Monday, 1 February 2016

The "Shotgun Clause" - what is it, and is it fair?

The shotgun clause is an often cited tool used in shareholder agreements to provide liquidity to shareholders. This blog post will briefly examine the shotgun clause and discuss some pros and cons.

What is a shotgun clause?

Simply stated, it is a type of buy/sell agreement between shareholders or partners in a business. The shotgun clause is usually added to a shareholders agreement in order to provide shareholders with liquidity in case one wants to exit the business or partnership. It is usually provided as an option of last resort in cases where the shareholders can't agree or have a significant difference of opinion and need to go their separate ways.

A simple example...

Sam and Tom are 50% partners in an incorporated business that manufactures desserts. Sam wants the company to focus on salty treats but Tom disagrees and thinks sweet treats are the way to go. The two shareholders are at an impasse. According to their shareholders' agreement, they are each entitled to call the shotgun clause in cases where they are at an impasse and need to go their separate ways. Therefore, due to his difference of opinion with Tom over sweet vs salty, Sam would like to use the shotgun clause in their shareholder agreement.

As a first step, Sam would need to set an offer price for Tom's shares.

After Sam offers a price to Tom for Tom's 50% of the company, Tom would then have the option of either:
  • accepting Sam's offer or, instead,
  • Tom could buy Sam's shares at the price that Sam had offered for Tom's shares.

The idea is that Sam wouldn't lowball his offer for Tom's shares because there exists the possibility that Tom could turn the tables on him and buy Sam's own shares at the price he offered Tom.  Theoretically, it should force Sam to be fair in the price he offers Tom.

Seems fair, right? Maybe not....

At first glance it seems quite fair. It appears that Sam would be quite compelled to offer Tom a “fair” price to avoid the risk of his own shares being bought by Tom at too low a price. The two then can part ways without one party getting a low offer.

The reality is that shotgun clauses have the potential of being quite unfair, depending on the circumstances. For example, if Sam knew that Tom just went through a costly divorce and doesn't have the financial means to buy his shares out he could use that knowledge to price his offer at a point that is just out of reach for Tom. Shotgun clauses usually advantage the party that is financially stronger.

Also, in cases where one shareholder has a much larger share of a company than the other shareholder, then the smaller shareholder might not be able to buy the larger stake in the company and could be at a disadvantage for that reason.

There is also the issue of information asymmetry. For instance, if Sam was more involved in the business than Tom and knew that a big customer was on the cusp of signing a long term purchasing agreement with the company and Tom was not aware of this information, then Sam might offer Tom a price that is not reflective of this new information.

There can also be a situation where a business is more valuable to one shareholder than it is to another. This could be perhaps due to personal goodwill which exists for one of the parties, which is not commercial in nature. Again, if there is an asymmetry that exists between the shareholders then there exists the possibility of one party having leverage over the other.

A shotgun clause in a shareholder agreement can possibly be a fair way to exit a business relationship but there certainly are risks and circumstances which may make it not completely fair.

Please contact Steve Skrlac, MBA, CFA, CBV for assistance with a business valuation issue.

Keystone Business Valuations – located in Burlington, Ontario and serving the GTA and southern Ontario.

905-592-1525 •

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