Startups in the Whirlpool of Divorce

Michigan Business & Entrepreneurial Law Review Michigan Business & Entrepreneurial Law Review

Volume 12 Issue 1

2023

Startups in the Whirlpool of Divorce Startups in the Whirlpool of Divorce

Mira Ganor

University of Texas School of Law

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Mira Ganor,

Startups in the Whirlpool of Divorce

, 12 MICH. BUS. & ENTREPRENEURIAL L. REV. 1 (2023).

Available at: https://repository.law.umich.edu/mbelr/vol12/iss1/2

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STARTUPS IN THE WHIRLPOOL OF

DIVORCE

Mira Ganor

BSTRACT

Startups use stock options to compensate their employees. An employee’s divorce 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 a divorce

settlement. I argue that the startup, along with the relevant tax rules, imposes obstacles

on the transferability of the securities to the employee’s former spouse that are likely to

distort the settlement outcome. An inefficient outcome is likely because 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. While amending the IRC would

allow for more outcomes and could enable the parties to reach a more efficient result,

corporate law’s attempt to protect the shareholders’ rights and scrutinize contractual ar-

rangements such as voting agreements and appraisal waivers could have an

ex-ante unintended consequence. Specifically, since the startup is likely to continue, it may

deprive the former spouse of any equity rights following the divorce and attempt to prevent

possible complications to future corporate transactions once the tax pretext is lifted.

Judge Solomon Casseb, Jr. Research Professor in Law, University of Texas School of

Law. I would like to thank Dhammika Dharmapala, Saul Levmore, and participants at the Law and

Economics Workshop at the University of Chicago Law School for very helpful comments and

discussions. Margaret Fulcher provided superb research assistance. I am thankful to the members of

the Michigan Business & Entrepreneurial Law Review for exceptional editorial work. Comments are

welcome and can be sent to me at [email protected].

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2 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

TABLE OF CONTENTS

NTRODUCTION ..................................................................................................... 2

I. THE STARTUP’S INTERESTS .................................................................... 7

A. The Ability to Restrict ..................................................................... 8

B. Motivating the Employee ................................................................ 9

C. Retaining the Employee ................................................................ 12

D. Shareholder Base — Size & Lawsuits .......................................... 15

E. The Employee’s Happiness and Productivity ............................... 22

II. T

HE EMPLOYEE’S INTERESTS ............................................................... 25

III. THE NON-EMPLOYEE SPOUSE’S INTERESTS ......................................... 27

A. Risk Level & Access to the Private Market .................................. 28

B. Value Uncertainty & Low Valuation Bias .................................... 34

C. Separation & Independence ......................................................... 36

IV. HIDING BEHIND THE INTERNAL REVENUE CODE – SUGGESTIONS

FOR REFORM ........................................................................................ 37

CONCLUSION ...................................................................................................... 43

INTRODUCTION

Ms. MacKenzie Scott, the former Mrs. Jeff Bezos, has been making headlines

for her exceptionally generous donations as well as for being one of the five

wealthiest women in the world.

Her wealth is largely comprised of shares of

Amazon.com, Inc. (Amazon), the company her former husband founded and built

while they were married. However, Ms. Scott received formal ownership of her

shares in Amazon only after her divorce from Mr. Bezos.

Amazon’s status as a

publicly traded company may well have facilitated the transfer of the shares to

Ms. Scott. Had Amazon still been a private company at the time of the divorce,

the result likely would have been different because while stock of a publicly

traded company is generally liquid and relatively easy to transfer, the transfera-

bility of equity in startups is usually restricted.

A startup employee’s divorce raises unique and complex questions related to

the common practice of granting equity compensation to startup employees

1. Laurel Wamsley, MacKenzie Scott Has Donated More than $4 Billion in Last 4 Months,

NPR (Dec. 16, 2020, 3:04 PM ET), https://www.npr.org/2020/12/16/947189767/mackenzie-scott-

has-donated-more-than-4-billion-in-last-4-months.

2. Jordan Valinsky, MacKenzie Bezos is Set to Become the World’s Fourth-Wealthiest

Woman, CNN

BUS., https://www.cnn.com/2019/04/05/business/mackenzie-bezos-wealth/index.html

(Apr. 5, 2019, 9:13 AM) (“She will be worth at least $35 billion after receiving a quarter of Bezos’

Amazon shares. . . . Jeff Bezos will retain voting control over all MacKenzie Bezos’ shares and will

also maintain all his interests in the Washington Post and Blue Origin, a private space company.”).

3. See 17 C.F.R. § 230.144 (2023); see also Rule 144: Selling Restricted and Control Secu-

rities, U.S.

SEC. & EXCH. COMM’N (Jan. 16, 2013), https://www.sec.gov/reportspubs/investor-publi-

cations/investorpubsrule144 (describing the limited transferability of restricted or controlled stock).

4. Jill Krasny, Here’s Why Jet.com Gives Every Employee Equity, I

NC. (July–Aug. 2016),

https://www.inc.com/magazine/201607/jill-krasny/sharing-equity-workers.html (“Equity arrangements

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Winter 2023] Startups in the Whirlpool of Divorce 3

while restricting transfers of such equity.

Given the increased incidence of

divorce during the Covid-19 pandemic,

this Article explores the rights of the

non-employee spouse to the startup equity received by the employee and exposes

various conflicting interests associated with the allocation of equity following a

startup employee’s divorce.

In addition to its impact on transferability, the distinction between a private

and public company has several effects on the rights to the assets involved in the

divorce. Hypothetically, had Ms. Scott received cash rather than stock of a pub-

licly traded company, she could have used the cash to purchase stock of Amazon

on the market, as the two are interchangeable.

While tax effects and price vola-

tility in reaction to large changes in demand and fluctuations in volume of trading

can make a difference,

for the most part, the exchange of cash for publicly traded

stock, or vice versa, can be achieved effortlessly. By contrast, the securities of a

private company cannot be easily acquired,

and restrictions on transfer and

investment make its stock unique and largely nonfungible. Consequently, the

are increasingly standard for startups. . . . 80 percent of job postings from U.S. startups involve some

equity.”).

5. See, e.g., Richard Harroch, How Employee Stock Options Work in Startup Companies,

ORBES, (Feb 27, 2016, 10:32 AM), https://www.forbes.com/sites/allbusiness/2016/02/27/how-em

ployee-stock-options-work-in-startup-companies/?sh=6a5984736633 (“Most Stock Option Agree-

ments provide that the option is nontransferable. The agreements also state that the stock purchased

by exercising the option may be subject to rights of purchase or rights of first refusal on any potential

transfers.”).

6. L.J. Williamson, Austin Husband and Wife Attorney Team Kirker Davis Responds to

Coronavirus Spike in Divorces, Adds Three New Attorneys, EIN

NEWS (June 26, 2020 11:00),

https://www.einnews.com/pr_news/520331732/austin-husband-and-wife-attorney-team-kirker-

davis-responds-to-coronavirus-spike-in-divorces-adds-three-new-attorneys (stating that a family law

firm in Austin added associates, rather than scaling back, during the pandemic, as “[t]he upward trend

in divorce filings during the pandemic is, unfortunately, anything but a myth…”).

7. Amazon has traded on Nasdaq since May 1997. See, e.g., Investor Relations: FAQs,

MAZON, https://ir.aboutamazon.com/faqs/ (last visited Apr. 18, 2022) (stating that Amazon went

public in 1997 and is traded on Nasdaq).

8. See, for example, Tesla’s downward stock price reaction to Elon Musk’s proposal to sell

stock despite apparent attempts to distance the sale from fundamentals of the business but rather at-

tribute it to tax requirements and the results of a Twitter poll. Walé Azeez, Tesla Shares Slide After

Elon Musk Asks Twitter if He Should Sell, CNN

BUS. (Nov. 8, 2021, 11:44 AM), https://www.

cnn.com/2021/11/08/investing/tesla-stock-elon-musk-twitter-poll/index.html; cf. Mira Ganor,

Manipulative Behavior in Auction IPOs, 6 D

EPAUL BUS. & COM. L.J. 1, 10–12 (2007) (analyzing the

special connection between Google’s IPO and volume of trading).

9. See Stephen Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 C

AL.

L. REV. 279, 281 (2000) (“[I]nvestors are unable to purchase securities of companies choosing not to

engage in a public offering unless the investors qualify to participate in a far more restrictive

private placement of securities.”); Eric Reed, Should You Invest in Private Companies?, Y

AHOO

IN. (June 4, 2022), https://finance.yahoo.com/news/invest-private-companies-120000956.html

(“An individual investor cannot invest in private companies directly because they are restricted to

accredited and institutional investors.”).

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4 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

ownership of securities in a private company is generally limited to employees,

service providers, and accredited investors.

To be sure, when a couple divorces, the spouse does not automatically receive

part of the equity the employee owned during the marriage. Instead, the court will

first determine whether the spouse has an interest in the equity following the di-

vorce.

In community property states such as California (where the majority of

startups are located),

if the startup granted the equity to the employee during the

marriage, then the equity belongs to the employee and the spouse equally.

Alternatively, the separate property doctrine is applied in other states. Under sep-

arate property doctrine, the court will distribute the assets equitably between the

former spouses.

If the spouse has an interest in the startup equity following the divorce, the

next step is determining whether the spouse should receive equity in kind or

assets of equivalent value, such as cash or other property, or a combination

thereof. For example, in the famous divorce of billionaire oilman Harold Hamm,

10. See, e.g., infra notes 151 & 152. In some cases, former employees may retain the shares

as well as surviving heirs of deceased stockholders. In other cases, the private company can exercise

a right of first refusal that allows the company to buy back the shares upon a triggering event such as

the death of the shareholder or the termination of employment. See, e.g., S

TOCK OPTION AGREEMENT

FORM, infra note 20 at Exhibit A. For more exceptions, such as crowdfunding, see infra Part IV.

11. See Marital Property, L

EGAL INFO. INST. CORNELL L. SCH. (Mar. 2022), https://www.

law.cornell.edu/wex/marital_property (“In a divorce case, the court divides all property owned by

spouses into two categories according to its state law: 1) marital property owned between spouses,

and 2) separate property of each spouse.”).

12. Matthew Winkler et al., 50 States, 50 Startups, B

LOOMBERG (Sept. 2, 2022), https://www.

bloomberg.com/features/2022-opinion-50-states-50-startups/ (“California has more startups than any

other state, counting more than 4 million small businesses in 2021.”).

13. Community Property, LEGAL INFO. INST. CORNELL L. SCH. (July 2022), https://www.law.

cornell.edu/wex/community_property (“Community property refers to assets acquired during a mar-

riage by either spouse. These assets can include property, income and even debt. Not all states recog-

nize community property. In a ‘community property’ state (such as California), any income, real

estate, or other property acquired by either spouse during the marriage belongs to both spouses. Under

community property laws, both spouses own everything equally, regardless of who purchased it or

earned the income. This is often contrasted with ‘separate property’ states.”).

14. See Tanza Loudenback, In Nine US States, a Divorce Could Mean Losing Half of Every-

thing You Own, BUS. INSIDER (Jan. 21, 2020, 9:05 AM), https://www.businessinsider.com/personal-

finance/which-states-are-community-property-states-in-divorce (“If you live in a state that doesn’t

observe community property law and you and your spouse can’t agree on how to divide your marital

assets, then it’s subject to equitable distribution. This means everything (except for gifts or inher-

itances) is divided ‘fairly’ at a judge’s discretion, considering each person’s earning potential or

income, financial needs, and personal assets.”). In some states, even if the equity was granted to the

employee before the marriage, where the value of the equity increased during the marriage because

of the work of the employee during the marriage, then the non-employee spouse has potentially a

claim to part of the equity. See, e.g., Joshua Schneyer, The $1 Billion Divorce: Why Harold Hamm’s

Ex-Wife Didn’t Win More, REUTERS (Nov. 16, 2014, 8:30 AM), https://www.reuters.com/article/us-

hamm-divorce-ruling-insight/the-1-billion-divorce-why-harold-hamms-ex-wife-didnt-win-more-

idUSKCN0J00J020141116 (describing the case of the divorce of billionaire and oil investor Harold

Hamm, which involved assets that were obtained before the marriage and increased in value during

the marriage).

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Winter 2023] Startups in the Whirlpool of Divorce 5

Mr. Hamm wrote a nearly one-billion-dollar check to his former spouse.

contrast, Mr. Bezos transferred some of his Amazon shares to his former spouse.

Both Continental Resources, Inc.

and Amazon were publicly traded on either

the New York Stock Exchange

or Nasdaq

at the time of the divorces.

Conversely, spouses of startup employees are largely deprived of ownership

rights upon the divorce despite having been part of a household that had owner-

ship of the private equity prior to the divorce.

As previously mentioned, startup

equity is largely non-transferable, and startups usually ban former spouses from

owning stock options in the company.

As a result, the divorce severs the former

spouse’s ownership rights.

Thus, the Article identifies the unique situation of a person who, through the

former spouse’s employment, had an interest in the startup equity despite not

having personally been an accredited investor or a startup employee. Yet, this

person was deprived of her interest after a divorce, notwithstanding her past sac-

rifice and reliance on the interest in the startup. This Article argues that the startup

compensation stock option plan serves as a type of postnuptial agreement that

disadvantages the employee’s spouse by restricting and barring the transfer of

equity compensation to her upon the divorce. This Article questions the contrac-

tual and legal restrictions on the former spouse’s ability to directly own the

startup’s securities. After all, her former spouse owned and acquired them as an

employee of the startup during their marriage.

Conflicts of interest between the employee, the former spouse, and the startup

are similarly examined and considered. In addition to the perspective of each

divorcing spouse, the startup’s perspective is particularly interesting. First, the

startup has obvious bias from its association with the employee. Thus, the spouse,

who is not an employee, finds herself on the opposite side of the startup when

trying to directly claim ownership of the equity as well as when trying to receive

15. Rebecca Ungarino, The Last Time a Billionaire CEO Got Divorced Without a Prenup He

Hand Wrote a Check for $974,790,317.77, B

US. INSIDER (Jan. 10, 2019, 1:05 PM), https://www.in-

sider.com/jeff-bezos-divorce-comparison-to-harold-hamm-2019-1.

16. Valinsky, supra note 2.

17. Mr. Hamm is the founder of Continental Resources, Inc. Schneyer, supra note 14.

18. In November 2022, Mr. Hamm took Continental Resources, Inc. private. Andrea Murphy,

America’s Largest Private Companies 2022: Twitter and Continental Resources Join the Ranks,

FORBES (Dec. 1, 2022, 9:45 AM), https://www.forbes.com/sites/andreamurphy/2022/12/01/americas-

largest-private-companies-2022-twitter-and-continental-resources-join-the-ranks/?sh=3208ace934c7

(“Continental Resources was delisted from the New York Stock Exchange on November 22, 2022.”).

19. Amazon.com, Inc. Common Stock (AMZN), NASDAQ, https://www.nasdaq.com/market-ac-

tivity/stocks/amzn (last visited May 4, 2023).

20. See, e.g., O

PTION AGREEMENT, ORRICK: STOCK PLAN TOOLKIT (July 2022),

https://www.orrick.com/Total-Access/Tool-Kit/Start-Up-Forms/Equity-Compensation/Option%

20Agreement (“This Option may not be transferred in any manner otherwise than by will or by the

laws of descent or distribution and may be exercised during the lifetime of Optionee only by him or

her.”) [hereinafter S

TOCK OPTION AGREEMENT FORM].

21. Id.

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6 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

equivalent value in its stead. These conflicting interests also complicate the out-

come of the divorce.

Aside from its bias for its employee, the startup has various independent

interests in the outcome. Some of these interests motivate and explain bans on

transfers of options to the employee’s spouse.

For example, the startup has an

interest in protecting its fundraising and sale prospects, which is made easier by

excluding spouses from the shareholder base.

Recent developments in Delaware law that have weakened or even eliminated

the protective power of contractual mechanisms designed to protect companies

from individual stockholders likely exacerbate the issue.

For example, special

arrangements that prevent the use of appraisal and voting rights to obstruct an

acquisition transaction (such as a spouse entering into an irrevocable voting rights

agreement) may not be enforced, may expose the officers of the startup to breach

of fiduciary duty claims, and/or may subject a potential acquirer to litigation.

As a result of these developments, startups are likely to be more inclined to keep

spouses out of their capitalization table. Thus, while these developments seem to

strengthen stockholder protections, they may also unintentionally harm a special

type of stakeholder whose interest in the corporation derives from the potential

of becoming a stockholder—former spouses.

Thus, from the startup’s point of view, there are legitimate reasons to protect

the business and insulate it from future friction by preventing ownership rights

from falling into the hands of potentially disgruntled and irrational shareholders

and those whose interests are misaligned with the interests of the majority share-

holders. This Article shows that the startup is both interested in restricting the

transfer of the securities to the non-employee spouse and in keeping the valuation

of its common stock, the security it uses to compensate its employees, low. These

dual interests are likely to have a significant adverse effect on the spouse.

Special tax requirements of the Internal Revenue Code have been an easy

justification for equity transfer restrictions. While tax law does not ban the trans-

fer of equity to the former spouse upon divorce, it does disqualify options from

the special tax status when they are transferred to the spouse.

Thus, this Article

argues that the IRC is potentially distorting the distribution of equity between the

divorcing couple by treating the tax liability of the spouse and that of the

employee differently when they own the same option.

22. I acknowledge couples of various gender identities. In this paper, I assume that only one

spouse is working for a VC-backed startup; and for clarity, I assume that the non-employee spouse is

identifying as a woman and the employee spouse is identifying as a man. Given the gender gap in the

Silicon Valley, this assumption is realistic, though not inclusive. I generally refer to the spouse who

is employed by the startup as the “employee” and the spouse who is not employed by the startup as

the “spouse.”

23. In re Pattern Energy Grp. Inc. S’holders Litig., No. 2020-0357-MTZ, 2021 WL 1812674,

at *62 (Del. Ch. May 6, 2021); see infra notes 67–69 and accompanying text.

24. Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199, 1215 (Del. 2021).

25. See infra note 183.

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Winter 2023] Startups in the Whirlpool of Divorce 7

The tax rules and policies afford three alternatives to a spouse who wants to

maintain equity rights following the divorce, all of which are potentially costly.

The spouse may (a) prolong the relationship with the employee through an IRS-

approved fiction where the spouse becomes the beneficial owner of the equity

while the employee remains the formal owner of record,

(b) forgo the option

value of the equity and instead invest money in the startup in order to exercise

options, the underlying stock of which will be owned directly by the spouse,

by opting to receive a type of transferable option. This last alternative is particu-

larly problematic because, when the employee’s work at the startup is terminated,

the spouse will be required to either let her rights expire or pay the exercise price

and immediately recognize income.

The remainder of the Article proceeds as follows. Part II analyzes the

startup’s interests in restricting the transferability of the employee’s securities,

focusing on the effects a transfer of the securities to the spouse will have on the

employee’s ongoing relationship to the startup. It also considers the startup’s bias

for its employee. Part II further analyzes what effects a spouse’s ownership of the

startup’s equity has on the startup that result from the change in the size of the

shareholder base and composition thereof. Part III focuses on the employee’s spe-

cial perspective, including their potential close attachment to the startup and its

equity. Part IV looks at what effects restricting the transfer of startup equity has

on the spouse, detailing the legal obstacles faced by a spouse who tries to replicate

the investment interest in the startup that she is denied following the divorce. Part

V reviews the relevant tax rules and their contribution to the transferability

restrictions, questioning the necessity of the current rules and suggesting reforms

to the IRC so it will not serve as a pretext for restricting the spouse’s access to

startup equity following the divorce. The last section concludes.

THE STARTUP’S INTERESTS

This part focuses on the startup’s perspective. To be sure, each person in the

divorcing couple is clearly and directly affected by the dissolution of the union

and the related division of assets, including the equity rights in the startup. Each

of their perspectives is considered in the following sections. Yet, the divorce, and

especially the allocation of its equity following the divorce, is likely to affect the

startup as well. Thus, understanding the startup’s interests in the divorce’s out-

come is key to understanding the restrictions startups impose on the transfer of

its equity. This part evaluates four main concerns of the startup: (1) motivating

employees, (2) employee retention, (3) the composition and size of the share-

holder base, and (4) the employee’s happiness and productivity. The section

begins with a short discussion on the startup’s ability to restrict equity transfers.

26. See infra note 187.

27. See infra notes 201 and accompanying text.

28. See infra notes 172, 185, & 201-204.

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8 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

A. The Ability to Restrict

It is important to discuss the contours of the startup’s ability to restrict the

transfer of its securities. Venture-backed startups in the United States are com-

monly formed as corporations,

allowing shareholders to enjoy limited liability.

While shareholders qua shareholders are not entitled to bind the business, they

are also not personally liable for the debts of the corporation or its other share-

holders. State corporate law nonetheless accommodates the potential need of a

company to restrict the transfer of its securities. For example, both the Delaware

General Corporation Law (“DGCL”)

and the Model Business Corporation Act

(“MBCA”) expressly allow a corporation to restrict the transfer of its securities.

Both codes also include catch-all provisions related to equity transfer restrictions.

The DGCL allows any “lawful restriction” on transfer

while the MBCA allows

transfer restrictions for any “reasonable purpose.”

Additionally, both statutes

expressly provide that restrictions intended to maintain a legal or statutory

advantage for the corporation are presumptively reasonable.

Examples of such

advantages include, inter alia, maintaining the corporation’s status as a non-

reporting entity, maintaining its exemption from disclosure requirements under

the Exchange Act and SEC regulations,

and maintaining its qualification as a

Real Estate Investment Trusts (“REIT”).

29. See generally, e.g., Victor Fleischer, The Rational Exuberance of Structuring Venture

Capital Start-ups, 57 T

AX L. REV. 137 (2003) (explaining the rationality of choosing the corporate

form for VC-backed startups); cf. Calvin Johnson, Why Do Venture Capital Funds Burn Research

and Development Deductions?, 29 V

A. TAX REV. 29 (2009) (arguing against the use of C-corpora-

tions for VC-backed startups).

30. Most US venture-backed startups incorporate under Delaware law. Cf., e.g.,

Jaspreet Mann, Where to Incorporate Your Business: California or Delaware?, DLA

IPER, https://www.dlapiperaccelerate.com/knowledge/2017/where-to-incorporate-your-business-

california-or-delaware.html (last visited May 17, 2022) (“Founders of investor-funded emerging

companies should know that the investors prefer Delaware by a long shot.”).

31. D

EL. CODE ANN. tit. 8 § 202 (2022); MODEL BUS. CORP. ACT § 6.27 (AM. BAR ASS’N 2016).

32. D

EL. CODE ANN. tit. 8 § 202(e) (2022).

33. M

ODEL BUS. CORP. ACT § 6.27(c)(3) (AM. BAR ASS’N 2016).

34. D

EL. CODE ANN. tit. 8 § 202(d) (2022); MODEL BUS. CORP. ACT §6.27(c)(1)-(2) (AM. BAR

ASS’N 2016).

35. 17 C.F.R. § 240.12g-1 (2023).

36. Updated Investor Bulletin: Real Estate Investment Trusts (REITs), INVESTOR.GOV

(Dec. 9, 2011), https://www.investor.gov/introduction-investing/general-resources/news-alerts/

alerts-bulletins/investor-bulletins/real (“A REIT is a company that owns and typically operates in-

come-producing real estate or related assets.”). To qualify as a REIT, the Internal Revenue Code

requires, among other things, that not more than half of the company’s stock be owned by only five,

or fewer, individuals, which might be violated if shares could be freely transferred. I.R.C. §§

856(h)(1)(A), 542(a)(2) (“At any time during the last half of the taxable year more than 50 percent in

value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals.”).

Another IRC requirement relates to ISO plans. For discussion on ISOs and the associated requirement,

see infra Section IV.

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Winter 2023] Startups in the Whirlpool of Divorce 9

B. Motivating the Employee

A better understanding of the startup’s perspective requires considering why

the startup grants equity to employees in the first place. Startups, as well as mature

companies, use equity compensation to incentivize the employee to enhance the

value of the business, thus aligning the interests of the employee with those of

the shareholders.

Since the employee owns a stake in the company, the reasoning

goes, he will work harder to increase the value of his stake in the company. In

addition, equity compensation incentivizes the employee to stay with the company

at least until he can unlock the value of the equity compensation. To that end,

vesting schedules discourage employees from leaving the company immediately

after receiving equity compensation

since they vest full ownership in the equity

over time unless the employment relationship is terminated.

While equity compensation has been used to retain employees and motivate

them, it has also been used as a substitute for higher salaries and other related

employment benefits, such as pension plans, especially where cash is limited.

However, after the technology bubble burst, companies were pressured to raise

their employees’ salaries because the value of equity compensation had dramati-

cally declined such that it was no longer seen as a comparable substitute.

How-

ever, the level of equity compensation has nonetheless remained high even though

it no longer serves as a substitute for higher salaries, because it continues to incen-

tivize performance and align the employee’s interests with those of the startup.

37. See Employee Stock Option Plans, U.S. SEC. & EXCH. COMM’N (Oct. 23, 2014),

https://www.sec.gov/fast-answers/answers-empopt (“Many companies use employee stock options

plans to compensate, retain, and attract employees.”); see also Krasny, supra note 4 (“That equity

‘creates a team sport,’ says co-founder Seth Sternberg, ‘where everyone’s contribution directly helps

them.’ Dennis J. White, a Boston-based partner in the law firm Verrill Dana, says equity also can

‘provide some compensation to employees’ when you’re short on cash. ‘It’s also a retention tool—no

one wants to leave and give up the upside’ of stock.”).

38. See Jeremy Bulow & John B. Shoven, Accounting for Stock Options, 19 J.

ECON. PERSPS.

115, 116 (2005) (“If the worker leaves the firm before his or her options have vested, then the options

are forfeited . . . . [S]imilar retention incentives could be achieved with restricted stock grants (grants

of stock with vesting occurring over time).”).

39. The typical vesting schedule is four years from grant, with a one-year cliff followed by

monthly vesting. Jeff Bussgang, Stock Vesting: Why Is Four the Magic Number?, V

ENTUREBEAT

(June 2, 2010, 6:00 AM), https://venturebeat.com/2010/06/02/stock-vesting-why-is-four-the-magic-

number/.

40. See, e.g., J

OSEPH BLASI ET AL., IN THE COMPANY OF OWNERS: THE TRUTH ABOUT STOCK

OPTIONS (AND WHY EVERY EMPLOYEE SHOULD HAVE THEM) 108 (2003) (“[S]ome high-tech

companies—like Amazon, for instance—consistently underpaid their employees in the early years . . .

substituting options for a part of the normal market wage.”).

41. Cf. id. at 114 (quoting CEO Steve Ballmer’s memo to Microsoft employees from Dec.

2002) (“Stock options remain a great long-term opportunity for employees to share in the success of

the company. That remains important, but reality has set in . . . we will review all employees . . . for

consideration of a base salary increase.”).

42. Id.; see also Oracle Corp. v. Falotti, 187 F. Supp. 2d 1184, 1200 (N.D. Cal. 2001), aff’d,

319 F.3d 1106 (9th Cir. 2003) (“Oracle’s stock-option plan stated that its purpose was . . . to provide

an incentive to eligible employees, officers, independent consultants, directors who are also employ-

ees or consultants, and advisers whose present and potential contributions are important to the

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10 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

However, transferring the equity to a spouse upon divorce severs the incen-

tive since the employee no longer owns the equity. This result is particularly pro-

nounced with equity that has not yet vested because it was supposed to create a

continued incentive to the original recipient of the equity. If the spouse is not also

employed by the startup, the startup does not gain from the spouse’s ownership.

Instead, the startup gains a shareholder who—unlike an employee, a service

provider, or a venture capitalist—has shareholder rights without adding any value

to the startup.

One mitigating factor in the reduced effectiveness of incentive compensation

after its transfer to a former spouse incident to a divorce is that continued perfor-

mance may reduce the employee’s future obligations to the spouse and the cou-

ple’s children.

Indeed, the wealth of a parent, and not just the income, affects

the amount of child support.

Thus, to the extent that the value of the spouse’s

property affects the obligations of the employee, at least some of the incentive is

maintained.

Giving an employee a cash bonus also incentivizes the employee to work

harder for the company. The gratitude, the feeling of being appreciated, and the

hope of gaining another bonus all incentivize the employee to work harder for the

employer. For the same reasons, the employee’s equity compensation will con-

tinue to incentivize him to work harder for the company even after he transfers

some of the equity compensation to his former spouse. To be sure, the actual

ownership of the equity, especially with a vesting schedule, binds the employee

even more to the company than a cash bonus as the employee benefits directly

from the increase in the value of the company which increases the value of his

equity directly.

While splitting the equity with the former spouse leaves the employee with

fewer equity rights in the company (thus weakening his incentive to increase the

value of the startup), the employee’s remaining equity interests nonetheless con-

tinue to align his interests with those of the employer because the decline in the

value of his equity was not caused by the startup’s poor performance or a dilutive

continued success of the Company . . . and to enable the Company to continue to enlist and retain in

its employ the best available talent.”); see Chris Bryant, Tech Shares Are Crashing, So Kiss Your

Bonus Goodbye, B

LOOMBERG (May 10, 2022, 1:00 AM), https://www.bloomberg.com/opinion/arti-

cles/2022-05-10/tech-shares-are-crashing-so-kiss-goodbye-to-your-bonus (analyzing current pres-

sures and tradeoffs between salaries and equity-based compensation amid fluctuations in share prices

of publicly traded technology companies).

43. To be sure, the increase in wealth of the spouse may well increase the welfare of the shared

children and thus could benefit the employee.

44. Courts have considered the ownership of options in the calculation of child support. See,

e.g., In re Marriage of Cheriton, 92 Cal. App. 4th 269, 290 (2001) (“By statute, parents are required

to provide child support according to their ‘ability,’ their ‘circumstances and station in life,’ and their

‘standard of living.’ . . . It is fair to assume that in most cases assets contribute to the ability to provide

support. . . . [F]or purposes of spousal support, considerations include the ‘ability to pay of the sup-

porting party, taking into account the supporting party’s earning capacity, earned and unearned

income, assets, and standard of living.’” (emphasis removed)).

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Winter 2023] Startups in the Whirlpool of Divorce 11

event, such as a large issuance of shares to other employees.

In fact, following

the transfer, the employee could be motivated to work even harder in order to

increase the value of his now smaller stake and make up for the lost portion.

It is possible that animosity or the desire to see the former spouse suffer a

loss might mitigate the perceived cost to the employee of a decline in the

startup’s value. After all, such a decline hurts the former spouse as well. Thus,

the employee’s incentive may be weaker following the divorce. However, if the

employee acts rationally he should attempt to recover the value of the lost prop-

erty by working even harder to increase the startup’s value.

Another example that demonstrates the weakness of the employee incentives

argument in support of restrictions on equity transfers to the spouse can be found

in the recent venture capital (VC) trend that allows employees and founders to

sell some of their equity in the startup, sometimes even significant portions of

their shareholdings, in a round of investing.

This liquidity venue allows

employees to enjoy the benefits of their investment without needing to wait for a

traditional exit that will happen only after a number of years. The relative avail-

ability of capital and the resulting market, in which investors compete for invest-

ments, has allowed the startup to offer some liquidity to employees. In the past,

such liquidity was unthinkable since the startup could not spare the cash. This

trend shows that the employees who participate in these secondary sales are still

motivated enough to continue to work for the company even with fewer shares.

If securities are transferred to a former spouse as part of the divorce agreement,

the employee who will end up owning fewer securities is still likely to be moti-

vated as the motivational effect is not totally rational or quantifiable. To be sure,

more (rather than fewer) securities have an increased motivational effect, but the

optimal number of securities needed to motivate the employee is not easily ascer-

tainable. The size of the equity grant to employees is not calculated in a purely

45. If the employee participates pro rata in the issuance, and maintained his percentage hold-

ing, he is not diluted (if, for example, the employee exercises his or her preemptive rights).

46. E.g., Seth Fiegerman, Uber Sells 15% Stake to SoftBank, CNN

BUS. (Dec. 28, 2017, 6:31

PM ET), https://money.cnn.com/2017/12/28/technology/uber-softbank-investment/index.html

(“The vast majority of that investment comes from SoftBank buying up shares held by existing Uber

shareholders, including employees and earlier investors.”); Tips for Startup Founders Considering

Secondary Stock Sales, S

ILICON VALLEY BANK (Aug. 19, 2019), https://www.svb.com/blogs/svb-pri-

vate-bank/secondary-liquidity-startup-founders (“There has been a sharp increase in the number of

founders who choose to access liquidity by selling some of their shares early on. . . . secondary trans-

actions are done in conjunction with raising a round of financing, and it is a good opportunity to give

liquidity to family & friends that invested early on or seed stage investors to reduce the number of

shareholders on the books or allow early employees to gain liquidity alongside the founders.”).

47. See Michael Szalontay, The Rise of Secondaries in Tech, FORBES (Sept. 16, 2021,

7:30 AM), https://www.forbes.com/sites/forbesfinancecouncil/2021/09/16/the-rise-of-secondaries-

in-tech/?sh=20e7a7f5f5e5 (“In the past two decades, the median times to exit have trended upward

across the industry reaching an average of over six years from Series A to an eventual exit from 2011-

2020. . . . Traditional VC funds do not like the notion of secondaries. They believe that until a venture

has become really successful and is generating profits, all potential cash earmarked for the business

should go toward scaling the business further . . . . However, times are changing. As managers have

larger funds and more money to put into play, secondaries are also becoming more fashionable . . . .”).

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12 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

scientific process nor do employees react in a completely rational or even edu-

cated manner about their equity holdings. In fact, misperception of the true value

of options is common even by those who are more financially sophisticated than

the average startup employee.

In addition, with the proliferation of secondaries,

it is also more likely that the former spouse might liquidate her equity before an

acquisition of the startup, which will lower the risk of friction if the ultimate exit

is not sufficiently favorable to the common shareholders.

C. Retaining the Employee

The transfer of equity from the employee to the spouse can affect the

employee’s future with the startup. For example, a new employer will usually

offer the employee equity in its business as a hiring bonus that will compensate

him for the equity he will lose in his previous employer.

As a result, any equity

in the startup that hasn’t yet vested at the time of termination will revert back to

the original employer. Similarly, if the spouse received any of the unvested

equity, she would also lose the rights to that equity when the employment is ter-

minated. In addition, termination also starts the clock on a relatively short period

48. For example, the increase in CEO stock option grants in the 1990s was partially explained

by board of directors’ misperception of the true cost of the option grants to the shareholders. See, e.g.,

Kevin J. Murphy, Explaining Executive Compensation: Managerial Power vs. the Perceived Cost of

Stock Options, 69 U. CHI. L. REV. 847, 858 (2002) (“The increasing prevalence of broad-based option

grants” is partially explained by the fact that “companies routinely but erroneously perceive options

as relatively low-cost ways to convey compensation.”). Similarly, there is empirical evidence that

suggests that sophisticated managers of public companies are influenced by the number of options

they own rather than the value of the options or percentage of the company the options represent, due

to psychological influences. See, e.g., Mira Ganor, Why Do Managers Dismantle Staggered Boards,

33 DEL. J. CORP. L. 149, 180 (“[I]t may be that managers are psychologically more influenced by the

number of the options than by the actual option value.”).

49. Cf. Katie Shonk, Signing Bonus Negotiation 101, H

ARV. L. SCH.: PROGRAM ON NEGOT.

(Jan. 30, 2024), https://www.pon.harvard.edu/daily/business-negotiations/signing-bonus-negotia-

tion-101/ (“If you would lose an expected bonus or other benefits by leaving your current employer,

the hiring organization may try to compensate you by opening up a signing bonus negotiation.”).

Compare this practice to non-compete agreements, which are against a strong public policy in

California, unless they are part of an acquisition of equity and goodwill. C

AL. BUS. & PROF. CODE §§

16600–16602.5 (2007); see generally Eric Posner et al., Investing in Human Capital: The Efficiency

of Covenants Not to Compete 22–25 (Univ. Va. L. & Econ. Rsch. Paper No. 01-08, 2004), https://pa-

pers.ssrn.com/sol3/papers.cfm?abstract_id=285805. A growing number of states restrict the use of

non-competes. For example, Illinois recently passed the Freedom to Work Act in 2021, which pro-

hibits non-compete agreements with low wage employees and came into effect in 2022. See 820 I

LL.

COMP. STAT. 90/10 (effective Jan. 1, 2022); see also James Witz et al., The Trend Continues: Illinois

Imposes Additional Prerequisites and Restrictions on Employers’ Use of Restrictive Covenants,

ITTLER (Aug. 18, 2021), https://www.littler.com/publication-press/publication/trend-continues-illi-

nois-imposes-additional-prerequisites-and (discussing the 2021 changes to the Illinois Freedom to

Work Act and its place in a larger anti-non-compete agreement trend). Another example is Colorado’s

new rule. C

OLO. REV. STAT. § 8-2-113 (2022); see Employers Who Violate Colorado’s Non-Compete

Laws Face Stiff New Penalties, Including Jail, G

UNDERSON DETTMER (Feb. 28, 2022),

https://www.gunder.com/news/employers-who-violate-colorados-non-compete-laws-face-stiff-new-

penalties-including-jail/ (“Effective March 1, 2022, employers who violate Colorado’s restrictions on

post-job non-compete provisions may face criminal penalties, including up to 120 days in jail.”).

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Winter 2023] Startups in the Whirlpool of Divorce 13

to exercise options that have already vested,

which will further require the

option-holder to pay the exercise price and relevant taxes.

For example, vested

options may usually only be exercised up to ninety days after the termination, and

a tax liability is incurred when non-incentive stock options are exercised.

It might be argued that the spouse does not have rights to unvested equity

since those options will vest only if the employee continues to work for the startup

during which time the former spouse will no longer be contributing to the joint

effort of the couple. However, and especially when the divorce occurs during the

cliff period,

at least some of the unvested equity may belong to the former

spouse because at least a portion of the unvested rights are traceable to the com-

mon effort of the couple before the divorce.

Unsurprisingly, different

jurisdictions vary in regard to the spouse’s right to unvested equity.

Whether

the spouse is transferred equity or not, if the employee leaves the startup before

the securities fully vest—or, with regard to restricted securities, the restrictions

have lapsed—both spouses lose the unvested equity.

Thus, if a new employer lures the employee with a compensation package of a

size and value consistent with market standards without accounting for the fact that

some of the employee’s unvested equity in their previous employer now belongs to

the spouse, the employee will likely receive a windfall at the former spouse’s

expense. However, if it can be shown that some of the new employer’s equity was

granted to substitute for the loss of unvested options in the old employer rather than

as compensation for future work, the former spouse could argue that she should

receive part of the equity in the new employer to replace the rights she lost to the

unvested equity that was forfeited when the prior employment was terminated.

50. See infra note 172 and accompanying text.

51. In the case of a non-qualifying stock option, ordinary income tax is recognized when the

option is exercised, see. e.g., infra note 172; and in the case of an ISO, the exercise of the option may

trigger alternative minimum tax liability, I.R.C. § 56(b)(3).

52. C

ARTA, Why You Only Have 90 Days to Exercise Your Options When You Leave a

Startup—And Why That’s Changing,

MEDIUM (Oct. 26, 2019 https://medium.com/eshares-blog/why-

you-only-have-90-days-to-exercise-your-options-when-you-leave-a-startup-and-why-thats-c7f2f40b

c309 (“The vast majority of startups use the same 90-day PTE [post termination exercise]

window . . . .”).

53. A common vesting schedule is one in which the equity vests over a four-year period on a

monthly basis. Bussgang, supra note 39. The schedule usually includes a cliff of one year: during the

first year no equity is vested until the end of the year when a quarter of the equity vests. Id.

54. For example, if the couple’s separation is after 10 months since the grant, the wife could

argue for a right to at least 10/12 of the cliff. Cf. Community Property, supra note 13.

55. See, e.g., Jeff Landers, Dividing Stock Options and Restricted Stock in Divorce, F

ORBES

(Mar. 19, 2014, 2:24 PM ), https://www.forbes.com/sites/jefflanders/2014/03/19/dividing-stock-op-

tions-and-restricted-stock-in-divorce/#72a3dba831c8 (“In some states, if the stock options/restricted

stock have not vested as of the Date of Separation, they are not considered marital property. In other

states they are, but their current value will depend on numerous factors including how far in the future

they vest.”).

56. Cf. In re Marriage of Hug, 154 Cal. App. 3d 780, 784, 792 (Cal. Ct. App. 1984) (“[T]here

is no compelling reason to require that employee stock options must always be classified as compen-

sation exclusively for past, present, or future services. Rather, since the purposes underlying stock

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14 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

course, if the former spouse is entitled to part of the recruiting incentive package,

the new employer is adversely affected in the same way that the former employer

was when the rights to its equity were transferred to the employee’s former spouse.

Thus, the new employer might be reluctant to hire the employee in a way that

interferes with the employee’s job mobility.

To be sure, following the transfer of equity to the former spouse–and under

the assumption that a new recruiting package will not be shared with the former

spouse–the employee will be an easier, cheaper target for potential competing

employers. This is because he will stand to lose less equity when leaving the old

employer and thus the potential new employer will need to replace less equity

and could even be successful in recruiting the employee with a smaller package.

Accordingly, the current employer loses some of the incentive associated with

equity compensation when part of the equity is transferred to the former spouse,

unless the former spouse receives an enforceable right to any grants from future

employers. For these reasons, the startup might have to replace the equity trans-

ferred to the spouse with a new grant in order to retain the employee.

This result interferes with the employee’s employment choices specifically

and the labor market generally by introducing exogenous elements foreign to the

employee’s job and the competing companies’ businesses. It is also inefficient

insofar as the transfer of rights to the former spouse should be irrelevant to the

employee’s decision to move to a new employer. However, because startups are

currently taking longer to achieve liquidity, employees are staying longer in order

to avoid losing their equity.

This may indicate a potential labor market failure

wherein employees who are good at working in startups are staying too long in

mature businesses instead of moving to nascent ventures where their skills could

be put to better use.

Thus, transferring equity to the former spouse–to the extent

that it facilitates and encourages the right employees to move on–may ultimately

have a positive effect on market efficiency.

However, this phenomenon provides another explanation why startups seek to

ban the transfer of equity to former spouses: in addition to reducing the employee’s

incentive to work harder, it may also make the employee more susceptible to

options differ, reference to the facts of each particular case must be made to reveal the features and

implications of a particular employee stock option. . . . [N]o single rule or formula is applicable to

every dissolution case involving employee stock options.”).

57. Cf. Richard S. Markovits, Monopoly and the Allocative Inefficiency of First-Best-Alloca-

tively-Efficient Tort Law in Our Worse-Than-Second-Best World: The Whys and Some Therefores, 46

ASE W. RSRV. L. REV. 313, 319–20 (1996) (discussing the general theory of Second Best, the defi-

ciency of an isolated allocative efficiency analysis without a study of the aggregate effects, and the

applications of this theory to the law).

58. See generally, Yifat Aran, Note, Beyond Covenants Not to Compete: Equilibrium in High-

Tech Startup Labor Markets, 70 S

TAN. L. REV. 1235 (Apr. 2018) (discussing delayed liquidity events

in Silicon Valley and their connection to restricted employee mobility and inefficient talent allocation).

59. Id.

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Winter 2023] Startups in the Whirlpool of Divorce 15

poaching from competitors. Thus, to compete and retain the employee, the startup

might have to grant the employee more equity.

D. Shareholder Base — Size & Lawsuits

Fear of an unvetted, disgruntled shareholder interfering with the business is

another potential reason why startups seek to restrict the transfer of shares. Gen-

erally, the rights of a company’s shareholders include the right to vote, sue,

inspect, or sell the equity.

While voting rights may be limited or eliminated, or

the shares could be part of a class of non-voting shares,

the common stock of

venture-backed startups usually have voting rights, though often subject to voting

agreements.

Employees who receive equity compensation may be asked to sign

an agreement giving the company or the venture investors drag-along rights that

allow the rights’ holders to force the employees to sell their common stock if a

majority of the shareholders are in favor of an acquisition.

The voting agree-

ment often also includes irrevocable proxies

that enable the startup to enforce

the contractual rights by voting the employees’ shares.

The irrevocable proxy

and drag-along rights may allow an acquirer to escape appraisal rights, at least

where the shareholder is deemed sophisticated.

However, as made clear in

60. Cf. David Streitfeld, Engineers Allege Hiring Collusion in Silicon Valley, N.Y. TIMES

(Feb. 28, 2014), https://www.nytimes.com/2014/03/01/technology/engineers-allege-hiring-collusion-

in-silicon-valley.html (“[A] class-action lawsuit that accuses industry executives of agreeing . . . not

to poach one another’s employees. . . . involves 64,000 programmers and seeks billions of dollars in

damages. Its mastermind, court papers say, was . . . Steve Jobs.”).

61. See Robert B. Thompson, Preemption and Federalism in Corporate Governance: Protect-

ing Shareholder Rights to Vote, Sell, and Sue, 62 L.

& CONTEMP. PROBS. 215, 216 (1999) (“Share-

holders have only a limited role: They can vote, sell, or sue.”); see infra notes 73–74 and accompa-

nying text (discussing shareholder inspection rights).

62. E.g., Ken Bertsch, Snap and the Rise of No-Vote Common Shares, H

ARV. L. REV. F. ON

CORP. GOVERNANCE (May 26, 2017), https://corpgov.law.harvard.edu/2017/05/26/snap-and-the-

rise-of-no-vote-common-shares (referencing “Snap Inc.’s IPO [on Mar. 2, 2017], featuring public

shares with no voting rights”).

63. See D

EL. CODE ANN. tit. 8 § 218(c) (2022).

64. See, e.g., Robert B. Little & Joseph A. Orien, Issues and Best Practices in Drafting Drag-

Along Provisions, G

IBSON DUNN (Nov. 28, 2016), https://www.gibsondunn.com/issues-and-best-

practices-in-drafting-drag-along-provisions/ (“Drag-along rights . . . give the majority owner of a

company the right to force minority owners to participate in a sale of the company . . . .”).

65. See D

EL. CODE ANN. tit. 8 § 212(e) (2022); Haft v. Haft, 671 A.2d 413 (Del. Ch. 1995).

66. See, e.g., Voting Agreement Sample Agreement from NVCA’s Model Legal Document

Library, NVCA (Mar. 2022), https://nvca.org/recommends/nvca-2020-voting-agreement-citi-com-

ments-to-section-4-3/ (using drag along rights and proxies to facilitate the sale of the startup by low-

ering or eliminating the risk of acquirers who might otherwise face dissenting shareholders’ appraisal

rights following the consummation of the sale) [hereinafter Voting Agreement Sample].

67. While the Delaware Supreme Court in Manti Holdings approved the enforcement of

appraisal waiver agreements against “sophisticated” parties who “negotiated and signed” such agree-

ments for consideration, the court clarified that an appraisal waiver “clause purporting to bind suc-

cessors, assigns, and transferees may be unenforceable.” Manti Holdings, LLC v. Authentix Acquisi-

tion Co., 261 A.3d 1199, 1215 (Del. 2021).

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16 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

Riverstone, these assignments will not support a Corwin defense

and thus may

expose the board or officers who exercise these rights to liability for breach of

fiduciary duty.

Options, on the other hand, must be exercised before the holder

can exercise any voting rights attached to the underlying stock.

Proponents of restricting the employee’s ability to transfer equity to the

former spouse incident to a divorce often claim that the startup needs protection

from the possibility that the spouse could transfer its stock to the company’s com-

petitors or that, to prevent such a result, the company will be forced to buy its

own equity from the spouse in order to prevent a sale.

This argument, however,

ignores the fact that the same concern applies to the employee: a disgruntled for-

mer employee who retains equity in the startup can either rationally seek the high-

est possible price for his shares or emotionally seek revenge against the former

employer by transferring his shares to a competitor. To curtail that risk, the

startup customarily enters into arrangements that restrict such transfers.

Importantly, these same arrangements could apply to the shares transferred pur-

suant to a divorce, similarly preventing the former spouse from transferring her

equity to any undesirable shareholder.

In addition, shareholders, but not option-holders, have information rights,

which include a right to receive the shareholder list and a right to inspect the com-

pany’s books and records for a proper business purpose.

The Delaware judiciary

68. Corwin v. KKR Financial Holdings LLC, 125 A.3d 304, 306 (Del. 2015) (explaining that

the approval of fully informed, disinterested, and uncoerced holders of the majority of the shares will

cleanse the transaction, and claims of breach of fiduciary duties will not be heard as “the voluntary

judgment of the disinterested stockholders to approve the merger invoked the business judgment rule

standard of review . . . . Delaware corporate law has long been reluctant to second-guess the judgment

of a disinterested stockholder majority that determines that a transaction with a party other than a

controlling stockholder is in their best interests.”).

69. In re Pattern Energy Grp. Inc. S’holders Litig., No. 2020-0357-MTZ, 2021 WL 1812674,

at *62 (Del. Ch. May 6, 2021) (“In light of CBRE’s contractual obligation to vote in favor of the

merger, which CBRE agreed to without being informed of the merger’s terms, the Director Defend-

ants cannot invoke Corwin’s protections. CBRE was neither fully informed nor disinterested, and its

votes were compelled by contractual duty.”).

70. See Matthew Bartus, Establishing the Ownership Culture: Stock vs Options, C

OOLEY GO

(Jan. 23, 2022), https://www.cooleygo.com/establishing-ownership-culture-stock-vs-options/ (“People

holding options are not stockholders, do not vote like stockholders, and are merely holders of a con-

tractual right to acquire stock.”).

71. See, e.g., Marital Property Rights in Founder’s Stock,

SPRINGMEYER L.,

www.calstartuplawfirm.com/business-lawyer-blog/marital-property-founders-stock.php (last visited

May 6, 2022) (“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 . . . . 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.”).

72. See, e.g., S

TOCK OPTION AGREEMENT FORM, supra note 20, at Exhibit A; infra note 89

and accompanying text (noting that startups customarily enter into arrangements in order to restrict

such transfers).

73. See D

EL. CODE ANN. Tit. 8 § 220 (2022); MODEL BUS. CORP. ACT § 16.02 (AM. BAR

ASS’N 2016); see also, Edward B. Micheletti & Jenness E. Parker, This Isn’t Your Grandparents’

Books and Records Demand, S

KADDEN (Oct. 7, 2021), https://www.skadden.com/insights/

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Winter 2023] Startups in the Whirlpool of Divorce 17

has recognized that this right is especially important for a private company’s share-

holders where it may be a vital avenue for evaluating the investment.

Clearly,

the startup benefits by preventing these information rights from reaching the

wrong hands. For example, it may want to block inside information from leaking

to business partners, customers, suppliers, and especially competitors. However, a

rational, savvy shareholder without a larger stake in one of the startup’s competi-

tors or its business partner should have no incentive to compromise the startup by

using her shareholder information rights in a way that harms the company.

Consequently, if, for some reason, a former spouse is more likely to use

shareholder rights against the interests of the company than is the employee, then

the restriction on the transfer of equity clearly serves the interest of the company.

However, while the former spouse may well harbor ill feelings for the employee

following the divorce, her rational interest is in increasing the value of her equity

even if the employee is still associated with the startup. Furthermore, the use of a

third-party fiduciary obligated to act on the spouse’s behalf as a shareholder

assuages any concern that the spouse will use her shareholder rights irrationally.

However, this is a costly solution that requires the hiring of a fiduciary and, even

more concerning to the startup, assumes that the spouse’s rational interests align

with those of the venture investors and the startup.

However, there may be scenarios where the spouse’s rational interests diverge

from those of the startup and the employee. For example, if a sale of the startup

does not satisfactorily compensate the common stockholders,

the spouse may be

more likely to oppose the sale than the employee. This may be especially true if

the employee is an executive since executives are usually compensated at the time

of an acquisition in order to gain their support.

Even further, if the employee is

retained following the transaction, then the lost value of his equity resulting from

a low-value acquisition will probably be replaced by new employment and new

publications/2021/10/the-informed-board/this-isnt-your-grandparents-books-and-records (“There’s

no way to guarantee that emails or texts will not have to be produced in response to a Section 220

demand.”).

74. Woods v. Sahara Enter., 238 A.3d 879, 890 (Del. Ch. 2020). Vice Chancellor Laster stated

that the “valuation of a stockholder’s investment in a corporation, particularly where the corporation

is privately held, has long been recognized as a proper purpose under 8 Del. C. § 220.” Id. (quoting

Thomas & Betts Corp. v. Leviton Mfg. Co., 685 A.2d 702, 713 (Del. Ch. 1995)).

75. See, e.g., Krasny, supra note 4 (“Equity grants can result in numerous minority stockhold-

ers, whose demands and grievances can be a major distraction. . . . Good Technology is one exam-

ple. . . . BlackBerry purchased [Good Technology] for $425 million, less than half of the company’s

$1.1 billion private valuation. Some of Good’s common stockholders woke up to find their stock

options were practically worthless—after they’d paid taxes on their shares based on higher valuations.

Now, minority share-holders are suing board members for breach of fiduciary duty.”).

76. See, e.g., Katie Benner, When a Unicorn Start-Up Stumbles, Its Employees Get Hurt, N.Y.

TIMES (Dec. 23, 2015), https://www.nytimes.com/2015/12/27/technology/when-a-unicorn-start-up-

stumbles-its-employees-get-hurt.html (“What Good’s employees experienced is an example of who

loses out when a company backed by venture capital goes south. . . . [T]hose hit the hardest during a

company’s fall are the rank-and-file employees. Investors and executives generally get protections in

a start-up that employees do not. . . . Executives frequently get special bonuses so they will not leave

during deal talks.”).

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18 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

equity in the surviving company.

“Acquihires,” where the main purpose of the

acquisition is to gain the skilled employees of a distressed company, are a prime

example of this phenomenon. Pursuant to an acquihire, the acquirer will use reten-

tion packages to keep talented employees, while common shareholders get little,

if anything, for their stock.

In such a scenario, because a non-employee former

spouse will not receive a benefit similar to that of the employee, she will be more

inclined to oppose the sale of the company and to sue.

However, former employees of the company may also be in a position

identical to that of the spouse. Specifically, both may own the startup’s common

stock without any employment interest or prospects in the startup or the acquiring

company. Thus, both will oppose an acquisition in which their stock becomes

virtually worthless, for example, where the consideration is barely enough to

cover the liquidation preference of the VC investors holding preferred shares.

Thus, since most startups will eventually have former employees as share-

holders, there is little reason for the company to deem that the former spouse

becoming a shareholder is a uniquely adverse event. However, it could be argued

that any increase in the number of disgruntled shareholders that the company and

its potential acquirer might face is likely to also increase at least the administra-

tive costs of an acquisition, not to mention that it may chill prospective acquirers’

enthusiasm for acquiring the company.

Put differently, when the employee

transfers part of his equity to his former spouse and both become common share-

holders, the number of the company’s shareholders increases, and the likelihood

that one of them exercises their rights in a way that is adverse to potential

acquirers–and in some cases the company–increases.

Increases in the number of shareholders might also trigger disclosure obliga-

tions under securities laws. Specifically, prior to the Jumpstart Our Business

Startups (JOBS) Act of 2012 (the “JOBS Act”),

reaching 500 shareholders would

have triggered registration and disclosure requirements under the Securities

Exchange Act of 1934 (the “Exchange Act”) akin to that of a publicly traded

77. See, e.g., Press Release, Facebook, Facebook to Acquire WhatsApp (Feb. 19, 2014) (avail-

able at https://investor.fb.com/investor-news/press-release-details/2014/Facebook-to-Acquire-Whats

App/default.aspx) (“The agreement also provides for an additional $3 billion in restricted stock units

to be granted to WhatsApp’s founders and employees . . . .”).

78. Danielle Naftulin, So You’re Being Acqui-Hired, C

OOLEY GO (Jan. 21, 2022),

https://www.cooleygo.com/acqui-hire-basics/ (“An acqui-hire basically is a fancy way to say your

company is being bought predominantly for the fabulous team you’ve assembled and not for the prod-

uct/service you were (trying) to bring to market. . . . [I]t’s typically an acquisition of stock or assets,

with the bulk of the purchase price being earmarked for employee packages (retention and other-

wise).”).

79. Liquidation preferences give the VCs who invest through preferred stock specially nego-

tiated priority rights in a merger transaction. See, e.g., Jesse Fried & Mira Ganor, Agency Costs of

Venture Capitalist Control in Startups, 81 N.Y.U. L. R

EV. 967, 981–97 (2006).

80. See, e.g., Voting Agreement Sample, supra note 66 (“[M]any acquirers in M&A transac-

tions will require the seller to deliver a certain percentage of the vote . . . .”).

81. Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 501, 126 Stat. 306, 325

(2012) (amending 15 U.S.C. 78l(g)(1)(A)).

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Winter 2023] Startups in the Whirlpool of Divorce 19

company.

In fact, the timing of several high-profile IPOs, such as Facebook’s and

Google’s, have coincided with and been influenced by reaching this threshold.

However, under the JOBS Act and the Securities and Exchange Commission

(“SEC”) regulations promulgated thereunder, shareholders who received their

shares as part of an employee incentive plan are no longer included when

calculating the number of shareholders for determining registration and disclo-

sure obligations.

Furthermore, the JOBS Act increased the threshold from

500 shareholders

to 2,000.

Although this threshold no longer presents a sub-

stantial impediment to transferring stock to a former spouse,

it may well serve

as at least a partial explanation for why companies regularly continue to restrict

equity transfers. On the other hand, this practice may linger despite the

elimination of a major reason behind it just because it has become the custom.

If the employee is a founder or key employee with significant equity in the

startup, the divorce can create even more pronounced problems. The larger

the employee’s stake in the company, the more rights might be transferred to the

spouse when partitioning assets. Consequently, venture funds often condition

their investments in startups on a spouse’s agreement to restrict her rights in a

divorce, preventing her from holding the same rights as the employee with respect

82. Provided the total assets of the company exceed $10 million. 17 C.F.R. § 240.12g-1 (2023).

83. See, e.g., Steven Davidoff Solomon, Facebook and the 500-Person Threshold, N.Y.

TIMES

(Jan. 3, 2011), https://dealbook.nytimes.com/2011/01/03/facebook-and-the-500-person-threshold/

(“Google decided that if it was going to have to release its nonpublic financial and other information

to the S.E.C. and the public, it might as well get its bang for the buck and do it in connection with an

I.P.O.”).

84. 17 C.F.R. § 240.12g5-1(a)(8(i)(A) (2023).

85. Mark S. Bergman et al., SEC Increases Thresholds for Exchange Act Registration, P

AUL

WEISS (May 9, 2016), https://www.paulweiss.com/media/3526468/9may16sec.pdf (“The prior

threshold had been 500 holders of record without regard to accredited investor status.”).

86. Provided that less than 500 shareholders are not accredited investors. 17 C.F.R. § 240.

12g-1 (2023) (“An issuer is not required to register a class of equity securities . . . if on the last day

of its most recent fiscal year: (a) The issuer had total assets not exceeding $10 million; or (b) (1) The

class of equity securities was held of record by fewer than 2,000 persons and fewer than 500 of those

persons were not accredited investors ( . . . determined as of such day rather than at the time of the

sale of the securities) . . . .”).

87. An interesting distinction is the fact that for the purpose of the exemption from the regis-

tration requirement under Section 12(g), a company needs to count holders of record at the end of the

fiscal year (and not the date of the sale); for the purpose of qualifying for Rule 506 exemptions from

registration of a securities offer, a company needs to count the number of purchasers, and the SEC

has clarified that a spouse “should not be deemed a purchaser” when she “did not make any invest-

ment decision, and because the placement of the securities in joint name may simply be a tax or estate

planning technique.” Securities Act Rules: Questions and Answers of General Applicability, U.S.

SEC.

& EXCH. COMM’N (Jan. 26, 2009), https://www.sec.gov/divisions/corpfin/guidance/securi-

tiesactrules-interps.htm (scroll to Question 255.40).

88. Cf. Elisabeth de Fontenay, The Deregulation of Private Capital and the Decline of the

Public Company, 68 H

ASTINGS L.J. 445, 460 (2017) (“Facebook’s vocal displeasure over being

forced to cross the public-private divide in this fashion was directly responsible for Congress’s even-

tual decision to increase the record shareholder trigger from 500 to 2000 in the JOBS Act.”).

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20 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

to the shares.

Admittedly, the concern that the spouse will exercise control over

the startup despite, in some cases, lacking business acumen and relevant

knowledge on par with that of the employee is understandable.

Even without the forced prior agreement, control is unlikely to be transferred

to the spouse in the divorce. Instead, at most, she is likely to share the equity and

get half of the employee’s stake. Although dividing the equity could dissipate the

founder’s control if the spouse received a significant share, it would not create an

additional controller. In fact, the lost control resulting from an even split would

likely motivate the couple to leave the control with the founder and compensate

the spouse for the private benefits of control she relinquished. This is in contrast

with how the equity would likely be allocated if a founder died before his spouse.

The Bezos’s divorce provides an example of why a couple might allocate

control to the founder following the divorce. Specifically, had Mr. Bezos lost

control of Amazon following his divorce, the stock price would have dropped to

the extent that the market assigned value to his skills and control.

That decline

would also have negatively affected the value of his former spouse’s, Ms. Scott’s,

equity. Thus, when the couple entered into a control agreement that preserved

Mr. Bezos’s voting rights, it may well have benefited Ms. Scott as well. To be

sure, it may be that the market no longer values Mr. Bezos’s control. In fact, the

stock market reacted positively to the announcement of his recent departure as

CEO.

However, he remains the company’s executive chairman and controlling

89. Ben Steverman & Anders Melin, A Prenup Is the Latest Must-Have for Tech Startup

Founders in Love, T

HE SEATTLE TIMES (Oct. 14, 2019, 2:31 AM), https://www.seattletimes.com/

business/a-prenup-is-the-latest-must-have-for-tech-startup-founders-in-love/ (“Venture capital firms

often demand that founders’ husbands and wives sign ‘spousal consent’ forms. Such agreements de-

termine who gets to vote for board members, and how and when shares can be sold. In the event of a

divorce settlement (or death or disability), a founders’ spouse might end up with company shares. But

the agreements ensure that an ex can’t exercise much, if any, control over the company post-

divorce.”).

90. Cf. Lucian Bebchuk & Kobi Kastiel, The Untenable Case for Perpetual Dual-Class Stock,

ARV. L. REV. F. ON CORP. GOVERNANCE (Apr. 24, 2017), https://corpgov.law.harvard.edu/2017/04/

24/the-untenable-case-for-perpetual-dual-class-stock/ (advocating for sunset rules in the case of

founders and dual class capital structures); John Gapper, The Battle for CBS Is Old-Fashioned Enter-

tainment, F

IN. TIMES (May 23, 2018), https://www.ft.com/content/1bc2255e-5d07-11e8-9334-

2218e7146b04 (“Ms Redstone was not the founder, yet wields her father’s power.”).

91. Cf. Google, Inc., Registration Statement (Form S-1) 29 (Aug. 18, 2004),

https://www.sec.gov/Archives/edgar/data/1288776/000119312504142742/ds1a.htm#toc59330_1

(“We are creating a corporate structure that is designed for stability over long time horizons. By

investing in Google, you are placing an unusual long term bet on the team, especially Sergey [Brin]

and me [Larry Page] . . . . [W]e have set up a corporate structure that will make it harder for outside

parties to take over or influence Google. . . . This structure [is] called a dual class voting struc-

ture . . . .”); see also Mira Ganor, Why Do Dual Class Firms Have Staggered Boards?, 10 O

HIO

T. BUS. L.J. 147 (2016) (discussing the special capital structure of Google).

92. Daniel Martins, Why Amazon Stock Climbed After Jeff Bezos Departure, T

HESTREET

(Jul. 7, 2021), https://www.thestreet.com/amazon/news/why-amazon-stock-climbed-after-jeff-bezos-

departure (“July 6 [2021] was not one of the best days in the stock market. All major indices, including

the S&P 500 and the Nasdaq, pulled back . . . . Immune to bearishness was Amazon stock . . . : in the

green for the day and at a historical peak not reached since early September 2020. The big news, and

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Winter 2023] Startups in the Whirlpool of Divorce 21

shareholder, and thus the market may have reacted differently to him losing the

controlling stake than it did to him merely stepping down as CEO.

In any case,

it seems clear that Mr. Bezos valued the control of the company since he kept it

following the divorce.

Alternatively, the couple may have recognized that

dividing control would have been the same as losing it, wasting its value.

When a founder divorces, transferring shares to his former spouse may be

more of a burden to the startup than when regular employees transfer shares. For

example, dividing the founder’s equity between him and his former spouse might

result in a change of control. In turn, a change of control is usually a triggering

event that gives rise to the investors’ protective rights, including redemption

rights.

On the other hand, splitting the equity between the employee and former

spouse can help the company in some cases, for example, if the investors are

interested in decreasing the employee’s influence on the company. A famous

example of investors using extreme measures to reduce a founder’s influence is

Uber. There, the VC funds increased the board’s size and then packed it in order

to decrease the influence of Travis Kalanick, the company’s founder who served

as a board member after he was ousted as Uber’s CEO following disagreements

with VC investors and allegations of an “intense” management style.

the most likely catalyst for Amazon’s large gains on a down day in the markets, was the change of

leadership. Effective this Monday, founder Jeff Bezos is no longer the company’s CEO . . . .”).

93. Patrick Thomas, Why Jeff Bezos Is Stepping Down as CEO but Staying on as Executive

Chairman,

WALL ST. J. (Feb. 3, 2021, 11:59 AM ET), https://www.wsj.com/articles/why-jeff-bezos-

is-stepping-down-as-ceo-but-staying-on-as-executive-chairman-and-what-that-means-11612366771

(“Jeff Bezos . . . is giving up his chief executive position, but not his seat of power. Mr. Bezos will

become Amazon’s executive chairman . . . .”).

94. Jay Greene & Veronica Dagher, Jeff Bezos to Retain Voting Control of Wife’s Amazon

Shares After Divorce,

WALL ST. J. (Apr. 4, 2019, 6:56 PM ET), https://www.wsj.com/articles/jeff-

bezos-keeping-75-of-couples-amazon-stock-in-divorce-all-voting-rights-11554399197 (“Jeff Bezos

will retain 75% of the shares that he owns with his wife, MacKenzie Bezos, and have voting control

over the remaining shares she owns in the company.”).

95. The value includes both subjective value and objective value; the later derives from the

private benefits from control and is compensated with a control premium when sold. In theory,

he could sell to a third party who would have paid for the control premium and thus share in the value

of the control. However, it is not clear that they could have found a willing and able person to purchase

the control, which could have adverse effects on the company, especially if the market valued his

contribution.

96. See, e.g., Amit Kataria & Brian Snyder, Morrison & Foerster Discusses Buying Shares of

Private Companies from Existing Shareholders, C

OLUM. L. SCH.: CLS BLUE SKY BLOG (Aug. 6,

2020), https://clsbluesky.law.columbia.edu/2020/08/06/morrison-foerster-discusses-buying-shares-

of-private-companies-from-existing-shareholders/ (“A secondary transaction might trigger undesira-

ble consequences under the Shareholders Agreement, requiring waivers or consents to avoid those

consequences. As an example, . . . the seller might be losing control. Change of control could trigger

a range of consequences, including the ability of other shareholders to require liquidation in accord-

ance with their liquidation preferences, or the fall-away of transfer restrictions or non-compete obli-

gations on the founders or key management.”).

97. See, e.g., Heather Somerville, SoftBank Is Now Uber’s Largest Shareholder as Deal

Closes, R

EUTERS (Jan. 18, 2018, 8:26 PM), https://www.reuters.com/article/us-uber-softbank-tender/

softbank-is-now-ubers-largest-shareholder-as-deal-closes-idUSKBN1F72WL (“Uber will expand its

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22 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

Mr. Kalanick’s equity had been split with his spouse as part of a divorce, the

resulting decreased influence could have protected the company from his

influence as its founder and as an allegedly poor leader.

Where the transfer of the equity is barred, a potential solution is for the couple

to enter into an agreement that provides that the employee will retain legal title to

the equity, with the former spouse becoming the beneficial owner who can instruct

the employee regarding its disposition.

To be sure, the employee’s incentives are

diminished in the same way as if he had transferred the shares to his former spouse

because the ownership is in name only. Similarly, although such agreements

formally maintain the employee’s ownership, they fail to protect the company’s

interests, especially if the agreement allows the spouse to instruct the employee in

the exercise of any attached shareholder rights. This concern, though, might be

mitigated because the employee is likely to attempt to persuade the former spouse

against acting irrationally, which might not have been possible if the spouse owned

the equity directly. On the other hand, as the company is not privy to the benefi-

ciary agreement between the divorcing couple, this arrangement allows the

company to remain ignorant of the beneficial owner’s identity. Consequently,

the capitalization table will not reflect the non-employee’s interests. Thus, such an

arrangement may circumvent the deterring effects of the risk of dissenting

appraisal rights and litigation on potential acquirers.

E. The Employee’s Happiness and Productivity

In general, the employee’s personal life is likely to affect the employee’s

productivity, motivation, risk tolerance, and decision-making.

Thus, major

events like divorce clearly affect the employee and as a result their employer, the

startup. When comparing the employee and ex-spouse, the employer’s interests

are more aligned with the formers. While the employee’s happiness can increase

the company’s value for the benefit of the shareholders, the spouse’s happiness

has no such effect—unless, of course, the spouse is otherwise connected to the

startup, for example, as a stakeholder.

100

Thus, it seems natural that the startup is

biased in favor of the employee even if it comes at the former spouse’s expense.

Therefore, to the extent that restricting the transfer of equity enables the employee

to achieve a better outcome for himself in the divorce and related asset allocation,

then it serves the startup as well.

board from 11 to 17 members including four independent directors, limit some early shareholders’

voting power and slash the control wielded Kalanick, who remains on the board.”).

98. See infra note 187 and accompanying text.

99. Clement S. Bellet et al., Does Employee Happiness Have an Impact on Productivity? (Saïd

Bus. Sch. WP 2019-13, 2023), https://ssrn.com/abstract=3470734 (“First, we provide causal field

evidence on the relationship between happiness and productivity.”).

100. For example, if the spouse is one of the startup’s customers, then the better off she is after

the divorce, the better able she will be to afford the startup’s services or products.

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Winter 2023] Startups in the Whirlpool of Divorce 23

Increasing the employee’s happiness is a legitimate business goal as satisfied

employees are likely more productive.

101

However, if the business considers the

employee’s wellbeing for its own sake—separated from the goal of maximizing

shareholder value—then the net effect on the happiness of society may militate

against the employee when the increase in the employee’s happiness comes at the

expense of that of his former spouse. This challenge of simultaneously juggling

the interests of various stakeholders is a common concern and criticism of the

focus on stakeholders rather than shareholders.

102

However, unlike cases where

corporate law can be enlisted to enhance or replace deficient rules—such as the

tax law’s failure to redistribute wealth equitably across society which may, argu-

ably, justify deviation from the goal of maximizing shareholder value—there

seems to be no such failure in family law that would require the startups to inter-

vene in the employee’s favor at first glance.

However, most venture-backed startups are formed in California–a jurisdic-

tion that is perceived as pro-spousal support–which may offer some explanation

for the tendency of startups to intervene on their employees’ behalf.

103

California

is also often considered among the worst states for divorce,

104

since getting a

divorce in California can have incidental negative effects on the divorcing

employee’s happiness due to the cost and time that it takes to divorce. These latter

effects, however, are not related to any disparate treatment in favor of or against

the spouse.

105

Nonetheless, it could be argued that corporate law encroaches on

state family law in order to counteract its perceived negative effects. To be clear,

this Article does not make this argument. However, it explains the common prac-

tice of startups discussed above, viewing their intervention as a reaction to a body

of state law that leans toward one side of the spectrum. On the other hand, this

practice might be nothing more than a tool to circumvent family law in order to

benefit the employee at no cost to the startup. Instead, any cost is borne by the

spouse, thus maximizing the startup’s value.

Thus, for a variety of reasons, the startup naturally sides with the employee

at the spouse’s expense, rendering it no surprise that it usually prevents the

101. See supra note 99.

102. Cf. In re Trados, 73 A.3d at 42 n. 16 (“The enterprise value standard compounds the

number of valuation alternatives that must be solved simultaneously, and the resulting multivariate

fiduciary calculus quickly devolves into the equitable equivalent of a constituency statute with a con-

comitant decline in accountability.”).

103. See, e.g., Why Katie Hamilton Should Request to Transfer Her Divorce to California,

RIFFITH, YOUNG & LASS (Apr. 20, 2015), https://www.gylfamilylawfirm.com/blog/2015/april/why-

katie-hamilton-should-request-to-transfer-he/ (“California spousal support laws strongly favor the

spouse receiving support as opposed to the spousal support laws in Texas. Texas law regarding

alimony is much more restrictive.”).

104. Top 7 Worst States for Divorce,

ABC NEWS (Aug. 6, 2014, 5:21 AM), https://abcnews.go.

com/Business/top-worst-states-divorce/story?id=24851360 (including California on a list of seven

states that are “the worst states for divorce”).

105. Id. (“It can take 360 days to process the paperwork and $395 to get a divorce in California.”).

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24 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

transfer of equity to the spouse upon divorce.

106

Siding with the employee at the

spouse’s expense can also be understood as a collegial act, i.e., one that is influ-

enced by the continuing relationship with the employee. Alternatively, the

restriction may be the result of the founders’ self-interest. Specifically, the found-

ers, who usually control the startup’s policies—at least at the pre-IPO stage—

may protect their own position in a potential divorce by restricting the transfer of

equity to all former spouses, including their own.

By restricting the transfer of equity to divorcing spouses, startups offer their

employees a cheap alternative to prenuptial and postnuptial agreements, which

not only saves legal costs but also avoids the awkward conversations surrounding

such agreements. Perhaps more importantly, however, prenuptial agreements are

governed by family law, which includes requirements, such as mutual legal

representation, that protect both parties to the agreement.

107

By contrast, the

startup arrangement is unilateral, unnegotiated, and lacking transparency. Thus,

by disguising the arrangement as serving the startup’s direct need, it and the

employee circumvent, or at least weaken, the protections to which the former

spouse would be entitled under family law. Further, the spouse may feel pressured

to agree so as not to interfere with the employee’s employment requirements.

108

In addition to affecting the outcome of the employee’s divorce, restrictions

on equity transfers potentially make it more costly and challenging to divorce,

thus decreasing the incidence of divorce.

109

For example, a spouse may choose

not to pursue the dissolution of the marriage in order to keep her rights to the

employee’s equity. To the extent that a couple’s differences are reconcilable or if

couples tend to dissolve relationships too hastily, then this incidental effect of the

transfer restrictions may be beneficial. In cases where the employee is interested

in maintaining the marriage even though the spouse might not be, then the

restrictions carry an added benefit that the employee will be happier, which may

itself also indirectly serve the startup.

The startup may be interested in the continuation of the employee’s marriage

for other reasons, for example, where the employee serves in a senior managerial

role and a divorce, especially an acrimonious one, is likely to generate bad

106. See, e.g., STOCK OPTION AGREEMENT FORM, supra note 20 (“This Option may not be

transferred in any manner otherwise than by will or by the laws of descent or distribution and may be

exercised during the lifetime of Optionee only by him or her.”). In addition to the restriction on trans-

ferability of options, the transferability of the underlying stock may also be restricted once the option

is exercise. See, e.g., id. at Exhibit A.

107. See, e.g., Y. Jennifer Lee, Till Prenup Do Us Part?, A

M. BAR ASS’N (Aug. 10, 2022),

https://www.americanbar.org/groups/gpsolo/publications/gp_solo/2022/july-august/till-prenup-do-

us-part/ (“[I]n California, absent extremely limited exceptions, prenuptial agreements are generally

unenforceable if a party to the agreement was unrepresented by counsel. . . . The agreement must also

contain provisions that reflect full disclosures by both parties prior to entering into the agreement.”).

108. See supra note 89 and accompanying text.

109. To be clear, it is outside the scope of this Article to argue for or against the marriage

institution, or for or against divorce, as a general policy that benefits society or any individuals in

general or in any case; rather this Article identifies and analyzes some of the effects that marriage and

divorce may have on startups and vice versa.

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Winter 2023] Startups in the Whirlpool of Divorce 25

publicity, tarnishing the startup’s reputation by association. Alternatively, the

employee’s spouse, though not formally employed, may be providing services to

the startup—for example, by hosting social functions or informally advising the

employee-spouse on work-related issues—thus rendering the startup directly

interested in the marriage. However, this incentive may be mitigated by the fact

that, following the divorce, the employee may remarry to a spouse that can pro-

vide services to the employer of equivalent or even superior value. Thus, it is

apparent the benefits to the startup from avoiding the employee’s divorce may

differ from case to case and, on balance, are not necessarily positive.

Specifically, economic reasons are not a healthy basis for prolonging or even

perpetuating a relationship. In turn, the quality of such a relationship may affect

the startup. To be sure, although even a good marriage that increases the happi-

ness of the employee may be distracting and time consuming, as long as the

marriage is successful, the startup will likely benefit. Just so, artificially continu-

ing a troubled marriage is likely to be even more distracting. Thus, while the

startup is likely to be affected by the employee’s marital status, there is little

evidence to suggest that the startup, on average, would perceive more benefit

from the marriage’s continuation compared to its demise.

II.

THE EMPLOYEE’S INTERESTS

Startup-imposed restrictions on the transfer of the employee’s securities to his

spouse incident to a divorce can advance the employee’s personal interests. This

part considers basic employee interests, including both rational and irrational

interests.

An employee in the process of a divorce is likely to seek to maximize his

share of the couple’s assets subject to his ability to tolerate the relative riskiness

of the resulting portfolio. For example, while equity transfer restrictions will

allow the employee to keep the startup’s securities following the divorce, it may

leave him with excessive risk if the spouse receives a higher portion of the cou-

ple’s less risky assets (such as real estate and cash) as compensation.

110

In this

case, however, the excessive risk may only be temporary as liquidity constraints

resulting from the recent increase in the time it takes startups to reach an exit has

caused a growing number of them to facilitate the sale of their securities by their

employees

111

—thus allowing the employee to reset the riskiness of his portfolio

following the divorce.

Furthermore, startup employees are often attached to their work and are

emotionally connected to the technology and the inventions they have helped

110. This depends on the employee’s risk tolerance. It may be that he is an extreme risk seeker

who enjoys a high level of risk, or it may be that the employee is left with an unbalanced portfolio

that moved him out of his comfort zone. To be sure, the employee could be in need for liquidity after

the divorce. See, e.g., Szalontay, supra note 47 (stating that “divorce and taxes are all legitimate

reasons for liquidity”).

111. See id. (stating that “secondaries are also becoming more fashionable”). For further

discussion on secondaries, see supra text accompanying note 47.

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26 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

create.

112

Since the ownership of the securities is associated with this work, the

employee is likely to have similar emotional attachment to the securities.

113

Thus,

it is likely that the employee assigns a high value to the equity,

114

higher than its

intrinsic value,

115

as a result of the special connection he feels for the fruit of his

work. However, the employee isn’t only driven by emotion. He may also have

rational connections to the securities related to the control they offer over

the startup.

116

Under this view, the securities offer control over the use of the

employee’s technology. This may be particularly salient for founders or key

employees who can exert significant influence as a result of their ownership of

significant equity stakes in the startup.

117

Thus, in addition to and on top of his

wealth-maximizing goals, the securities may serve as a tool for the employee to

realize his entrepreneurial vision.

118

The spouse may share the employee’s emotional attachment to the securities

because of an endowment effect

119

caused by being part of a household that owns

the securities.

120

Yet, this effect may have a greater influence on the employee than

his spouse because he has been the actual owner and especially because he received

the securities in return for his work with the startup.

121

In particular, where a

112. Cf. Mira Ganor, Recoupling Founders with Their IP—Improving Innovation by Rational-

izing IRC Section 351 (Licensing vs. Assignment of Founders’ IP in VC Backed Start-Ups), 44

CORP. L. 493 (2019) (questioning the “practice of early assignment of founder’s intellectual prop-

erty to venture capital backed startup companies”).

113. This is because the securities represent ownership of the company that owns the product

of the employee’s work.

114. Similarly to the employee, the spouse too may assign value to the equity that is not based

solely on pure economic calculations, cf. Landers, supra note 55 (“‘The result of the negotiation may

likely depend on the value placed on the options’ ownership by the employee spouse which could be

based partly on knowledge of the companies’ performance and partly based on unpredictable

emotion.’”).

115. It is also likely that the employee assigns a higher value to the securities than the spouse

because of asymmetric information that causes the spouse to undervalue the securities. See, e.g.,

ATTHEW SYMONDS, SOFTWAR: AN INTIMATE PORTRAIT OF LARRY ELLISON AND ORACLE 351

(2003) (“Nancy [Ellison’s wife at the time he founded the company] . . . agreed to sell him her stock

in SDL [today Oracle] for $500. Ellison remarks, ‘She didn’t care about the stock at all . . . . Years

later she called me to joke about the value of “her half” of the stock—then worth about half a billion

dollars.’”).

116. See, e.g., id. at 353 (“[Ellison] was terrified that by getting married . . . he risked losing

control of Oracle if it ended in divorce. . . . [H]e presented Barbara [his third wife] with a prenuptial

agreement . . . .”).

117. Regular, non-key, startup employees are unlikely to have sufficient securities needed for

control over the company.

118. Cf. Ganor, supra note 112 (questioning the “practice of early assignment of founder’s

intellectual property to venture capital backed startup companies”).

119. Richard Thaler, Toward a Positive Theory of Consumer Choice, 1 J.

ECON. BEHAV. &

ORG. 39, 44 (1980) (stating that “goods that are included in the individual’s endowment will be more

highly valued than those not held in the endowment”).

120. See infra pp. 47.

121. Cf., Greg Klass & Kathryn Zeiler, Against Endowment Theory: Experimental Economics

and Legal Scholarship, 45-46 (Geo. Pub. L. & Legal Theory Rsch. Paper No. 13-013, 2013)

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Winter 2023] Startups in the Whirlpool of Divorce 27

founder or key employee has a symbiotic relationship with the startup, he is likely

to assign an especially high value to his ability to exert control over the startup.

122

However, aside from control over the startup, the employee may value the

securities for the control they offer over his spouse. Many spouses find that finances

create a potentially insurmountable obstacle to a divorce. Thus, restricting transfer

of the securities that would otherwise follow a divorce may perpetuate the marriage

because the ensuing economic loss of any future upside expected from the securities

restricts the non-employee spouse’s financial capacity to pursue a divorce. The

employee, therefore, may see the securities as a mechanism to ensure his spouse’s

financial dependence—in other words, as a binding mechanism tying the couple

together for as long as he is interested in maintaining the marital relationship.

123

Yet still, the employee’s motivation to leverage the securities over his spouse

may be irrational and/or emotionally driven. For example, where an acrimonious

relationship triggers antisocial behavior, he may view the securities as a tool to hurt

his former spouse.

124

To be sure, such irrational behavior could also be seen from

the other side: the spouse might attempt to hurt the employee by trying to take what

he treasures, the rights to the startup he has helped build and is attached to.

III.

THE NON-EMPLOYEE SPOUSE’S INTERESTS

Like the employee, although a spouse may be interested in maximizing the

value of her assets following the divorce, her goals may not be limited to

pure profit maximization.

125

In the following Sections, I highlight three of these

considerations.

(Criticizing the endowment theory and stating that “[w]e have long known that factors like how we

acquire a good and reputation can influence our choices.”).

122. See, e.g., Elon Musk, Elon Musk: Correcting the Record About My Divorce, B

US. INSIDER

(Jul. 8, 2010, 3:34 PM), https://www.businessinsider.com/correcting-the-record-about-my-divorce-

2010-7 (“I even had to endure her [Musk’s first wife, Justine] attempt to enjoin my companies, which

would have required her participation and permission in every significant corporate decision. . . . Jus-

tine tried to dispute the separate property agreement that we signed in March 2002. This agreement

said that any separate property we created would remain separate property, so the novels she wrote

would be hers and any companies I created would be mine. . . . Justine said no to this offer and con-

tinued to insist on receiving ownership in Tesla and SpaceX.”).

123. Or at least until an exit event, at which time the spouse may be more easily able to share

in the proceeds. There may still be some short delays, such as lockup arrangements following an IPO,

but the securities will be much more liquid. See, e.g., Initial Public Offerings: Lockup Agreements,

U.S.

SEC. & EXCH. COMM’N (Sept. 6, 2011), http://www.sec.gov/answers/lockup.htm (describing the

typical 180 days lockup agreement).

124. Olivia Solon, Big Money, Big Ego, Big Bills: How to Get Divorced Silicon Valley Style,

UARDIAN (Apr. 19, 2017, 6:00 ), https://www.theguardian.com/lifeandstyle/2017/apr/19/big-

money-big-ego-big-bills-how-to-get-divorced-silicon-valley-style (“But when it comes to divorce,

some of his Silicon Valley clients want to screw over their partner at all costs instead of settling, even

if it would make better financial sense.”).

125. See Landers, supra note 55 [125].

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28 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

A. Risk Level & Access to the Private Market

In this Part, I assume the spouse is not herself employed by a startup that

provides her with an equivalent or similar type of equity to that which the

employee holds in his startup. Studies find a vast gender equity gap in Silicon

Valley: Male employees and male founders own tenfold the amount of equity

than females own in Silicon Valley.

126

Generally, gender bias makes it less likely

for women to secure VC financing and they are less likely to secure a job with

high equity compensation.

127

Thus, it is less likely that a woman will own equity

with upward potential and a level of risk equal to that of the male employee.

While a spouse can be considered to have already demonstrated a high

aptitude for accepting and managing risk, she will nonetheless lose access to the

private equity market in which the startup’s securities trade because she is

unlikely to be considered an “accredited investor.” Under federal securities laws,

individuals qualify as an “accredited investor” when his or her annual income or

net worth is above a specified threshold.

128

In August 2020, however, financial

sophistication was added as another means by which an individual could qualify

as an accredited investor.

129

Because of their financial sophistication or relative

wealth, accredited investors are uniquely empowered to participate in unregis-

tered private offerings under the assumption that they do not need the additional

protections that accompany registered securities.

130

A startup’s directors also qualify as accredited investors when investing in

the startup they manage.

131

Yet, across Silicon Valley, far fewer women serve as

126. See, e.g., Courtney Connley, A New Report Highlights Silicon Valley’s Stunning Gender

Equity Gap, CNBC (Sept. 20, 2018, 8:30 AM ), https://www.cnbc.com/2018/09/19/in-silicon-valley-

women-face-an-equity-gap-that-is-far-larger-than-the-pay-gap.html (“[M]en own 91 percent of

employee and founder equity in Silicon Valley, leaving women a scant 9 percent. . . . [A] lack of

women owners, senior executives, early-stage employees and investors all contribute to the equity

gap. . . . [E]arly employees of small private startups tend to get the largest share of employee

equity, at the lowest price.”).

127. See id. (“In addition to hiring women early, Carta’s study calls on Silicon Valley leaders

to help close the equity gap by eliminating discrimination and bias in the investing process.”); cf.

Venture Capital and Entrepreneurship, H

ARV. KENNEDY SCH. WOMEN & PUB. POL’Y PROGRAM,

https://wappp.hks.harvard.edu/venture-capital-and-entrepreneurship (last visited Mar. 2, 2024)

(“[O]nly around 13% of venture capital dollars go to startups with a woman on the founding team.”).

128. See infra note 141.

129. Press Release, U.S. Sec. and Exch. Comm’n., SEC Modernizes the Accredited Investor

Definition (https://www.sec.gov/news/press-release/2020-191) (Aug. 26, 2020) (“[F]or the first time,

individuals will be permitted to participate in our private capital markets not only based on their

income or net worth, but also based on established, clear measures of financial sophistication.” (quot-

ing Chairman Jay Clayton)).

130. Accredited Investors: Updated Investor Bulletin, I

NVESTOR.GOV (Apr. 14, 2021),

https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/updated-investor-

bulletin-accredited-investors (stating that certain offerings are limited to accredited, sophisticated

investors, “[t]hus rendering unnecessary the protections that come from a registered offering”).

131. 17 C.F.R. § 230.501(a)(4) (2023).

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Winter 2023] Startups in the Whirlpool of Divorce 29

directors than men.

132

Despite the California legislature’s recent efforts to ame-

liorate the disparity—for example, in 2018 it passed a new law requiring greater

representation from women on boards

133

—change remains incremental. The

2018 law, for example, applied only to public companies.

134

However, despite a

constitutional challenge, the California law has changed the status quo. Since its

passage, the number of women on public boards organized under the state’s laws

has increased.

135

An investment in a startup is coupled with a risk

136

that cannot be accurately

quantified or replicated by the spouse. To be sure, in some cases the spouse could

be fully compensated for the value of the equity in cash or other property

(as opposed to “in-kind”). Yet, unlike a case where a couple owns the fungible

securities of a publicly traded company, which the spouse could reinvest in and/or

purchase on the market after the divorce, a spouse who receives cash instead of a

portion of the startup’s securities could not use the cash to acquire more equity in

the startup—at least not before it goes public.

137

132. See, e.g., Yun Li, More Women in the Boardroom Could Drive Higher Credit Ratings and

Stock Returns for Firms — They Still Hold Just 29% of Seats, CNBC (Mar. 11, 2022, 10:13 AM),

https://www.cnbc.com/2022/03/11/women-gain-ground-in-the-boardroom-holding-29percent-of-di-

rector-seats-in-2022.html (“Women held 29% of corporate board seats in 2022, up from 24% two

years ago, according to Moody’s Investors Service.”).

133. Women on Boards, CAL. SEC’Y STATE, https://www.sos.ca.gov/business-programs/

women-boards (last visited July 6, 2022) (“In 2018, Women on Boards (SB 826) was signed into law

to advance equitable gender representation on California corporate boards. California led the way as

the first state in the nation to require all publicly held domestic or foreign corporations whose princi-

pal executive offices are located in California to have at least one female director on their boards

by December 31, 2019, either by filling an open seat or by adding a seat. By December 31, 2021, such

publicly held corporations were required to have minimum numbers of female directors based on the

total size of the corporation’s board of directors. . . . When Women on Boards passed in 2018,

one-fourth of California’s publicly held corporations had no women directors on their boards.”).

134. Id.

135. ASSOC. PRESS, California Judge Rules Law to Include Women on Boards of Directors

is Unconstitutional, (May 16, 2022, 3:59 PM), https://www.nbcnews.com/business/business-

news/california-judge-rules-law-include-women-boards-directors-unconstituti-rcna29071 (“In the

three years it has been on the books, it’s been credited with improving the standing of women in

corporate boardrooms.”).

136. Cf. I

NVESTOR.GOV, supra note 130 (“Unlike offerings registered with the SEC in which

certain information is required to be disclosed, companies and private funds, such as a hedge fund or

venture capital fund, engaging in these exempt offerings do not have to make prescribed disclosures

to accredited investors. These offerings involve unique risks and you should be aware that you could

lose your entire investment.”).

137. Since following the IPO the price of the stock in the market is expected to increase, it is

better to have bought the stock before the IPO. See, e.g., Stephen J. Choi & A.C. Pritchard, Should

Issuers Be on the Hook for Laddering? An Empirical Analysis of the IPO Market Manipulation Liti-

gation, 73 U.

CIN. L. REV. 179, 186 (2004) (discussing stock price boosts after IPO quiet periods,

which allow initial institutional investors to profit); cf. Ganor, supra note 8 (analyzing the special case

of auction IPOs and explaining the price increase in these IPOs).

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30 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

The closed market for investing in startups also offers potential for significant

gain from future growth.

138

Though owning the startup’s shares before an IPO

can be a lucrative investment, it is usually unattainable for the average retail

investor since they are neither accredited nor an employee of a startup.

139

If that

is true of the spouse following the divorce, she will lose access to the private

market and any upside from the securities traded in that market despite her pro-

longed interest in the equity during the marriage. This appears unfair since a

startup employee’s former spouse stands in a different position than the average

investor. Specifically, by being part of a household that included the startup

employee and the securities, the spouse has already borne the special risk of loss

associated with owning the startup’s securities and likely had to forgo alternative

benefits such as higher household income and additional pension rights.

140

Yet it remains the case that, even if the couple was accredited during the

marriage, the spouse is unlikely to individually qualify as an accredited investor

following the divorce. This is because the net income threshold for a single person

is two-thirds the net income required of a couple.

141

In other words, the couple

can qualify with a combined income that is less than twice that of a single

person.

142

Thus, if a couple had qualified as accredited investors based on a com-

bined

143

income of over $300,000,

it may well be that one or both of them will no

longer qualify following the divorce.

144

While the apparent disparity may be jus-

tified by the assumption that a couple can save money by running a single house-

hold, the income test remains challenging for the single individual, as she will

only qualify if she is able to net over $200,000.

145

The net-worth test

146

may be

138. Having access to the private equity market may be attractive to investors as it allows them

to invest in the startups even before the IPO and thus reap the benefit of the fast growth that leads to

the IPO. Cf. Jazmin Goodwin, How to Invest in IPOs, CNN

BUS., https://www.cnn.com/2021/06/03/

business-money/how-to-invest-ipo-feseries/index.html (June 3, 2021, 10:10 AM) (“[T]he reason

most people invest in IPOs is for the opportunity to invest in the company relatively early in its life

cycle and profit from potential future growth.”).

139. Investing at the time of the IPO is still considered a relatively early and risky investment,

which attracts investors. See, e.g., id. Yet, the upside is much larger for those who invested before

the IPO.

140. See supra Part II pp. 11–14 (discussing how equity compensation used to be an alternative

to cash compensation and pension plans, at least until the tech bubble burst).

141. 17 C.F.R. § 230.501(a)(6) (2023) (“[An accredited investor includes] [a]ny natural person

who had an individual income in excess of $200,000 in each of the two most recent years or joint

income with that person’s spouse or spousal equivalent in excess of $300,000 in each of those years

and has a reasonable expectation of reaching the same income level in the current year . . . .”).

142. See Id.

143. See Id.

144. Securities Act Rules: Questions and Answers of General Applicability, supra note 87

(scroll to question 255.15) (“If a person has been married for some but not all of the three years,

however, he or she may satisfy the rule on the basis of the joint income test for the years during which

the person was married and on the basis of the individual income test for the other years.”).

145. See supra note 160.

146. I

NVESTOR.GOV, supra note 136 (“Calculating net worth involves adding up all your assets

and subtracting all your liabilities. The resulting sum is your net worth.”).

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Winter 2023] Startups in the Whirlpool of Divorce 31

even more challenging for the single individual, who will only qualify if her net

worth is over $1,000,000 excluding her primary residence, the same net worth

threshold required of a couple.

147

If the net income and net worth barriers prove insurmountable to the former

spouse, she will lose access to the private market. Yet this appears to be an

incongruous result. When a typical individual’s income and/or net worth falls

below the applicable threshold, he or she may nonetheless continue in the invest-

ments made while accredited.

148

In other words, the individual is under no obli-

gation to divest themself of the private investment although their income and/or

net worth would be insufficient to make the investment in the first place. Thus,

the ex-spouse, who loses the startup’s equity upon divorce, is worse off. Unlike

the typical individual who loses their status as an accredited investor, the former

spouse loses not only her ability to continue making investments in the private

market, but also the investments she made while she was accredited. Furthermore,

since, on average, women earn less than men,

149

divorced women are more likely

than their male counterparts to lose accreditation as a result of the divorce. Main-

taining the spouse’s rights to the portion of the startup’s securities that, though

recorded as owned by the employee, nonetheless reflect a risk the former couple

assumed jointly, may be the only access the spouse retains to the private capital

markets upon divorce.

Similarly, since women are less likely than men to work for VC-backed

startups,

150

they are less likely to be able to access the private equity market

through equity-based compensation. When a private company offers equity com-

pensation to its employees, Rule 701 promulgated under the Securities Act of

1933, entitles those employees to hold the securities whether or not they qualify

as accredited investors.

151

Although such equity transfers are limited and the

147. 17 C.F.R. § 230.501(a)(5) (2023) (“[An accredited investor includes] [a]ny natural person

whose individual net worth, or joint net worth with that person’s spouse or spousal equivalent,

exceeds $1,000,000 . . . [but] [t]he person’s primary residence shall not be included as an asset . . . .”).

148. See, e.g., Accredited Investors & Investing, W

EALTHWARD CAP., https://www.wealthward.

com/accredited-investing#:~:text=You%20can%20lose%20accredited%20investor,if%20your%20cer-

tifications%20are%20invalidated (last visited Mar. 2, 2024) (“Losing your status won’t affect any

investments you are already involved in, but it will affect your options moving forward as you will no

longer have access to accredited investments.”).

149. Wendy Chun-Hoon, 5 Fast Facts: The Gender Wage Gap, U.S. D

EP’T LAB. BLOG

(Mar. 14, 2023), https://blog.dol.gov/2023/03/14/5-fast-facts-the-gender-wage-gap#:~:text=Stats.,

for%20Black%20and%20Hispanic%20women (“Overall, women are not paid as much as men, even

when working full time and year-round. On average, women working full time, year-round are paid

83.7% of what men are paid.”).

150. See, e.g., Connley, supra note 126 (“[A] lack of women owners, senior executives, early-

stage employees and investors all contribute to the equity gap. . . . [W]omen represent 29 percent of

employees in companies with up to 10 employees. Once a company has over 500 employees, female

representation increases to 44 percent.”).

151. Securities Act Rules: Questions and Answers of General Applicability, supra note 87

(scroll to question 254.04) (“Rule 701 was adopted after Regulation D and was designed specifically

for stock option and other compensatory employee benefit plans.”).

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32 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

issued securities are classified as restricted,

152

securities laws explicitly permit

their transfer to a spouse or former spouse

153

as a gift or pursuant to “domestic

relations orders.”

154

Nevertheless, such transfers can still be, and usually are,

restricted by the startup itself.

155

Crowdfunding presents a relatively new (yet limited) means for non-

accreditor investors to access the private capital market. In 2021, the SEC raised

the amount that a company can crowdfund considerably: Now a company may

crowdfund up to $5 million in a 12-month period.

156

However, the regulation also

limits the amount that the company can issue to non-accredited investors. Cur-

rently, limits are calculated as either 5 or 10% of the purchaser’s annual income

and net worth, respectively, ultimately ranging from $2,200 to $107,000 aggre-

gated across all investments during a twelve-month period.

157

Crowdfunding, however, poses additional challenges for startups. At bottom,

regulations require the company to prepare and file costly disclosures both while

fundraising and, at times, periodically afterward.

158

Even beyond regulatory

requirements, however, crowdfunding may deter future VC financing because

crowdfunding results in the addition of either hundreds of small shareholders or

one investment vehicle the size of which confers significant control.

159

Either

result is considered likely to complicate a future acquisition, creating risk for pro-

spective VC investors.

160

Further, as a result of the vetting function the VC market

152. 17 C.F.R. § 230.701(g) (2023).

153. 17 C.F.R. § 230.701(c)(3) (2023) (“Definition of ‘family member.’ For purposes of this

section, family member includes any . . . spouse, former spouse . . . .”).

154. 17 C.F.R. § 230.701(c) (2023).

155. See, e.g., Steverman & Melin, supra note 89 and accompanying text; S

TOCK OPTION

AGREEMENT FORM, supra note 20.

156. 17 C.F.R. § 227.100(a)(1) (2023).

157. 17 C.F.R. § 227.100(a)(2) (2023).

158. 17 C.F.R. § 227.201 (2023) (outlining disclosure requirements); 17 C.F.R. § 227.202

(2023) (outlining ongoing reporting requirements); Dennis Craig, Equity Crowdfunding—Is It for

You?, COOLEY GO (Feb. 20, 2023), https://www.cooleygo.com/equity-crowdfunding-is-it-for-you/

(“While not as expensive or time-consuming as an IPO, there is still a fair amount of time and cost

involved . . . . As part of the registration process, company information will be made public . . . . This

could be a non-starter for companies that prefer to stay in ‘stealth mode’ for strategic reasons. . . .[A]n

under-subscribed offering will become public knowledge and may reflect poorly on the company.”).

159. Cameron Hagen, Crowdfunding Considerations for Early-Stage Companies, JD

SUPRA:

MINTZ EDGE (Nov. 11, 2021), https://www.jdsupra.com/legalnews/crowdfunding-considerations-

for-early-1875069/.

160. Id. (“Traditional venture capital investors may be deterred by the number of investors re-

sulting from a prior crowdfunding round. Even with a cap table that has a special purpose vehicle or

a custodian holding the securities sold in a crowdfunding offering, the complications relating to hun-

dreds or thousands of beneficial owners may reduce the company’s attractiveness to future institu-

tional investors.”); see Craig, supra note 158. (“While many online crowdfunding platforms have

mitigated this set of issues by having the crowdfunding investors all participate through a single entity,

this approach raises new issue by potentially putting a lot of control in the hands of the crowdfunding

entity. In our experience, this particular cluster of issues often leads companies to forego the equity

crowdfunding route altogether.”).

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Winter 2023] Startups in the Whirlpool of Divorce 33

performs with respect to nascent technology companies, crowdfunding is thought

to signal that traditional market actors saw the firm as a bad investment.

161

Despite these hurdles, a few companies have reportedly used crowdfunding suc-

cessfully, largely as a means to generate publicity, strengthen relationships with

customers, and create momentum through marketing initiatives.

162

Thus, a risk-seeking spouse is unlikely to be able to replace her lost equity

interest on her own. While a risk averse person would discount a risky

investment— such as early investment in the equity of a startup—risk seekers

instead assign a positive value (a “premium”) to the same investment because of

its potential for substantial growth.

163

Additionally, the non-employee spouse’s

employment may be relatively conservative or low-risk, further augmenting her

risk tolerance. Although such a choice may indicate risk aversion, in the context

of her former marriage to an individual employed in a relatively risky venture it

may instead signal a conscious choice to balance out what would otherwise be a

high-risk household.

164

Upon separation, however, this choice may leave the

spouse with an overly conservative, excessively low-risk position if her interest

in the equity is replaced by a lump sum.

The former spouse may have chosen to do so because she shares the

employee’s belief in the startup’s future success and the associated future value

of the equity. As such, she would be in the company of optimists, risk-seekers,

and gamblers, who not only opt for investments in startups but also derive special

benefit and satisfaction from owning risky investments.

165

Dividing the marital

161. Neil Littman, Myth-Busting in Equity Crowdfunding, FORBES (Oct. 6, 2021, 7:45 AM ),

https://www.forbes.com/sites/forbesfinancecouncil/2021/10/06/myth-busting-in-equity-crowdfund-

ing/?sh=58cfd8b70421 (“Some investors (professional and institutional investors, in particular)

believe that only companies that can’t raise capital from more traditional sources (e.g., a venture

capitalist) turn to equity crowdfunding out of desperation. Therefore, there is a negative selection bias

in the equity crowdfunding market where the crowd is only seeing subpar companies and investment

opportunities.”).

162. Hagen, supra note 159 (“Crowdfunding also creates a social and marketing aspect to

raising capital, enabling companies to create awareness and momentum for their business and

products or services.”); Littman, supra note 161 (“[C]rowdfunding offers a way for companies to

build stronger relationships with the people who care about their product or service the most.”).

163. Generally, a person’s preference for a given level of risk can influence their choices and can

adjust in response to exogenous events, such as a financial crisis or a pandemic, reflecting a change of

their risk tolerance function or a move on the function due to a change in outcome distribution, cf. Shai

Bernstein et al., Flight to Safety: How Economic Downturns Affect Talent Flows to Startups, (NBER

Working Paper Series, Working Paper 27907, 2022) http://www.nber.org/papers/w27907 (finding

evidence that suggests the COVID pandemic increased risk aversion among job seekers and shifted

their preferences away from early-stage startups.); Mira Ganor, Agency Costs in the Era of Economic

Crisis – The Enhanced Connection between CEO Compensation and Corporate Cash Holdings, 55

RIZ. L. REV. 105-149 (2013) (finding evidence that suggests the Great Recession increased risk aver-

sion of highly compensated CEOs who, in turn, increased corporate cash holdings.).

164. The spouse might have even elected to stay at home to be more available to the couple’s

children while the employee spouse spent a significant time at the budding startup, as their career

demanded.

165. John Markoff & David Leonhart, Microsoft to Give Its Employees Stock Instead of

Options, N.Y.

TIMES (Jul. 8, 2003), https://www.nytimes.com/2003/07/08/business/microsoft-to-

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34 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

estate in a risk neutral way (or without taking into account the special risks

assigned to different assets) may thus harm the risk-loving spouse left with an

excessively conservative investment. Consequently, revoking access to the risky

investment deprives the spouse of more than just the expected value of the secu-

rities. In other words, the unique upside potential of private market investments

means that, from the perspective of the risk seeking spouse, they are not easily

replaced. Though the spouse could just as well be risk neutral or risk averse,

166

seems unlikely in light of the significant sacrifices she makes to facilitate her

partner’s involvement in a risky venture—sacrifices which she likely makes with

the expectation that the cost will be justified by the upside potential of the cou-

ple’s equity in the startup. In any case, it should not be assumed that the spouse

will not value risk since the downside—depriving her of a type of risk that she

may value and is unlikely to be able to replace—can be unfair. Thus, from the

spouse’s perspective, she should be entitled to choose between a lump sum and

the equity itself.

167

B. Value Uncertainty & Low Valuation Bias

Calculating the appropriate size of a lump sum is not an exact science.

Awarding the spouse cash or property in lieu of her interest in the startup’s secu-

rities thus raises questions related to determining whether the award really is

equivalent. The startup creates special problems for valuation. Specifically, the

startup’s equity is illiquid and, since its shares are not publicly traded, pricing

give-its-employees-stock-instead-of-options-2003070894060647345.html (“In Silicon Valley, stock

options have long been held out as the currency of the realm. They are seen as an effective tool used

by entrepreneurs and venture capitalists to assemble highly motivated teams of technology experts

who are willing to work long hours for months or years, gambling that in the end the stock market

value of their options will justify their efforts.”).

166. A risk averse spouse is one who would prefer a lump sum to a continued ownership interest

in the securities. A risk neutral spouse will be indifferent between the two.

167. It should be noted that to the extent that and as long as the non-employee spouse has ali-

mony rights and receives child support, the imbalance in risk level caused by the break of the marriage

might be mitigated as the court may consider the economic welfare of the employee when calculating

these rights. See, e.g., Mejia v. Reed, 74 P.3d 166, 175 (Cal. 2003) (“Assets at the time of dissolution

play little part in the computation of child support. They may enter indirectly into the calculation in

two ways: (1) In assessing earning capacity, a trial court may consider the earnings from invested

assets (see, e.g., In re Marriage of Cheriton (2001) 92 Cal.App.4

269, 292, 111 Cal. Rptr. 2d 893);

and (2) a court may deem assets a ‘special circumstance’ (Fam. Code, § 4057, subd. (b)(5)) that may

justify a departure from the guideline figure for support payments (In re Marriage of Loh (2001) 93

Cal.App.4th 325, 332, 112 Cal. Rptr. 2d 893). But these are exceptional situations; the child support

obligation is based primarily on actual earnings and earning capacity.”); Murray v. Murray, 716

N.E.2d 288, 294 (Ohio Ct. App. 1999) (“If we were to hold that executive stock options were not to

be included in ‘gross income’ . . . an employee receiving such options would be able to shield a sig-

nificant portion of his income from the courts, and deprive his children of the standard of living they

would otherwise enjoy. This would be in direct contradiction of the very purpose of the child support

statute, the child’s best interest.”).

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Winter 2023] Startups in the Whirlpool of Divorce 35

the startup’s securities is especially difficult.

168

Instead, assigning value to the

startup’s equity is almost exclusively based on assumptions about its growth

potential, which is far from an exact science.

169

Even where there is information

about the startup’s value, the spouse is unlikely to have access to it when negoti-

ating a buyout incident to a divorce. Receiving securities in kind avoids these

valuation challenges.

Further valuation issues arise from the startup’s interest in keeping the price

of its common stock low. Because common stock comprises both employees’ and

founders’ compensation and incentive packages,

170

a low price enables the startup

to set a low exercise price for the stock options it grants to employees as com-

pensation, thus increasing the options’ incentive value.

171

If instead the startup

granted options which, at the time of the grant, have an exercise price lower than

the underlying stock’s fair market value, the difference between the two is taxable

as income to the employee. Triggering such a tax liability before selling the stock

may pose significant difficulties since the employee’s compensation structure

makes him less likely to have sufficient liquidity to cover the liability.

172

In this

way, keeping the common stock’s price low allows the startup to grant higher

value options at no cost to its employees while at the same time lowering their

tax liability.

173

168. Landers, supra note 55 (“Determining the current value of stock options and restricted

stock for a privately held company, can be difficult.”).

169. See, e.g., Tahir J. Naim, Section 409A Valuations and Stock Option Grants for Start-up

Technology and Life Science Companies, F

ENWICK & WEST LLP, https://assets.fenwick.com/legacy/

FenwickDocuments/409_Valuations_Stock_Options.pdf (last visited May 18, 2022) (“Start-up com-

pany stock values are uncertain at best . . . .”).

170. See, e.g., Fried & Ganor, supra note 79 at 986 (“VCs’ use of preferred stock rather than

common stock permits the parties to reduce the tax imposed on employees, enabling the firm to pay

less on a pre-tax basis to employees.”).

171. William D. Cohan, Valuation Shell Game: Silicon Valley’s Dirty Secret, N.Y.

TIMES (Mar.

8, 2017), https://www.nytimes.com/2017/03/08/business/dealbook/valuation-shell-game-silicon-val-

leys-dirty-secret.html (“[409A] valuation allows hot, privately owned technology companies — like

Uber, Airbnb or Nextdoor — to issue common stock or stock options to employees at a low price and,

at the same time, or nearly the same time, sell preferred stock to outside investors at a price that is

often three or four times higher.”); cf. I.R.C. § 409A (requiring the company to evaluate professionally

only non-qualified options, with a safe-harbor that allows internal valuation so the value of the com-

mon stock is kept down by the special rights and preferences assigned to the preferred stock).

172. I.R.C. § 83(a); see also Topic No. 427 Stock Options, I

NTERNAL REVENUE SERV.,

https://www.irs.gov/taxtopics/tc427 (Oct. 4, 2022) (“For nonstatutory options without a readily

determinable fair market value, there’s no taxable event when the option is granted but you must

include in income the fair market value of the stock received on exercise, less the amount paid, when

you exercise the option. You have taxable income or deductible loss when you sell the stock you

received by exercising the option. You generally treat this amount as a capital gain or loss.”). To

qualify for an ISO the exercise price must at-least equal the fair market value (FMV) at time of grant.

I.R.C. § 422(b)(4).

173. Caroline Moon, 16 Things to Know About the 409A Valuation, A

NDREESSEN HOROWITZ

(Feb. 13, 2020), https://a16z.com/2020/02/13/16-things-about-the-409a-valuation/ (“Companies

want to keep the common FMV low since it makes stock options seem more lucrative to employees

and recruits.”). The low valuation also lowers the company’s compensation expense and thus

increases the bottom line, cf. Accounting for Employee Stock Options, C

ONG. U. S. CONG. BUDGET

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36 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

As a result, anything other than an in-kind payment of her interest in the

startup’s equity

174

will undercompensate the spouse to the extent it is based on a

deflated value of the common stock. Thus, where the startup’s interest in keeping

the price of its common stock low and excluding the spouse from its shareholder

base intersect,

175

the spouse will be left without adequate recourse.

Even if the employee’s securities could be accurately valued, the spouse is

likely to perceive the value of the securities to be higher than that of a lump

sum.

176

Specifically, having been part of a household that has owned the startup’s

securities, the spouse is likely to experience an endowment effect, causing her to

assign a higher value to these securities than she would if her interest were purely

economic. Further, where the value of the securities is in fact lower than the

spouse’s estimation, then the buyout only serves to hasten the realization of a bad

investment. At bottom, this early realization deprives the spouse of the oppor-

tunity to expect a higher value up until a market event finally reveals the securi-

ties’ true value.

177

Yet the early realization may benefit the spouse, for example,

by rightsizing her estimate of the securities’ upward potential, thus enabling her

to react earlier than other equity holders and better position herself based on a

more accurate picture of her financial state.

C. Separation & Independence

Importantly, even granting beneficial title over the securities to the spouse in

a trust arrangement whereby–although the employee remains the owner of

record–he acts as a fiduciary with respect to the securities in which the spouse

retains an interest is an imperfect solution. Most obviously, such an arrangement

OFF. (Apr. 2004), https://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/53xx/doc5334/04-02-

stockoptions.pdf (describing managers’ opposition to the then proposed amendment to the accounting

treatment of employee stock option grants because the treatment increases the amount required to be

subtracted from the company’s earnings and explaining that “[f]or financial-reporting purposes, firms

prefer to maximize their reported income.”).

174. See, e.g., What You Need to Know About Dividing Stock Options in Divorce, R

OSEN L.

FIRM, https://www.rosen.com/business/business-articles/dividing-stock-options/#:~:text=The%20eas-

iest%20and%20most%20common,spouse%20is%20entitled%20to%20%2450%2C000 (last visited

May 18, 2022) (“The easiest and most common method to divide stock options is to have the employee

spouse who owns the option offset the agreed upon value of the option with another asset.”); Kathryn

M. Grigg, Employers Face Complications If Stock Options Are Transferred in a Divorce, A

XLEY

(Jan. 25, 2019), https://www.axley.com/publication_article/employers-face-complications-if-stock-

options-are-transferred-in-a-divorce/5/ (“The most common way to divide stock options is for the

divorcing employee to retain the stock options and award the nonemployee spouse other marital assets

of equivalent value as an offset.”).

175. See generally supra Part II.

176. This may be influenced by both the value she assigns to risk and her emotional connection

to the stock, cf. Landers, supra note 55 [125].

177. To be sure, should the spouse receive a different property that is similarly hard to evaluate

as a substitute for her stake in the securities of the startup, such as the couple’s house, the endowment

effect towards both assets could offset and on balance could have a positive effect on the spouse.

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Winter 2023] Startups in the Whirlpool of Divorce 37

places the spouse in an awkward position.

178

For example, following a divorce,

there may be distrust between the former partners, or discomfort about creating

an arrangement that maintains the spouse’s dependence on the employee despite

the separation. Considerations like these may incentivize the spouse to forgo all

rights to the securities, despite her preference to maintain ownership of the secu-

rities, in order to avoid being forced to continue associating with or relying on

the employee. One possible solution would be making the employee the spouse’s

de facto trustee,

179

though this may still be insufficient insulation for a spouse

who prefers to, or must, sever all ties with the employee. It appears, then, that

trust arrangements may ultimately result in the spouse nonetheless losing all

rights to the securities.

IV.

HIDING BEHIND THE INTERNAL REVENUE CODE – SUGGESTIONS

FOR REFORM

Among the reasons for the startup to restrict the employee’s ability to transfer

his equity to the spouse is the United States IRC. This part analyzes the relevant

tax rules and suggests a reform to reduce the code’s effect on the allocation of

assets pursuant to a divorce. Specifically, if the code no longer diminished the

options’ value upon transfer to the spouse, the IRC could no longer serve as a

pretext by which the startup justifies equity transfer restrictions related to divorce.

Employees of VC-backed startups traditionally receive equity compensation

structured as stock options.

180

It is also common practice that plans governing

these options restrict the options’ transfer and limit the persons who may exercise

the options to the employee.

181

These restrictions are required to qualify the com-

pensation package for treatment as Incentive Stock Options (ISOs) under the

Internal Revenue Code (IRC).

182

The ISO holder, in turn, is treated favorably

under the IRC.

178. Cf. Louise Rafkin, The Paradox of Alimony for Men, N.Y. TIMES (Oct. 30, 2021),

https://www.nytimes.com/2021/10/30/style/men-alimony-spousal-support.html?action=click&mod-

ule=Well&pgtype=Homepage&section=Love (describing analogous complications caused by the

forced continued relationship following the divorce in the context of alimony because “[i]t’s hard to

move on when there’s a monthly reminder of your resentment”).

179. See infra note 187 and accompanying text.

180. See, e.g., Fried & Ganor, supra note 79, at 986 (explaining that option compensation is

“the most common form of equity compensation in startups”).

181. See e.g., S

TOCK OPTION AGREEMENT FORM, supra note 20, at 2–4 (describing the non-

transferability clause which covers both ISOs and NQSOs).

182. I.R.C. § 422(b)(5) (stating that “such option by its terms is not transferable by such indi-

vidual otherwise than by will or the laws of descent and distribution, and is exercisable, during his

lifetime, only by him”); Publication 525 (2022), Taxable and Nontaxable Income, INTERNAL

REVENUE SERV., https://www.irs.gov/publications/p525#en_US_2021_publink1000229220 (last vis-

ited Mar. 29, 2023) (“For [statutory stock] option[s], you must be an employee of the company grant-

ing the option, or a related company, at all times during the period beginning on the date the option

is granted and ending 3 months before the date you exercise the option . . . . Also, the option must be

nontransferable except at death.”); Mary Lewis, ISOs vs. NSOs What’s the Difference?, COOLEY GO

(Nov. 3, 2020), https://www.cooleygo.com/isos-v-nsos-whats-the-difference/#:~:text=Only%20

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38 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

For tax purposes, there are two types of employee options: (1) ISOs and (2)

Non-Qualifying Stock Options (NQSOs). ISO holders benefit from favorable

deferred tax treatment. Although upon sale the seller will be subject to a long-

term capital gain tax on the difference between the sale price of the underlying

stock and the exercise price of the option by which it was obtained, they will face

no tax liability until the sale actually occurs.

183

NQSOs, on the other hand, are

taxed at the time the option is exercised and at the higher rates of income tax.

184

Fatally for the former spouse, however, is that, to qualify as an ISO, the option

must not be transferred by the employee. In fact, the IRC emphatically prohibits

any transfer, even those to a spouse incident to a marriage or divorce, only

excusing transfers resulting from the employee’s death.

185

ISOs that are trans-

ferred are thereafter treated for tax purposes as NQSOs.

186

To avoid the unfavorable tax treatment while also preserving something of

the spouse’s interest in the startup’s securities, some divorce agreements grant the

spouse beneficial title to her share of the startup options while leaving the employee

as their owner of record. The IRS allows options held and exercised under such an

arrangement to continue qualifying as ISOs, having recognized the spouse’s rights

as a beneficiary of the options following the divorce as long as the employee

remains the owner of record—at least up to and including the time the options are

exercised.

187

While this scheme satisfies the IRC’s literal requirements and has

been recognized by the IRS as sufficient to maintain the ISO status, the arrangement

is not without its disadvantages. Not only does the trust arrangement require the

spouse to continue a relationship with the employee even after the divorce, but it

also forces them into a relationship of trust likely unsuitable for couples experienc-

ing a divorce. Being pushed into this arrangement by the IRC incentivizes the

spouse to forgo her rights to the options in order to avoid further interaction with

the employee and reduce her reliance on him. By contrast, this arrangement seems

employees%20can%20receive%20ISOs,services%20in%20some%20other%20capacity). (“ISOs are

only transferable upon the death of the recipient.”).

183. I.R.C. §§ 421(a)(1) & 422(a)(1). In case of a disqualifying disposition, a sale of the under-

lying stock either less than one year from exercising of the option or less than two years from the date

of the grant of the option, the employee will incur income tax liability at the time of the sale calculated

based on the FMV at the time of the exercise. I.R.C. § 421(b). In addition, the employee might incur

AMT at the time of the exercise of the ISO. I.R.C. § 56(b)(3).

184. See Topic No. 427 Stock Options, supra note 172.

185. See I.R.S. Private Letter Ruling 200519011 (Jan. 13, 2005), https://www.irs.gov/pub/irs-

wd/0519011.pdf [hereinafter Private Letter Ruling] (“Rev. Rul. 2002-22 also concludes that the trans-

fer of a statutory option to a spouse in connection with a divorce results in the disqualification of the

option under sections 422(b)(5) and 423(b)(9). Thus, if an option is transferred in connection with a

divorce, that option is disqualified and thereafter treated in the same manner as a NQSO.”).

186. Id.

187. See id. at 9 (“The Court’s recognizing X’s [the spouse’s] community property interest in

the ISOs and requiring E [the employee] to exercise X’s ISOs only in accordance with X’s instructions

and requiring E to designate X as the beneficiary of X’s share of the options will not violate the

requirements of section 422(b)(5) of the Code, relating to nontransferability and lifetime exercise by

the employee.”).

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Winter 2023] Startups in the Whirlpool of Divorce 39

to serve the startup’s and employee’s interests by delaying, if not outright prevent-

ing, the spouse from becoming the equity’s owner of record.

188

Once the option is exercised, the underlying stock can be transferred to the

spouse without forfeiting the ISO’s favorable tax treatment.

189

The employee’s

options, however, are typically subject to vesting schedules that lapse over time

unless the employment relationship is terminated.

190

If the option remains

unvested upon divorce, the spouse must wait for it to vest before it can be exer-

cised. The ISO can only be exercised if it has vested or if the company grants the

right to exercise the option early. Such early exercising, however, exposes

the spouse to an increased risk as the exercise price is paid at the time the option

is exercised. If the employment relationship is terminated before the end of the

original vesting period, the startup has the right to repurchase the stock obtained

by exercising the option early.

191

Yet, even where the option can be exercised

without delay or the risk of forfeiture, the spouse must still pay the exercise price

in order to exercise the option.

192

Furthermore, exercising the option terminates the advantages of holding an

option, namely, the ability to postpone exercising the option (until its expiration

date or an IPO) and to defer paying the exercise price, thus lowering the risk of

losing money if the option goes “underwater.”

193

Even where paying the exercise

price poses less of a barrier–for example where option plans allow for a “cashless

exercise” whereby part of the option is used to pay the exercise price–if the

188. Keeping the spouse out of the cap-table of the startup can help the startup raise VC fund-

ing. See supra Part I.

189. See infra note 183.

190. See supra notes 38 & 39 and accompanying text.

191. See Matthew Bartus, Early Exercisable Stock Options: What You Need To Know, C

OOLEY

GO (Jan. 23, 2022), https://www.cooleygo.com/early-exercisable-stock-options-what-you-need-to-

know/ (“Upon early exercise, the optionholder receives common stock that is subject to the same

vesting schedule that applied to the stock option. If the optionholder subsequently leaves the company

before that stock vests in full, then the company will generally have the right to repurchase the un-

vested stock . . . . Early exercise means investing in the Company earlier . . . . The optionholder risks

losing all or part of the investment if the value of the company’s common stock decreases.”).

192. See, e.g., Exercise Price, C

OOLEY GO, https://www.cooleygo.com/glossary/exercise-

price/ (“Every stock option has an exercise price, also called the strike price, which is the price at

which a share can be bought.”). Some compensation plans allow for a cashless exercise, which uses

the option itself to pay for the exercise price instead of making a cash payment. This results in the

forfeiture of some of the underlying stock at a ratio which is based on the FMV of the underlying

stock at the date of exercise and the exercise price. The higher the FMV of the stock, the fewer shares

the option-holder will have to forfeit to cover the exercise price in a cashless exercise. Assuming the

price of the stock will continue an upward trend, which is the expected trajectory of a successful VC-

backed startup, delaying the exercise of the option benefits the option-holder: the longer the option-

holder waits before exercising the option, the fewer shares she will have to forfeit to cover the exercise

price. Cashless exercise is common in warrants, see, e.g., Peter Werner, What You Should Know About

Warrants, C

OOLEY GO (June 15, 2022), https://www.cooleygo.com/what-you-should-know-about-

warrants/ (“Many warrants also allow for what is called a ‘cashless exercise,’ which allows the holder

to exercise without paying cash by reducing the number of shares receivable by the holder by an

amount equal in value to the aggregate exercise price that the holder would otherwise have to pay.”).

193. That is, the share price falls below the exercise price.

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40 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

spouse can wait until the value of the startup increases, then she will be able to

use less of the option to fund exercising the option.

The IRC’s treatment of the house in which the couple lived during the mar-

riage highlights the oddity of disqualifying the ISOs solely because the employee

transfers them to the spouse pursuant to a divorce settlement. Unlike ISOs, where

a house was registered solely in the employee’s name and is transferred to the

spouse pursuant to a divorce settlement, no tax liability is triggered.

194

When it

comes to real estate, the IRC places substance over form, placing less emphasis

on identifying the owner of record and which spouse formally holds title to the

property. Thus, the IRC allows a spouse who received a house through a divorce

settlement to include the period for which the employee owned the property when

calculating the duration of her ownership for purposes of qualifying for an

exemption from recognizing gain upon its sale as a main home

195

(as long as she

herself meets the residence requirement).

196

Rather than continue to treat these analogous transactions differently, the IRC

should look beyond identifying the owner of record and treat ISO ownership the

same way it treats home ownership. Where, formally, the employee may have

separately owned the securities during the marriage, the same employee may also

have separately owned the house. The spouse who had been living in the house

during the marriage can nevertheless apply this period to satisfy the IRC’s resi-

dency requirements despite the fact that the spouse did not own the house at the

time.

197

Likewise, her contributions to the household that enabled the employee to

earn and maintain ownership of the ISOs should entitle the spouse to receive and

own the options as ISOs rather than disqualify the securities from favorable tax

treatment because they were transferred pursuant to a divorce.

198

Instead, because

the wife was married to the employee while he was working for the startup and

owned the ISOs, the couple should be viewed as having assumed the same risks

in return under the same incentives. Thus, the transfer of the option as part of the

194. Publication 523 (2022), Selling Your Home, INTERNAL REVENUE SERV.,

https://www.irs.gov/publications/p523 (last visited Mar. 29, 2023) (“[I]f you transferred your home

(or share of a jointly owned home) to a spouse or ex-spouse as part of a divorce settlement, you are

considered to have no gain or loss.”).

195. Id. (“The IRC recognizes the importance of home ownership by allowing you to exclude

gain when you sell your main home. To qualify for the maximum exclusion of gain ($250,000 or

$500,000 if married filing jointly), you must meet the Eligibility Test . . . . If you owned the home for

at least 24 months (2 years) out of the last 5 years leading up to the date of sale . . . you meet the

ownership requirement. . . . If you owned the home and used it as your residence for at least 24 months

of the previous 5 years, you meet the residence requirement.”).

196. Id. (“If your home was transferred to you by a spouse or ex-spouse (whether in connection

with a divorce or not), you can count any time when your spouse owned the home as time when you

owned it. However, you must meet the residence requirement on your own.”).

197. Id.

198. It should be noted that under the current law, once the underlying stock is transferred to

the spouse, the transfer is not a disqualifying disposition and the period the employee held the ISO

from the date of the grant will be counted for the benefit of the spouse once she sells the stock at a

qualifying disposition. See supra note 183.

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Winter 2023] Startups in the Whirlpool of Divorce 41

marriage’s dissolution should not be treated as a disqualifying disposition, at the

very least where the employee received the ISOs while married to the spouse.

Although the current transfer restrictions could be considered in tailoring the

duration of favorable tax treatment of ISOs to only those circumstances under

which the options will incentivize the employee to stay at the startup and work

hard to increase its value, that position fails to account for the IRC’s preservation

of ISO status where the option is transferred following the employee’s death.

Just as, under this view, there would be no justification to extend the favorable

tax treatment to the spouse once the option is transferred in divorce since, once

transferred, it can no longer affect the employee’s incentives, neither can ISO

treatment affect the employee’s incentives where the option is transferred

because of the employee’s death. It remains unclear why the IRC allows ISO

treatment to continue if the spouse receives the option following the employee’s

death

199

but not their divorce. In both cases the options are unable to affect the

employee’s incentives, and, in both cases, the startup may have granted new

options, either to the employee or his replacement, in order to create an

alternative incentive structure.

Since the IRC bars transferring the ISO to the spouse, a spouse seeking to

maintain an equity interest in the startup following the divorce could agree to one

of the following three alternatives. First, she could agree to maintain her reliance

on the employee through an arrangement whereby the employee remains the

ISO’s holder of record and holds the options in trust for the spouse’s benefit.

Alternatively, the spouse could receive the company’s stock, after the ISOs are

exercised, in a disposition structured to maintain the options’ special tax treat-

ment.

200

This, however, requires paying the options’ exercise price,

201

at which

point the spouse may incur alternative minimum tax (AMT) liability.

202

Third, assuming the startup’s compensation stock-option plan permits such a

transfer, the employee may transfer the options to the spouse immediately

following the divorce. This transfer will automatically disqualify the options from

199. The transfer of the ISO to the heirs of the employee following his death is not a disquali-

fying disposition, I.R.C. § 422(b)(5), nor is the exercise of the ISO by the divorced spouse when the

employee dies after the divorce. See, e.g., Private Letter Ruling, supra note 185 at 10 (“If E [the

employee] dies while X’s [the spouse’s] ISOs are in E’s name, X, as beneficial owner and designated

beneficiary, may subsequently exercise such options and receive and dispose of the resulting stock

with the same tax consequences as if E had exercised the ISOs.”).

200. See id. at 9 (“Under section 424(c) of the Code, a transfer between E [the employee] and

X [the spouse] (or directly from Company to X) of stock resulting from the exercise of X’s ISOs

will not be a disposition of such stock, and all subsequent tax consequences with respect to such stock

will be X’s.”).

201. Scott Kupor, The Lack of Options for (Startup Employees’) Options, A

NDREESSEN

HOROWITZ (June 23, 2016), https://a16z.com/2016/06/23/options-timing/ (“Startup employees get

stock options . . . so if they choose to leave the company . . . they have only 90 days in which to

exercise or forfeit the options. And that’s the catch: Exercising requires cash. Not only do you have

to pay the company the exercise price for each share . . . the IRS then taxes you at year end on the

difference between the then-existing fair market value of the stock and the exercise price.”)

202. I.R.C. § 56(b)(3).

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42 Michigan Business & Entrepreneurial Law Review [Vol. 12:1

ISO status, thus waiving their favorable tax treatment. Instead, the ISOs will be

downgraded to NQSOs. If the employee leaves the startup, the spouse will have

only 90 days to exercise the options.

203

The NQSO can only be exercised by pay-

ing the exercise price, triggering an immediate tax liability. These costs may be

irretrievably lost if the startup proves unsuccessful and fails to produce sufficient

returns for its common stockholders.

204

By contrast, holding the unexercised

option reduces the risk that the exercise price will exceed the share price and

postpones any tax liabilities to a time when the startup is doing well.

205

Thus, treated by the tax code, ISOs are less valuable to the spouse than they

are to the employee since the spouse will lose the part of the options’ value at-

tributable to their favorable tax treatment as ISOs. Nevertheless, as discussed in

Part IV.A, ISOs may yet be more valuable to the spouse because, after the

divorce, she is unlikely to be able to replace the interest she held in the startup

while married with alternative equity rights carrying similar upside,

206

though it

bears mentioning that the employee might nonetheless be more attached to the

equity as a result of his personal work for the startup.

207

While the parties’ relative

valuations will vary from case to case, as it stands, the IRC’s adverse tax treat-

ment pushes spouses to agree to substitute a different asset for her share in the

ISOs when negotiating a divorce settlement. In other words, after a divorce, cur-

rent tax rules make it more expensive for the spouse to hold the couple’s options

than it does for the employee.

Furthermore, while the IRC does not restrict transferring NQSOs, startups

can, and usually do, include such restrictions in their options plans.

208

Even where

an options plan does not restrict transferring NQSOs, the options are not as valu-

able to the spouse as the ISOs would have been. Specifically, NQSOs are subject

203. See Kupor, supra note 201 (“Startup employees get stock options . . . so if they choose to

leave the company . . . they have only 90 days in which to exercise or forfeit the options. And that’s

the catch: Exercising requires cash. Not only do you have to pay the company the exercise price for

each share . . . the IRS then taxes you at year end on the difference between the then-existing fair

market value of the stock and the exercise price.”); C

ARTA, supra note 52(“Over the past 20 years,

the standard post-termination exercise (PTE) window and high cost of exercising have made these

‘golden handcuffs’ a common scenario. Forcing employees to exercise options within a 90-day

window after leaving a company-or lose them-favors people who are already wealthy and can afford

to shell out thousands of dollars for an asset they may be locked up from selling for years.”).

204. See, e.g., Krasny, supra note 4 (explaining the case of Good Technology, an example of a

common stockholders’ lawsuit because, after payment of liquidation preferences to VC investors,

nothing was left for the common shareholders).

205. Unless the option-holder can sell stock immediately following the exercise of the option,

to cover the liability triggered by the exercise, exercising the option is a risky position. Cf., e.g., Stacy

Cowley, Facebook’s Zuckerberg May Face $2 Billion Tax Bill, CNN

MONEY (FEB. 7, 2012, 5:59 PM

ET), https://money.cnn.com/2012/02/07/technology/zuckerberg_tax_bill/index.htm htm (“We

learned from the dot-com bust that people should . . . sell shares to cover the tax bill. . . . People were

exercising options and holding them in anticipation of the stock going up and up. . . . A lot of people

were stuck with huge tax bills and no money to pay the bills.”).

206. See supra notes 126-138 and accompanying text.

207. See supra Part III.

208. See, e.g., S

TOCK OPTION AGREEMENT FORM, supra note 20, at 4.

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Winter 2023] Startups in the Whirlpool of Divorce 43

to a less favorable tax treatment, especially if the employment relationship is

terminated. Upon termination, previously awarded employee options will expire

if not exercised within a short period, usually 90 days.

209

If exercised during that

period, the spouse will not only have to pay the exercise price of the option, but

also incur a tax liability—all at a time when the underlying stock is illiquid. Thus,

the option may be lost because exercising the NQSOs is economically prohibi-

tive. If instead the spouse were to receive ISOs and the IRC were amended to

allow such transfer, the employee’s termination would impose fewer costs on the

spouse since exercising an ISOs does not trigger an income tax liability.

ONCLUSION

Tax rules should not create obstacles to the transfer of ISOs acquired during

a marriage from an employee to his former spouse. The barriers to such transfers

the code currently raises seem to serve no purpose. Evaluating the obstacles posed

by corporate law, however, is more complicated, implicating both ex-post and

ex-ante considerations. For example, is facilitating the spouse’s ability to become

a shareholder in the first place sufficient to justify reducing the rights she will

gain once she becomes a shareholder? More broadly, how, if at all, should cor-

porate law’s treatment of persons who hold only “soft” rights to securities—e.g.,

the spouse before the divorce—compare to its treatment of those with more for-

mal rights? The foregoing analysis highlights the tension between corporate law’s

treatment of the corporation’s shareholders and how it treats the same firm’s

stakeholders by focusing on a stakeholder once removed from a shareholder: a

spouse whose stake in the corporation stems from the possibility that she will

become one of the corporation’s shareholders.

209. The post termination exercise period of 90 days is the requirement imposed on an ISO by

the IRC, which requires that the option-holder will be an employee of the startup or its subsidiary “at

all times during the period beginning on the date of the granting of the option and ending on the day

3 months before the date of such exercise.” See I.R.C. § 422(a)(2).