Startups in the Whirlpool of Divorce

Abstract

Startups use stock options to compensate their employees. The divorce of the employee could result in a change in the formal ownership of the startup securities. However, the startup, the employee, and the former spouse of the employee all have considerable and conflicting interests in the outcome of the allocation of the employee's securities as part of the divorce settlement. I argue that the startup, along with the relevant tax rules, impose obstacles on the transferability of the securities to the former spouse of the employee that are likely to distort the settlement outcome. An inefficient outcome is likely, as the person who may assign a higher value to owning the securities is both barred from owning them and prevented from receiving equivalent value in exchange. Amending the tax code would allow for more outcomes and could enable the parties to reach a more efficient result. However, corporate law's attempt to protect the shareholders' rights and scrutinize contractual arrangements such as voting agreements and appraisal waivers could have an unintended consequence of ex ante depriving the former spouse of any equity rights following the divorce, since the startup is likely to continue and attempt to prevent possible complications to future corporate transactions also when the tax pretext is lifted.

Keywords: startups, equity compensation, divorce, ISO, stock options, stakeholders, venture capital

JEL Classification: G24, G32, H25, J12, K22, M13, M52