Are you separating and you or your partner entitled to a share option?
Are you unsure how share options are valued or treated in a Family Law matter?
Read on to find out more about share options and how they are valued and characterised in Family Law disputes.
Share options are increasingly issued to employees as part of their remuneration package or as an incentive-based or performance-based term of employment. It is used as a means of linking employee performance to shareholder value. Typically there is a period of time before an employee is able to exercise the option by purchasing shares which raises two (2) important questions to be answered related to share options in family law property proceedings:-
- Are share options considered property or a financial resource?
- How are share options valued?
WHAT IS A SHARE OPTION?
Before considering how the law answers these two (2) questions it is important to understand what a share option is and the terminology surrounding options.
A share option is the right to buy a share or defined quantity of shares, at a specified price (the “exercise price” aka the “strike price”). As the name suggests it is not an obligation to purchase.
There are two varieties of share options namely:
- American options, which are the most common form, and allows for the option to be exercised at any time up to a specified date (the “expiration date”); and
- European options which allow for the option to only be exercised on the expiration date.
Usually the options that are granted do not vest immediately and the employee will only be entitled to the options after some time and often over a period of years. The shares are said to have vested on the date which the employee becomes entitled to the beneficial interest in the option, that is, the date the options are exercisable. However, it may be that, pursuant to the agreement between the employer and employee, there are still restrictions on the transfer of the options (e.g. that they cannot be transferred to another person or that they can only be transferred for a specific price). Vested options constitute those options where the vesting criteria have been satisfied (e.g. the specified period of time has passed or the employee remains gainfully employed by the employer) and the employee is able to exercise the option, but has not done so. An option is unvested when the vesting criteria has not yet been met.
The exercise date refers to the date on which the option is exercised, that is, the shares are purchased by the employee that is the subject of the option.
ARE SHARE OPTIONS PROPERTY OR A FINANCIAL RESOURCE?
What is the difference between property and a financial resource?
The Family Law Act 1975 (Cth) (‘the Act’) provides a circular definition of property as “property to which [the parties are jointly or a party of the relationship is] entitled, whether in possession or reversion”. The Act does not define what a financial resource is but it can be considered as a financial benefit that is likely to be given to a party in the future such as impending inheritance under a will, long-service leave entitlements, employment/partnership pension schemes or payment as a beneficiary of a discretionary trust, but is not property that a party currently has or is not currently entitled to receive.
The consequences of this distinction are that as an asset, the Court has the power to make orders with respect to property (pursuant to sections 79 and 90SM of the Family Law Act 1975 (Cth)). A financial resource however can only be considered when deciding on a just division of the rest of the property. At best it may result in an adjustment of property to the other separating party. Nonetheless how the Court treats share options can be critical when large portions of the net matrimonial pool are tied up as financial resources.
How does the Court characterise share options?
The Full Court of the Family Court in Hurst v Weber (2009) FamCAFC 137 overturned the decision of Federal Magistrate Baumann who treated the unvested share options as a financial resource due to performance hurdles, including remaining employed with company, which was required in order for the options to vest. The Court determined that they should have been treated as property.
The Court affirmed this view in Nielson & Nielson (2012) FamCA 70 maintaining that employee share options are to be treated as property not as a financial resource with the value of the property to be ascertained by discounting for various risks. Loughnan J commented that property is not determined by its ability to be sold. Importantly in this case the Husband agreed with the Wife that they were property, but submitted that they should be “treated” as a financial resource. The Court rejected this argument holding that if it is accepted to be property, then it cannot be dealt with in some other way.
Crisford J in Beaton & Ballam  FCWA 20 held that unvested employee share options ought to be treated as a financial resource adopting the reasoning of Ryan J in Beklar & Beklar  FamCA 327. Some factors which point to share units being characterised as a financial resource rather than property include whether they can be sold or dealt with before they vest, whether the holder receives nothing more than dividends on the underlying shares prior to them vesting, and evidence showing that the holder is unlikely to be employed when the share units vest.
The Federal Circuit Court of Australia held in Russel & Russell  FCCA 137 that unvested share options were to be considered a financial resource. In this case the husband was granted a number of unvested shares over a number of years, however those shares would only vest and consequently he would only have the right to sell those shares, three (3) years after they were allocated to him, on the condition that the company satisfied a number of performance indicators.
How share options are characterised by the Family Court remains unsettled. Presently each matter is determined by the facts of the particular case. It is arguable that options that, at the time of hearing, are free to be exercised and are ‘in the money’ (that is the share price exceeds the exercise price) ought to be treated as property because they have a net value that can be realised (once various adjustments have been made by a valuer). On the other hand, some factors pointing towards the Court treating share options as a financial resource (assuming they cannot be exercised at the date of the Hearing) include:
- their value is contingent on the share price exceeding the exercise price at some future time but prior to expiration date and they are inherently uncertain and unpredictable;
- they are often contingent on the continuation of employment and/or employee performance targets (that may be affected by forces outside of the employee’s control);
- there may be restrictions on the transfer of the options;
- there may be restrictions placed on the sale of the shares once the option is exercised.
Ultimately a careful analysis of the employee share option agreement is required to assist in determining whether they are likely to constitute property or a financial resource for family law purposes.
HOW ARE SHARE OPTIONS VALUED
The intrinsic value of an option is broadly the difference between the exercise price of the option and the value of the share. For example, the intrinsic value of an option to buy a share for $10 in XYZ Pty Ltd that currently has a share price of $100 is $90. The value of the option lies in the opportunity to take advantage of increases in the share price, hopefully as a result of employee performance, over the period of time before the expiration date.
The longer the period of time until the expiration date the greater the opportunity for the share price to increase and as such the greater the value of the option. As the time period before expiration draws to a close the less prospect there is of an increase in the share price and as such the total value of the option converges with the intrinsic value. This is known as the time value of an option and will impact any valuation that is undertaken in a determination of the value of a share option in a Family Law matter.
Valuing share options will often require an expert valuation by an accountant and can involve a number of methodologies. Each share option will be different and subject to its own agreement which will need to be examined to determine a valuation.
There are a number of factors that affect the value of the share option including:
- the underlying value of the share;
- the exercise price;
- the time to expiration;
- the stability and predictability of the share;
- the risk-free rate;
- the dividends expected during the life of the option (if any).
In valuing share options a number of discounts are typically applied to account for a range of factors, most fundamentally that they are an uncertain asset that may or may not provide value to the holder at some time in the future. Discounts are also applied for:-
- Lack of marketability, that is, the liquidity of the option is low (relevant to unvested options only);
- Tax liabilities;
- Risk of the holder ceasing to be employed before vesting date (usually only if there is some evidence of likelihood of the employee not remaining employed);
- Accounting for inflation and the opportunity cost of interest earning;
- Restrictions on transfer;
- Performance hurdles that are outside of the option holder’s control;
WHAT ALTERNATIVES ARE THERE IF PARTIES CANNOT AGREE ON HOW TO CHARACTERISE SHARE OPTIONS OR THEIR VALUE
Unfortunately, due to the uncertain nature of how to characterise and value share options, parties in a Family Law property dispute may disagree considerably as to these two (2) issues. The parties can obviously allow the Court to reach a determination, however, in circumstances where they cannot agree and do not want the expense of litigation there are some other alternatives that should be considered.
Parties may consider a deferred settlement arrangement for unexercised options based on an agreed distribution once the options are exercised and a determinable value is realised. Alternatively parties can enter into an ongoing maintenance Order, may allow for reimbursements or cash adjustments to be made in the future once the options have been exercised.
In any event it is clear that the law surrounding share options is not clear and legal advice, as well as the advice of an accountant or forensic valuer, should be obtained.
Doolan Wagner Family Lawyers offer specialist family law advice in St Leonards on Sydney’s North Shore. If you have recently separated or have a Family Law enquiry, please contact us on (02) 9437 0010 or email@example.com to discuss your matter in complete confidence. We have a team of experienced and caring professional family lawyers available to help you in this difficult time.
These posts are only intended as an overview or comment on current issues that may interest you and are not legal advice. If there are any matters that you would like us to advise you on, then please contact us.