Bringing a startup from an initial idea to the point where it turns a profit, can be advantageously sold, or goes public is an undertaking that requires enormous dedication, skill, and luck. Many founders and key startup employees put everything else in their lives on the back burner to make their dream a reality, knowing that an equity stake in a startup that makes it big can be a life-changing financial windfall. Unfortunately, that entrepreneurial ambition, with its high demands, long hours, and intense stress, can also take a toll on a founder’s closest relationships.
When someone with equity in a startup business gets divorced, they may be shocked to find out that their spouse could well have a claim on a share of the business they’ve worked so hard for. The emotional turmoil of their marriage dissolving is then compounded by the fear that they may lose control of what they’ve worked so hard to build. Property division is often one of the most contentious and tricky parts of a divorce, but it can be even more complicated when startup equity is involved. Accurate valuation, as well as correctly determining what (if any) portion of startup equity is marital property, must be undertaken to ensure that negotiation over property division is informed by the facts necessary to facilitate a property settlement that is fair to both parties.
- When Is a Startup Marital Property?
- Determining the Value of a Startup in Divorce
- Protecting a Startup During Divorce Proceedings
Need Help Protecting Your Startup Before & After A Divorce?
When Is A Startup Marital Property?
It is often the case that only one member of a couple is involved in a startup, but that does not mean their equity share of the company is theirs alone. Because California is a community property state, property and debt acquired by either spouse between the date they got married and the date they separated is generally considered to belong equally to both. The first question, therefore, is when the startup was formed.
If the business was started prior to the marriage, then it may be considered separate property, not subject to division. However, that characterization can change, at least in part, in certain circumstances—for instance, if marital funds were commingled with startup funds, or if the business increases in value during the marriage. If it was formed during the marriage, then the non-founder spouse will most likely have an equal claim to the founder spouse’s share of the company. In cases where there is dispute or uncertainty about what portion of a startup, if any, should be considered marital property, it is best to consult a knowledgeable family law attorney to determine how the law applies to the facts of your situation.
Keep in mind that although California law specifies that each spouse is entitled to half of their marital property, that does not mean they must split every asset down the middle. It can be possible to negotiate a settlement that grants the ex-spouse a greater share of other marital assets to enable the startup founder or employee to retain their full equity.
Determining The Value Of A Startup In Divorce
Business valuations for startups are always somewhat tricky, even when there is no divorce forcing a look at what a company is worth. Growing startups will often undergo evaluation as they seek new funding, adjust their strategic planning, or position themselves for mergers and acquisitions (M&A). Unlike a business with an established history and earnings, however, a startup may not have a product or service to sell yet, much less steady income, depending on its stage of growth. This can make the selection of an appropriate business valuation method difficult.
Traditional methods of business valuation can have significant shortcomings in evaluating startups, particularly those in the early stages of growth. For example, a market approach relies on comparison with similar transactions, which may be lacking for startups with novel business concepts. Asset-based valuation may struggle to assign an appropriate worth to intangible assets such as intellectual property, while also failing to consider prospective earnings. Furthermore, an income approach is most appropriate for a business that has positive cash flows, which may not be the case for an early-stage startup that hasn’t yet brought a product to market.
To get a more accurate picture of a startup’s worth, it may be necessary to use an alternate valuation method such as discounted cash flow (DCF), which estimates the value of an investment based on its future cash flows. Outside valuation advisors are often hired in a divorce to produce an independent assessment of a business’s worth. It is important to examine the evaluator’s assumptions about the company and the valuation method they use to ensure that both fit the situation.
Protecting A Startup During Divorce Proceedings
While anticipating things going wrong may seem coldhearted, the best opportunities for protecting a startup during a divorce come well before the breakup of a relationship is contemplated. For example, those entering a marriage with a startup should have a prenuptial agreement that clarifies the status of the business as separate property. It is even possible to protect a startup that was founded after the start of a marriage with a postnuptial agreement, though this must be done before a separation or divorce is contemplated. Either type of agreement should be created with the assistance of an experienced family law attorney to ensure its provisions are enforceable when they are needed.
A startup’s governing documents may also include provisions that limit how an equity interest in the company can be transferred, particularly if there are multiple founders or startup employees with equity interest. These can include blocking the transfer of equity to an ex-spouse, removing management authority from unauthorized equity holders, and creating a framework for initiating a buyout of an ex’s interest. Governing documents may also specify how valuation will be calculated for such a buyout. If this is the case, a spousal consent form would have been required to ensure that the spouse was aware of and consented to these provisions.
Regardless of what potential division of assets you may be facing, bringing in an experienced divorce attorney as soon as possible can help protect your interest in your startup. The right lawyer can help ensure that the facts of the case and any legal protections already in place are fully understood, provide referrals to appropriate experts who can produce an accurate business valuation, and challenge mistaken assumptions or conclusions that may result in an unbalanced property settlement.
Expert Family Law Representation For Entrepreneurs in Silicon Valley
If your divorce has you uncertain about the future of your startup, the experienced attorneys at Hoover Krepelka can help you find your way forward. We’ve worked with countless entrepreneurs over the years to help them protect their assets and safeguard their businesses in a divorce. To schedule your consultation, fill out the form below.
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