SHOULD I INCLUDE A “SHOTGUN/ESTRANGEMENT” CLAUSE IN MY BUY-SELL AGREEMENT?
A “shotgun or estrangement clause” (“Shotgun”) is an important clause to consider for buy-sell agreements as it permits for a clean entity break up when one owner is not pulling his weight, two owners just do not see eye to eye, one owner desires to retire or move into other business or personal opportunities, or for any other variety of reasons decides to have a business breakup. It permits one party to invoke such clause without the need for long drawn out negotiations that may put salt in old wounds. However, there are times when it is appropriate and times when it will lead to unfair and one sided circumstances. This short article addresses the situations when a shotgun clause is favorable, when it is not, and some steps that can be incorporated to minimize certain common abuses.
What is a Shotgun Clause:
In short, a shotgun clause is one where one owner (the “Initiator”) has the right or option to either make an offer to sell his interest to or purchase the other owner’s interest (the “Reactor”) at a certain price. For simplicity, assuming the Initiator exercises the option to sell his interest, the Reactor then has a certain time period in which to accept or reject the offer and purchase the Initiator’s interest at the proposed price. If the Reactor rejects the offer, the Reactor must sell his interest to the Initiator at the same price or any pre-negotiated variation of the same. If the Initiator’s price is too high, the Reactor will sell his share receiving a premium, but if the Initiator’s price is too low, the Reactor will purchase the Initiator’s shares at a discount. A shotgun buy out provides a clean way to avoid break up without a long drawn out chaotic entity dissolution involving attorneys, accountants, court proceedings, expenses and costs.
When Shotgun Clauses are Appropriate:
Shotgun clauses have their time and place. They are appropriate for many 2 to 3 person closely held businesses especially when the following are present:
- No Owner is Financially Dominant: If no owner has the right to financially dominate the other, then a shotgun clause would be appropriate. If one has the ability to buy the other out, the financially able owner, the Initiator, may make a heavily discounted offer and purchase the other owner’s interest at such discount knowing that the Reactor owner cannot afford it. Even if one owner has a net worth of $100 million and the other only $5 million, financial dominance depends on the less wealthy owner’s ability to buy the wealthier owner out, not on their relative net worths. For example, in a $5 million business with equal owners, a shotgun clause would work, but if he has a 20% interest in a $20 million business, then it is not likely the less wealthy owner can pay $16 million to buy the wealthier owner out.
- Each Owner has Expertise/Desire to Continue the Business Alone: Both owners must have the desire and expertise to manage and operate the business. If one owner does not, the other owner will sense this and make a discounted offer knowing the Reactor owner does not want to purchase and manage the day to day affairs of the business.
- Limited Number of Owners: Implicitly, the more owners one person has to buy out, the greater he will have to pay in relation to the value of his own interest. For instance, if there are five owners of a $10 million business and if one individual wants to buy the other four owners’ interest out he needs to pay $8 million whereas they only need to pay $2 million. This allows the other owners to indirectly have a financial dominance over one particular owner when exercising their option, as a group, to sell or buy. Further, the more owners, the more likely there will be one or two that do not want to manage the business themselves or have no expertise in how to operate and manage the business.As a general rule, absent a clear financial dominance or one owner being the rainmaker for the business, a shotgun clause buy out should work for up to three owners in most situations.
When Shotgun Clauses are Not Appropriate:
While many closely held businesses will meet the above criteria, there are certain situations where if present, a shotgun clause may permit one owner to “bully” another by allowing the Initiator to purchase the Reactor’s interest at a discount or sell his interest at an unfair premium:
- One Owner is Financially Dominant or has Substantial Control: As stated above, if one owner is financially dominant, he may bully the other owner into accepting a low price. Further, if the owner has substantial control, the owner could choose to exercise a shot gun buy out at a low price knowing the other owner cannot afford the shotgun buy out price.For instance, if there is a 80/20 ownership split for a business worth $10 million, the 80% owner only needs to pay $2 million to purchase the 20% owners out, while the 20% owner would need $8 million to purchase the 80% owner out. Since $8 million in financing may be much harder to obtain than $2 million, the 80% Initiator owner may be able to only offer $1.5 million for the 20% Reactor owner’s interest.
- One Owner Does Not Want to or is Unable to Run the Business: If one owner always wants to be a silent owner, lacks the expertise to manage the business, desires to remain retired or is disabled, it may not be in the interest of such owner to include a shotgun clause.
- Too Many Owners: While it depends on the particular circumstances, a shotgun clause is not recommended if there are more than two or three owners or factions of owners since it adds too much confusion, and leads to an increased risk of a group of financially dominated owners.
- When One Owner is More Vested in the Business: If one owner is more vested in a business emotionally through family history or the business is his pet project, or is his sole source of income, or he has contracts with his related or controlled business, that owner may be bullied into paying a premium to keep access to these emotional and financial interests and ties. For instance, if an owner has a related business receiving $3 million of income from the entity that would disappear if his interest was sold, he may be willing to pay a $1 million premium to keep that contract and source of income or emotional ties.
- Voting or Profit Rights Differ from Proportionate Ownership Percentage: When voting and profit rights differ from strictly proportionate equity ownership, a shotgun clause may not work.For example if two owners own a business 50/50, but one has 60% of the voting rights whereas the other has 60% of the profits interest, an offer of $500 per each one percent of interest does not compare “apples to apples” since each partner’s interest provides a different set of rights. Each owner should have a common set of interests.
- Access to Information: If one owner manages the day to day business affairs and the other is a silent owner, the managing owner will inherently have greater access to information. While it may breach his legal fiduciary duty, he may learn about new business opportunities or risks and fail to disclose them. He may sell his interest to the silent owner if he learns of a new business risk or may purchase the silent owner’s interest at its current value if he learns of a new business opportunity that will increase the future value tremendously.
Steps to Avoid Abuse of a Shotgun Clause Even in Non-Ideal Situations:
Last, since nothing stays the same and circumstances change, certain steps can be taken to counter financial dominance, too many owners and lack of access to information.
- Initiator Pays in Cash While Reactor Pays by Note: One way to avoid a financially dominant owner from bullying a Reactor owner is to require the Initiator to pay in immediate available funds at the Closing and allow the Reactor to pay by a note payable over a number of years with a prenegotiated reasonable rate of interest. Then, if the Reactor does not have the immediate funds or cannot obtain appropriate financing, the shotgun clause automatically provides for expressed financing through the note at a predetermined minimal interest rate to help level the playing field.
- Adding a Premium to the Initiator’s Purchase: Since a financially dominant Initiator would offer a lower price hoping to purchase the Reactor’s interest cheaply, the Reactor could be given the right to purchase at a prenegotiated discounted offered price whereas the Initiator would have to pay this price plus a premium to help negate such discount. For instance, if the Initiator offers a co-owner $5 million for an interest worth $6 million, the Reactor could purchase the Initiator’s interest for $5 million or any variation of the same, but the Initiator would be required to pay the full Fair Market Value predetermined offer price or formula determined Fair Market Value multiplied by 120%, or $6 million.
- The Price Includes a Component to Adjust Post-Sale Growth: To defend against asymmetrical information, the purchase price paid by the Initiator could be payable over a number of years and could be adjusted annually based on post-sale annual performance. For instance, the final price could be increased/decreased X% for each 10% increase/decrease in income for the trailing two years. This avoids asymmetrical information issues as the selling owner has an interest in the continued profitability of the business without having full risk.
- Multiple Owner Buyouts: Instead of requiring one owner to buyout all four other owners, the agreement may enable a particular owner (or group of owners) to effect a shotgun clause against particular owners where the initiating owner sets the price, and the reacting owner decides who sells his interest. This may be a way to buy out a problematic owner without a complete dissolution or long legal battle.
Conclusion:
A shotgun clause is an important and essential addition to many buy-sell agreements for closely held businesses. There are certain times when they are appropriate and not appropriate. Further, certain protections should be considered even if the current situation looks favorable to a shotgun clause as a current situation may change as owners’ fortunes, health interests and circumstances change. However, a shotgun clause is an essential business planning tool that each closely held business should consider and review from time to time.
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