Dividing Stock Options During Divorce in California

Some assets are easy to divide in a divorce - selling a car and dividing the profits is usually a no-brainer. Dividing stock options, however, can present a unique set of challenges. Stock options that can't be sold to a third party or don't have any real value (for example, stock options in a private company or unvested options) can be difficult to value and divide.

However, California courts have determined several ways to deal with the division of stock options in divorce.

A Common Stock Option Hypothetical

Here's a typical Silicon Valley scenario: One spouse lands a great job working for a start-up company, and as part of the compensation package, receives stock options subject to a four-year vesting schedule. The couple is unsure whether the start-up will continue as is, be acquired, or fold up like many other companies in the Valley.

The couple later decides to divorce, and during a discussion about the division of assets, the stock options come up. They want to figure out what to do with the options, but the rules are unclear. First, they will need to understand some of the foundations of marital property rights in California.

Community property

Under California law, there is a presumption that any assets - including stock options - 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 is divided equally between the spouses (a 50/50 split) in a divorce.

Separate Property

Separate property is not part of the martial estate, which means the spouse that owns the separate property, owns it separately from their spouse (not jointly) and gets to keep it after the divorce. Separate property is not subject to division in a divorce. In California, separate property includes all property that is acquired by either spouse:

• before the marriage
• by gift or inheritance, or
• after the date of separation (see below).

So, generally speaking, any stock options granted to the employee spouse before the couple married or after the couple separated are considered the employee spouse's separate property, and not subject to division in the divorce.

Date of separation

The "date of separation" is a very important date, because it establishes separate property rights. The date of separation is the date that one spouse subjectively decided that the marriage was over and then objectively did something to implement that decision, such as moving out.

Many divorcing couples argue over the exact date of separation, because it may have a major impact on which assets are considered community property (and thus subject to equal division) or separate property. For example, stock options received before the date of separation are considered community property and subject to equal division, but any options or other property received after that date are considered the separate property of the spouse that receives them.

Coming back to the hypothetical above, let's assume that there is no argument over the date of separation. However, the couple discovers that some of the options "vested" during the marriage and before the date of separation. They now have to determine how this might impact the division.

Vested Versus Unvested Options

Once employee stock options "vest," employees can "exercise" their options to buy shares in the company at a "strike" price, which is the fixed price that's typically stated in the original grant or stock option agreement between the employer and the employee.

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 don't any value because:

• employees have no control over these options, and
• unvested options are relinquished when an employee leaves the company – they can't take these options with them.

However, the courts in California disagree with this view, and have held that even though unvested options may not have a present fair market value, they are subject to division in a divorce.

Dividing the Options

So how does the court determine what portion of the options belong to the non-employee spouse? Generally, courts use one of several formulas (commonly referred to as "time rules").

Two of the main time rule formulas used are the Hug¹ formula and the Nelson² formula. Before deciding which formula to use, a court may first want to determine why the options were granted to the employee (e.g., in order to attract the employee to the job, as a reward for past performance, or as an incentive to continue working for the company) as this will impact which rule is more appropriate.

The Hug formula

The Hug formula is used in cases where the options were primarily intended to attract the employee to the job and reward past services. 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 "Exercisability" or vesting)

The Nelson Formula

The Nelson formula is used where the options were primarily intended 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 Exercisability)

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 divide the options.

Generally speaking, 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.

Distributing the options (or their value)

After application of either time rule, the couple will know how many options each are entitled to. The next step then would be to figure out how to distribute the options, or their value.

Say for example, it's is determined that each spouse is entitled to 5000 stock options in the employee-spouse's company; there are several ways to make sure the non-employee spouse receives either the options themselves or the value of those 5000 stock options. Here are a few of the most common solutions:

• The non-employee spouse may give up the rights to the 5000 stock options in exchange for some other asset or cash (this will require an agreement between the spouses as to what the options are worth - for public companies, stock values are public and can form the basis of your agreement, but for private companies, this might be a little more difficult to determine - the company may have an internal valuation that can provide a good estimate).
• The company might agree to have the 5000 stock options transferred to the non-employee spouse's name.
• The employee spouse may continue to hold the non-employee spouse's share of the options (5000) in a constructive trust; when the shares vest and if they can be sold, the non-employee spouse would be notified and could then request his or her portion be exercised and then sold.

Conclusion

Before you agree to give up any rights in your spouse's stock options, you may want to consider applying a time rule formula to the options, even though they may not presently be worth anything. You may want to retain an interest in these shares and the potential profits; if the company goes public, and/or the shares become valuable due to an acquisition or other circumstances, you'll be glad you held on.

This area of family law can be quite complex. If you have questions about the division of stock options you should contact an experienced family law attorney for advice.

Resources and Endnotes

We've got a wealth of information in our section on California Property Division in Divorce. For related information, see California Divorce & Family Laws.

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