or for those that do not have any real value, parties sometimes agree to give up their rights to that asset in exchange for some other asset. This exchange sometimes occurs with private company stock options granted to one party. Since an exact value of the options cannot be determined, one party may agree to some type of exchange.

A Start-Up Hypothetical

Here’s a typical Silicon Valley scenario: Husband has a job working for a start-up company. As part of his compensation package, he receives stock options subject to a four-year vesting schedule. The parties are unsure whether the start-up will continue as is, be acquired, or fold up like many other companies in the Valley.

Question – During the parties’ discussion about the division of assets pursuant to a divorce, the stock options issue arises. The parties try to figure out what to do with the options, and whether Husband should just keep them in exchange for his gratitude and agreement not to speak to Wife again.

California, the Land of Equality (At Least for Divorce)

Under California law, there is a presumption that any assets acquired from the date of marriage until the date the parties separate (referred to as the “date of separation”) are considered community property. This presumption is referred to as a “general community property presumption.” Community property would then be subject to equal division (50/50).

The date of separation is a very important date, as it establishes a different characterization in property rights. The date of separation is generally the date when one of the parties subjectively decided that the marriage was over and then objectively did something, such as moving out.  The parties sometimes later argue about the exact date of separation, as it can make a major impact on which assets are considered community property (and thus subject to equal division) or separate property (acquired after the date of separation). For example, bonuses received before the date of separation would be subject to equal division, but bonuses received after that date would be considered separate property.

In our hypothetical, let’s assume that there is no problem on the date of separation and the parties agree that it was the date that Husband moved out the home.

Some of Husband’s options vested during marriage and before the date of separation. Based on the general community property presumption, these vested options would be subject to equal division.

But what about those options that were granted during marriage but had not vested before the date of separation?

Some people may think that unvested options do not have present value and if Husband were to quit or be fired, they would be worthless anyway.

However, the courts in California disagree with this view, and believe that even though these options may not have a present value, they are subject to division.

Half the Pie or Just a Few Slices?

So how does the court determine what portion of the options belongs to the Wife?

Generally, courts use one of several formulas (commonly referred to as “time rules”). Before deciding which formula to use, a court may first want to determine why the options were granted to the employee (e.g., as an incentive to stay, to attract the employee to the job, or so forth).

Two of the main time rule formulas used are the Hug¹ formula and the Nelson² formula.

The Hug formula is used in cases where the options were primarily intended to reward past services, and to attract the employee to the job. The formula used in Hug is:

DOH – DOS
-----------------   x Number of shares exercisable = Community Property Shares
DOH - DOE

(DOH = Date of Hire; DOS = Date of Separation; DOE = Date of Excercisablity)

The Nelson formula is used where the options were primarily intended more as compensation for future performance, and as an incentive to stay with the company. The formula used in Nelson is:

DOG – DOS
-----------------   x Number of shares exercisable = Community Property Shares
DOG - DOE

(DOG = Date of Grant; DOS = Date of Separation; DOE = Date of Excercisability)

There are several other time rule formulas for other types of options, and the courts have wide discretion in deciding which formula (if any) to use, and how to equitably divide the pie.

Generally speaking though, the longer the time between the date of separation and the date the options vest, the smaller the overall percentage of options that will be considered community property. For example, if a specific number of options vested one month after separation, then a significant portion of those shares would be considered community property subject to equal division (50/50); however, if the options vested several years after the date of separation, then a much smaller percentage would be considered community property.

After application of either time rule, the parties could then agree that the employee spouse would retain the agreed-upon number of shares in trust for the other person. When the shares vest and if they can be sold, the non-employee spouse could then request that her portion of the shares be sold on her behalf.

Conclusion

Before a party agrees to give up rights in the other person’s stock options, he or she may want to consider applying a time rule formula to such options, even though they may not presently be worth anything. Should the shares later become valuable due to an acquisition or other circumstances, the non-employee spouse could still retain an interest in such shares and the potential profits.

Endnotes

1. Marriage of Hug (1984) 154 Cal. App. 3d 780.
2. Marriage of Nelson (1986) 177 Cal. App. 3d 150.