Typically, employers just don't care about ideas that are outside their line of business. After all, if I come up with a great social networking site but my employer is a financial software company, stealing my social networking IP will just be a distraction from their business activities. They're worse off for taking ownership of the IP.
Do tell your employer what you're doing and clear it with them. Aside from being the honest thing to do, it also sets you up to get formal legal permission. If they're not willing to do so, you know that immediately and can weigh your options from there, including quitting or giving up the startup.
In some cases, your employer may even give you money, advice, and customers. I once worked for a company whose CEO was the former CTO of Cybersmith (the gaming cafe company that went bust around 1999). She came up with an idea that was useful for Cybersmith's business but was not something Cybersmith was willing to put resources into. Cybersmith became her first (and only, it turned out) customer and gave them significant resources to fund development.
"3) The CEO will sign a document releasing our specific idea from the IP Agreement. Has anyone heard of this happening with success before??"
This happens more often than you think. The most prominent example is Apple Computer - Steve Wozniak was on HP's payroll when it was founded, and needed HP to sign away their rights to the Apple I. One of my cofounders is in the process of getting a similar release from Sony Entertainment, and I'll probably need something similar from my employer (I have verbal permission already).
agree with above, and just went through this a week or two ago. i got a letter from my company saying they have no ownership stake in what i'm doing (an extra complication was that i'm working part time in the office and part time on my idea as part of an agreement we struck.) it cost me like $1,000 out of pocket to get an attorney and a letter drafted saying my employer has no "right, title, or interest" in my new venture and related patents/applications/copyrights/etc., but in the grand scheme of things it's a no-brainer to make sure the IP around the idea/new business is clean.
if you have questions about this shoot me an email at houston at alum.mit.edu ... it was a pretty straightforward process.
I think the best answer though is probably the one you don't want to hear--option #1 (quitting and doing the startup only) is going to be best. Read Paul's comments about the need for focus and determination. If a startup isn't 100% focused on success then it probably won't get it.
You could try your option of going back as a contractor or doing part time work. Part time consulting though is tough. Keep that in mind. If you're on a tough project and you're only supposed to do a few hours here and there one of two things will typically happen: 1) you'll get sucked into more work, 2) they'll find somebody else that can give 40+ hours a week.
I've got the same issue now so we're in the same boat.
The company I'm currently at is actually really cool about stuff like this, so getting permission shouldn't be a problem. My concern was more the legal aspect, if the startup ever got the point of being considered for VC funding or being acquired. I wouldn't worry about my company taking legal action as much as scaring away investors or a company. I just want to sort out the legal issues before diving in full force...
Do tell your employer what you're doing and clear it with them. Aside from being the honest thing to do, it also sets you up to get formal legal permission. If they're not willing to do so, you know that immediately and can weigh your options from there, including quitting or giving up the startup.
In some cases, your employer may even give you money, advice, and customers. I once worked for a company whose CEO was the former CTO of Cybersmith (the gaming cafe company that went bust around 1999). She came up with an idea that was useful for Cybersmith's business but was not something Cybersmith was willing to put resources into. Cybersmith became her first (and only, it turned out) customer and gave them significant resources to fund development.
"3) The CEO will sign a document releasing our specific idea from the IP Agreement. Has anyone heard of this happening with success before??"
This happens more often than you think. The most prominent example is Apple Computer - Steve Wozniak was on HP's payroll when it was founded, and needed HP to sign away their rights to the Apple I. One of my cofounders is in the process of getting a similar release from Sony Entertainment, and I'll probably need something similar from my employer (I have verbal permission already).