Stock Compensation Classification & Valuation

classification of stocksDividing stock compensation during the divorce process is one of the most complex issues clients face and it is important divorcing parties seek the proper advice and expertise.   Within this article the term “stock options” and “stock compensation” are interchangeable and describe company benefit plans that award employees through stock compensation over a length of time called the “vesting schedule”.

Court Experience with Stock Compensation is Limited

Not until the early 1980s did courts begin to consider stock options assets of the marital estate subject to division.  Because of the newness of stock compensation plans and the courts’ delayed consideration of them, there are limited guidelines on how to approach these plans when dividing the marital assets.

The complexity of these company plans and the number of different rulings make it very difficult for many attorneys to correctly advise their clients of general apportionment of these plans and at times these compensation plans are improperly treated as commonplace stock accounts or are even neglected entirely in the marriage dissolution.

Courts must determine two things before they can distribute the stock options between the parties.  First, the court must classify the nature of the stock options and whether it is marital property subject to the division of assets in the divorce.  Secondly, and often most complex, the court must determine how to value the stock option.

Classification:

Before the parties can discuss the division of the options, the court must determine whether the stock options are marital property.  In California and other community property states, marital property includes any assets acquired by either spouse after the marriage.

At issue in much of this analysis is the vesting schedule associated with stock compensation.  While the stock was awarded during the marriage, the date of its vest may not happen until after the separation.  The question becomes, for the unvested shares granted during the marriage, what portion is marital property and what portion separate property.   It is important to note, that terms used to describe the stock options (vested, unvested, restricted, etc.) are solely marketplace terms and not definitive in the courts’ classification of the property.

Stock options vested during the marriage are generally considered a marital asset.  However, for unvested options, no prevailing trend exists among the majority of the courts making it very difficult for divorcing parties to evaluate the potential financial outcome of the asset’s division.

Valuation:

Like classification, there is no uniformity in valuation of stock options and the methods applied can be complex.  These complexities and the substantial discretion family law judges have in structuring divorce decrees makes the financial outcome of stock compensation division even more uncertain.   Typically, the value of the vested options are addressed in the marriage divorce decree, and sometimes judges consider the value of unvested options that were granted during the marriage.

Courts have applied two common formulas to determine, if any, the marital value of the unvested stock options.  The intrinsic value rule and the Black-Scholes formula. Neither method has dominated the divorce landscape.

The intrinsic value, a straightforward analysis, is the current market price of the stock minus the exercise price and multiplied by the number of shares of stock in the options.  For example, the intrinsic value of 20,000 shares of a stock with a fair market value of $25 and an exercise price of $15 would be calculated as such: ($25 market price – $15 exercise price) x 20,000 options = $200,000.

The Black-Scholes method, one of the most complicated formulas courts deal with, attempts to determine the present value of the option considering numerous factors including: the exercise price, the current stock price, the dividend yields for particular stocks, the option term, the market value of the underlying security, the current risk-free rate of return, and the underlying volatility.  This method usually requires hiring an expert.

Summary

There is no bright line rule for either classification or valuation of stock option plans.  Additionally, the plans themselves and their valuation can be complex.  Consequently, it is vital for divorcing clients with stock compensation to seek experts who can concisely explain to the court what rules should apply and why.

By Jenny Erdmann

 

 

 

 

 

 

 

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