Divorce in the Land of Startups
| Publication year | 2014 |
| Pages | 47 |
| Citation | Vol. 43 No. 12 Pg. 47 |
Articles Family Law
Divorce in the Land of Startups
By Dale E. Johnson
Family Law articles are sponsored by the CBA Family Law Section to provide information to family law practitioners. Articles focus on practice tips and discussions of current issues within the realm of family law.
Coordinating Editors
Patricia A. Cooper, Denver, of the Law Office of Stephen J. l-iarhai—(303) 329-8300, tcooper@harhai. com; l^eredith Patricl
About ttie Auttior
Dale E. Johnson is a former chair of the CBA Family Law Section and past president of the Colorado Chapter of the American Academy of Matrimonial Lawyers— dale@dalejohnsonfamilylaw.com. His office is located in Louisville. He acknowledges the assistance of Evan Branigan, an associate at Dale E. Johnson, P.C, in preparing this article.
This article offers some helpful hints for the family law attorney in a dissolution of marriage action where one party is an equity partner in a non-public startup company.
Colorado is home to many promising startup businesses that are not publicly traded. In 2013, Boulder was the top city in the United States for tech startups.[1] When an investor in a non-public startup company is caught up in a dissolution of marriage action, competing duties imposed by business law and family law could create significant problems for the family law attorney. This article provides an overview of these issues.
A Brief Introduction to Business Law and Terminology
There are numerous knowledgeable investors and investor groups who are willing to risk putting money and labor into startup companies. Investors are compensated in many forms, including stock units, stock options, restricted stock, and promissory notes convertible to stock.[2] In many cases, these investments are tiered such that one class of investors has rights that differ from those of other investors. The rights of each group are usually contained in the grant documents, but sometimes they are contained in operating or other agreements referenced in the grant documents.[3] These grant documents can also provide for cash calls and other obligations that bind the investor. Some option rights trigger tax consequences when they vest, even when there is no public market to trade the stock.[4]
Nondisclosure Agreements and Fiduciary Duties startup companies are subject to federal and state regulations. Investors are often required to sign documents stating that they understand the risks involved and that they have a certain level of net worth such that they can afford to assume the risk of future cash calls or loss of the investment.[5] They are also commonly required to sign a nondisclosure agreement (NDA) with the company, which prohibits them from disclosing company information or documents to third parties. Violations of an NDA can result in loss of investment rights and even claims for damages. Third parties may include a spouse, attorneys, accountants, and other professionals.
It is not unusual for the investor to be a member of the board of directors or an advisory board for the company. Such board membership will generally create fiduciary responsibilities.[6] Sharing of information with third parties by someone with insider information can trigger both SEC civil actions[7] and criminal sanctions.[8] Moreover, because the startup world is competitive, investors have to be concerned about many risks, in addition to the possible violation of securities or criminal laws. Intellectual property rights being developed must be protected. The internal financial status of the company must be guarded so that competitors are not provided this information.
Family Law: Disclosure Requirements
Colorado law has long provided that spouses stand in a confidential relationship to each other. Each has the responsibility to act in good faith and fairness to the other.[9] This rule is now embodied in Colorado Rule of Civil Procedure (Rule) 16.2, which provides that parties in a dissolution of marriage action stand in a "special relationship to one another and to the court system"[10] and that
[p]arties to domestic relations cases owe each other and the court a duty of full and honest disclosure of all facts that materially affect their rights and interests and those of the children involved in the case.[11]
The Rule also provides for a duty to "supplement or amend any disclosure in a timely manner" and for a five-year look back on non-disclosed property, which includes non-disclosed liabilities.[12]
Dividing Non-Assignable Equity Rights
Business and family law rights and duties can clash. The rights associated with equity interests, including unvested rights, are almost always non-assignable under the terms of the grant documents. In a dissolution of marriage context, that means a party with such rights cannot directly transfer any portion to that party’s spouse pursuant to a dissolution of marriage decree. In many instances, the grant documents mandate a loss of the equity rights (for example, a forced sale back to the company at some set value that could be far below the actual value) should a transfer occur.
Moreover, it is generally against Colorado public policy to force a spouse to accept a property division that forces the spouse to stay in business with the other spouse post-decree.[13] The reasons for this policy are obvious. The spouse holding the interest may be close friends with or part of a family that controls the business. Forcing that party’s ex-spouse to take a minority interest in such a business could subject the spouse to economic coercion and lead to further litigation. Forcing the owner–spouse to bring an angry or disruptive ex-spouse into such a family business can have similar negative results. Spouses can agree to stay in business together after the divorce, but a court cannot order it over the objection of either party, unless exceptional reasons support such a result.[14]
Both spouses often wish to settle the property division by dividing these non-assignable rights as an in-kind division. Both spouses may believe (reasonably or not) that the startup will hit a financial home run in the near future and want to share in the perceived potential upside. An in-kind division also avoids the cost in attorney fees and expert fees associated with trying to value the interest. To value an interest in a close corporation requires access to company financial materials by valuation experts. Depending on the company, this can be expensive and intrusive, even if the company is willing to cooperate. If the company resists providing access to the necessary financial information, the cost of obtaining that information, along with the costs of expert witnesses, may be enormous and not worth the cost to the marital estate. This is particularly true where the rights involved are high risk. In addition, even if valued, the parties may lack the funds to effectuate a buy-out of the rights within a reasonable time period.[15] There may be no way to secure the buy-out and the risks associated with a deferred buy-out may be unacceptable to the payee spouse.
There have been numerous articles written about valuation of a closely held corporation interest, including discussions of how to obtain documents, how to discount interests, and how to structure buy-outs.[16] Valuation issues are important, but this article focuses on the issues that must be addressed where both parties agree with an in-kind division approach rather than valuation and buyout of the asset.
Representing the Investor Spouse
The attorney representing the investor spouse should make certain that the non-investor spouse has access to the same documents regarding the rights and interests being divided as does the owner spouse. The attorney must do this while maintaining the confidentiality required under an NDA. In m any cases, the non-investor spouse has already seen some of these documents and will have been privy to conversations regarding the interests involved. Despite the nondisclosure agreements executed by the investor spouse, it is common for spouses to discuss the prospects of the company and the investment. Investors and their spouses often socialize with other investors and their spouses and their conversations will likely include discussion of the startup. The non-investor spouse may also have access to files where the documents are maintained on a home computer and may copy or move them in contemplation of dissolution without the investor spouse’s knowledge or consent.
Representing the Non-Investor Spouse
The attorney representing the non-investor spouse should obtain all the pertinent documents as soon as possible. However, to avoid triggering a violation of any NDA signed by the investor spouse, the non-investor spouse may have to enter into a separate NDA with the company before the documents are provided. At the time of a dissolution of marriage, emotions can run high. The expectations of the non-investor spouse regarding the company’s future may be unrealistic. The non-investor spouse may not understand the possible dissipation of the value of the...
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