Beware of pitfalls in the next-to-vest coverture formula for valuing stock options.

By Arik Van Zandt, Business Valuator

Next-to-Vest Coverture Formula

The value of stock options held by one or both parties in a dissolution offers unique challenges. If the stock option is out of the money as of the date of dissolution, is it really worthless? Likewise, is the full value of the stock option being captured by simply including the intrinsic “in the money” value at the time of dissolution? What element of post-separation duties (e.g. service or time) are required to achieve the value of the option? One of the fundamental items of a stock option that is generally overlooked is the vesting schedule itself. While many states use a next-to-vest coverture formula for determining the value of options during marriage, the vesting schedule itself creates differences, potentially significant differences, in the implied value based on the case law.

The coverture formula determines the separate v. marital allocation of shares based on a relationship between the date of separation and the grant date, as compared to the vest date and grant date. The timeline (above, right) displays what will be considered separate and marital propert – or a combination of the two – based on the date of employment, marriage date, separation date, and various stock option grant dates.

Effect of Different Vesting Schedules

Using a Valuation ExpertChanging the vesting schedule can have a significant impact on the separate v. community nature of a particular stock grant. Assuming a stock award of 2,000 shares with an award date of January 1, 2014 and a separation date of March 31, 2016, the difference in the shares allocation to community property would be over 20% less if the vesting schedule were quarterly rather than annually. One of the reasons for this is that the next-to-vest tranche of stock is significantly smaller when vesting occurs on a quarterly v. annual basis (125 shares v. 500 shares). Therefore, fewer shares are allocated to the community prior to separation by applying the next-to-vest coverture formula simply due to the vesting schedule. There are significantly different implied values, all while using the same formula. The above example is for one award that occurred during one year of marriage; if there were additional stock option awards granted during the course of the marriage, the effect of the vesting schedule on separate v. marital allocation would also carry a potential significant difference in value allocated to the marital community simply based on the vesting schedule of the awards.

It is convenient to simplify a situation down to a formula, but with that comes the consequences of varying results. In this case, the various vesting dates created dramatically different separate v. marital outputs when simply applying the next-to-vest coverture formula. n

Arik Van Zandt is a Managing Director with Alvarez & Marsal Valuation Services in Seattle. He specializes in the valuation of closely-held businesses and other assets, acquisitions, sales, buy-sell agreements, ESOPs, and incentive stock options.