Shotgun clause

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"Shotgun clause" is a term of art, rather than a legal term. It is a specific type of exit provision that may be included in a shareholders' agreement, and may often be referred to as a buy-sell agreement. The shotgun clause allows a shareholder to offer a specific price per share for the other shareholder(s)’ shares; the other shareholder(s) must then either accept the offer or buy the offering shareholder’s shares at that price per share.

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[edit] Discussion

Typically, an exit clause is triggered in situations where a business partnership has severely deteriorated, and so the situation is often likened to a divorce. In the same way that drawn-out battles between a splitting couple can often leave any children with emotional damage, so too can a business be damaged by drawn-out fighting between its owners. For this reason, experts in the area emphasize the importance of including an exit clause in a firm’s shareholders’ agreement in order to minimize the negative impact of a business-divorce. As with a prenuptial agreement, it is important to set out an exit clause early on in a business relationship when interests are still aligned and partners still like each other.

Shotgun clauses are usually recommended for companies where there are two owners with equal shares in the company, roughly equal involvement, and similar financial resources although they are by no means limited to these situations . If the shareholders are not in an equal position and of equal circumstances, then one of them may have no choice but to sell and consequently the other may, through the triggering of the shotgun, work an injustice on the other.

[edit] Process

The shareholder triggering the clause offers to buy the shares of the others at a specific price per share. The other shareholder(s) must then either accept the offer and sell their shares, or buy the triggering shareholder’s shares at that same price. Alternatively, the clause can be structured so that the triggering shareholder offers to sell his shares at a specific price per share, and the other shareholders can then accept the offer or sell their shares to the triggering shareholder at the set price.

The timeline is generally very short, although there are no hard and fast rules. It would not be unusual to have 20-40 days to elect to sell or buy, and another 20 to 40 days to close. If the recipient of the offer does not respond in the allotted period of time, the offer is assumed to have been accepted.

[edit] Rationale

The clause is most applicable when both partners want to run the company, but not together, and an amicable buy-out cannot be reached . It serves as a sort of “last resort” method for solving these disputes, while also helping to ensure that a “fair” price is offered. Since when triggering a shotgun clause the offering partner does not know whether she will end up buying or selling her shares, she must – in theory – pick a price that she would find acceptable in either outcome, thus preventing large over- or under-valuations of the firm. However, this only works when the partners are roughly equals in terms of their financial situation, and in their involvement with and their ability to run the business.

A certain amount of strategy enters into how and when to trigger the shotgun clause with the offering shareholder having the incentive to guess at the other shareholder’s ability to finance a buy-out. If one is financially limited, or unable to run the company on his own, then the other can trigger the clause and offer a low price for the shares, gambling that their partner will have no choice but to accept. In this sense, the shotgun clause favours shareholders with stronger cash resources, and encourages shareholders to pull the trigger when the other shareholder(s) are weak . This problem is exacerbated by the fact that obtaining financing from banks is difficult in these situations, due to the shotgun transaction’s very short timeline. Private equity and venture capital firms that provide funding for these situations can help to level the playing field (see Financing section below), although they are limited in number.

The shotgun clause is also biased towards shareholders with a greater ability to run the company themselves. A partner who is capable of running the business on her own would be able to offer a lower price than a partner who could not. For example, if one shareholder became disabled or seriously ill, he might be unable to manage the company. The other shareholder(s) might take advantage of the situation by triggering the shotgun clause at a low value, knowing that the other shareholder would not be able to buy them out for health reasons.

[edit] Financing

Shotgun clauses tend to favour those people with cash readily available. Once a shotgun clause has been triggered, shareholders can often face difficulties obtaining traditional financing in order to buy the other shareholders’ shares, due largely to the very short timeline of the transaction. Financing commitments from traditional banks typically take too long to obtain, and lenders often avoid situations where management conflicts are likely to disrupt the business. This means that owners facing a triggered shotgun clause are often forced to rely on their own resources if they wish to fend off being bought out. However, there are some private equity and venture capital firms that specialize in providing capital for shotgun situations. The first and best known of these firms is The Shotgun Fund. (http://www.shotgunfund.com)

[edit] Economics

In academic circles it has been argued that, under certain circumstances, these clauses are not economically efficient in that the partner who values the company most is not always the one that ends up buying the company. De Frutos and Kittsteiner suggest in their paper that in order to ensure an efficient outcome, there should not be a contractual obligation for the party who triggers the clause to name the price. Instead, they advocate including in the termination agreement a clause stating that the parties will negotiate for the right to be the person who chooses whether to buy or sell at the price specified by the other partner. They suggest that this negotiation takes the form of an ascending auction where the shareholders bid for the right not to set the price per share. Each partner raises his/her bid continuously, but either partner can drop out of the auction at any time. The party that drops out becomes the one who must propose the price per share, but that person receives a payment from the other partner equal to the bid at which the auction ended. The first and most well known of these specialty firms is The Shotgun Fund(tm).

[edit] References