Under California law, spouses divide shared property equally when they divorce. Stocks, particularly restricted stocks and stock options, can be one of the most complicated assets to split in a divorce. Understanding how to split stocks in a divorce means identifying which stock options belong to the community, the married couple as a unit, and which belong to one spouse alone. Once you know who owns what, you must determine their value.

Determining how much a stock is worth, particularly a stock subject to a vesting condition that has not yet vested, typically requires guidance from a professional well-versed in valuation calculations. The Stratte Firm has experience applying various valuation methods and, when necessary, consulting accountants for assistance. If you need help with dividing stocks, reach out to speak with us.

What Property Must You Divide During Divorce?

As a community property state, California courts divide community assets and debts equally in divorce. California Family Code (FAM) 2550. Before dividing assets and debts, the court classifies the property either spouse owns as community or separate property. FAM 2551.

Community (Marital) Property

Under FAM 706, a married couple’s community property includes most property obtained during the marriage. Collectively, all community property is the community estate, which may include:

  • Income,
  • Real estate,
  • Intellectual property,
  • Business interests,
  • Retirement benefits, and
  • Stocks and stock options.

Anything that is not community property is considered to be separate property. FAM 770.

Separate (Nonmarital) Property

Based on FAM 770, assets are separate property if obtained:

  • Before marriage,
  • After separation,
  • As a gift to one spouse only,
  • Through inheritance, or
  • As rents or profits from a spouse’s separate property.

Property is also separate if the couple has a premarital or marital agreement that is signed by both parties and not patently unfair. FAM 1611-12, 1615.

Spouses may disagree as to the precise date their separation occurred. Generally, the date of separation is when at least one spouse resolves to divorce and communicates that to the other. FAM 70. That communication ends the community, and property obtained after that point is separate.

What Types of Stocks Might an Employer Offer Employees?

Employers often offer stocks as an incentive to attract and retain talented employees. While employers may offer ordinary shares in the business, alternative stock types, including preferred stocks and stocks with vesting requirements, are common.

Preferred Stocks

Preferred stocks typically entitle the stockholder to dividends, which the company distributes on a distribution schedule. A preferred stockholder gets higher distribution priority than common stockholders. If the business does not have enough cash flow to distribute to all stockholders, the company distributes dividends to preferred stockholders first. What remains goes to common stockholders. Preferred stockholders also have higher priority in the event of liquidation. The business distributes liquidation proceeds to preferred stockholders first, then what remains to common stockholders.

Restricted Stocks

Restricted stock units (RSUs) do not officially transfer until they vest. The employer sets vesting conditions, which may include:

  • A schedule where an employee receives the stocks after working for the company for a set period of years;
  • A tiered vesting system where the employee receives stocks over time on a schedule based on their time with the company; or
  • Performance-based vesting, such as after the employee brings in a certain amount of revenue.

Restricted stocks are a form of compensation but do not count as income until they vest. Regardless of whether the employee receives liquid funds, they count as income in the year they vest, and the employee pays taxes on that income.

Stock Options

Stock options entitle an employee to the right to purchase stocks in the company at a specific price, called the strike price. A stock’s strike price is typically its fair market value when the employee begins work or otherwise receives the stock option. Stock options allow employees to purchase stocks at the strike price, even if the fair market value has increased significantly.

Like restricted stocks, stock options often have vesting requirements. Some stock options are “call” options, where the employee can exercise the option with few limitations. Many stock options, however, set a vesting schedule that only allows the employee to exercise the option after a set period has passed.

Unlike restricted stocks, stock options do not guarantee income when the vesting period ends. Once the option vests, the employee must affirmatively decide to exercise it by purchasing shares. Whether the stock counts as income when the employee purchases it or when they sell it depends on how the business structures the option.

How to Split Stocks in a Divorce

To split stocks in divorce, identify all stocks and stock options that either spouse has, then determine:

  • Whether the stocks are community or separate property,
  • Whether those stocks have vested, and
  • The value of all stocks in the community.

Once you know which stocks are part of the community estate and what they are worth, you divide your community property through negotiation, mediation, or courtroom litigation.

Whether stocks are community or separate depends on when you received the stock option or restricted stock, not when it vests. To properly divide the community estate, you need to determine the value of any unvested stock at the time you divorce. Because many elements of estimating the value of unvested stocks are speculative, accurately estimating value can be complicated and usually requires expert guidance.

When Are Stocks Marital Property?

Stocks with actual, present value are marital property if the employer provides the stock during the marriage. If the employee receives a stock option or restricted stock unit during the marriage, it is marital property, even if the stock has not vested.

Yet, if you wonder, for example, Is my spouse entitled to the appreciation in the value of stock that I obtained before the marriage? The answer is generally no. Because the underlying stock is separate property, the appreciation in value is, too.

Stock Valuation Methods

To determine a stock’s value, you may use one of several stock valuation methods, which vary based on what kind of stock you have. Notably, many of these methods involve complicated formulas that can be difficult to apply without guidance.

Preferred Stock Valuation Formula

To calculate the value of preferred stock, you can use the preferred stock valuation formula, P = D/r, where:

  • P = Value of preferred stock;
  • D = Fixed annual dividend payment; and
  • r = Required rate of return.

A stock’s required rate of return is the minimum rate the stockholder expects to receive. Determining what r should be typically requires a secondary calculation of the required rate of return. Common formulas to calculate r include the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC) method. Both require comparing risk with expected return to estimate value.

Restricted Stock Valuation 

The value of restricted stock depends on:

  • Its price on the date you complete the valuation;
  • The expected volatility of the stock price during the vesting period;
  • Expected taxes upon vesting;
  • Likelihood of vesting; and
  • The length of the vesting period.

To estimate the value of restricted stock, calculate how much it will be worth when it vests. Then, you determine the relative accuracy of your estimate by considering how likely the price is to increase or decrease. The value may decrease if the stock is unlikely to vest or increase if likely to vest.

Next, estimate the taxes the employee will owe, combining their expected earnings with your estimated value. Finally, the stock’s value typically decreases the longer its vesting period is. This decrease in value is based on the time value of money, the principle that money now has more value than money in the future because of its investment potential.

Stock Option Valuation 

Stock options are optional. Yet, they have significant potential value, making estimating the value of stock options in a divorce essential. To estimate the value of a stock option, first determine whether the option is:

  • In the money (ITM)—current price has surpassed the strike price;
  • At the money (ATM)—current price is relatively equal to the strike price; or
  • Out of the money (OTM)—current price is less than the strike price.

If the stock is ITM, subtract the strike price from the stock’s current price to determine its value if the employee exercised the option on the day you make the calculation. You multiply that number by the number of stocks the spouse has the option to purchase to determine the overall intrinsic value.

When a stock option has not vested, modify the intrinsic value by approximating the stock option’s extrinsic value. A stock option’s extrinsic value changes over time based on the amount of time left before an option expires and the option’s implied volatility, which is the market’s view on how likely the stock will increase or decrease in value.

Extrinsic value is an estimate of the probability that a stock will have a particular value when the employee exercises their right to purchase the stock. ATM options have the highest chance of increasing or decreasing in value, giving them higher extrinsic value than OTM or ITM stocks. A stock’s extrinsic value is also typically higher when there is more time before the option expires. Accurately estimating extrinsic value requires familiarity with general and specific market trends.

Professionals may also use the significantly more complicated Black-Scholes or Black-Scholes-Merton (BSM) model. While the result is often more precise, the formula is difficult to apply accurately.

The Importance of Experienced Guidance

Accurately estimating the value of unvested stocks requires knowledge that does not come naturally to many. Yet, when you divide unvested stocks in divorce, you estimate the value at the time of division, not at the time the stock vests. As a result, consulting professionals with experience valuing unvested stocks is often essential.

The Stratte Firm represents clients in family law matters involving complex asset division. We can help resolve valuation complications, even as to the value of unvested stocks. Contact us to learn more.

Resources:

California Family Code § 70, link.

California Family Code § 760, link.

California Family Code § 770, link.

California Family Code § 2550, link.

California Family Code § 2551, link.

California Family Code § 1611, link.

California Family Code § 1612, link.

California Family Code § 1615, link.