Marital Property Rights in Founder’s Stock

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A married california resident founds a company. Her spouse has a separate career and no active involvement in the business. Four years later, the company is growing and the founder’s stock is fully vested, but the marriage has faltered and the couple decides to divorce. What now?

California Law

States vary in how they treat marital property. In California, all earnings and property acquired during the marriage are considered “community property.” By default, each spouse has a right to 50% of all community property. Property owned before marriage or acquired by gift or inheritance during marriage is that spouse’s separate property. The purpose of the community property regime is to recognize the contributions of both spouses in the success and prosperity of the community as a whole.

Spousal Rights to the Stock

Since the founder formed the company during the marriage and presumably issued stock to herself around the same time, the stock is community property and the founder’s spouse has a 50% claim over it. Division of community property in California is not required to be division “in kind”--each physical object does not need to be divided. For example, one spouse might get the house and the other could get other assets of equal value to balance it out. Stocks, however, are likely to be split down the middle. It is feasible to do so, and because there are so many intangibles involved in the valuation of a start-up, it will likely be far more difficult to appraise the stock in order to balance it out with other assets.

So, it’s looking like the ex-spouse will get 50% of the founder’s stock. If the founder owned a majority of the company’s stock and had corresponding voting rights, losing 50% of her stock might mean losing control of the company.  The ex-spouse might even attempt to sell shares to a competitor, although the company will probably have a right of first refusal to purchase those shares before they get transferred to an outsider. Still, the company would have to be able to fork over cash to buy those shares back and the question of how much the shares are worth could become contentious.

Preventive Measures

There are ways to contract around the default California community property laws and make other arrangements to address marital property rights in founder’s stock.

1) Prenup

Before getting married, you can agree to treat certain types of property you obtain during marriage as separate property.

2) Postnup

After the wedding, but well before getting divorced, you can enter into an agreement similar to a prenup, but such agreements are more suspect and run a risk of not being enforced in court.

3) Buy-Sell Agreement

You may specify via contract what happens to a founder’s ownership of stock and enable the founder or the company to buy back any shares that get involuntarily transferred to an ex-spouse at an agreed-upon price. Or, you may choose to use other constraints, such as limiting the number of shares transferred and withholding voting rights. Such provisions could be included in a stock purchase agreement or shareholder agreement signed in conjunction with a spousal consent form.

4) Avoid commingling marital assets with non-marital assets.

For example, avoid withdrawing from your joint account or take out a second mortgage to buy business equipment.

5) Market-rate salary

If a founder is paid under market for the work they are putting in toward the company, the ex-spouse could later argue that he is entitled to more company assets because the family income was reduced to benefit the company or because the founder received equity as a replacement for a lower salary.