Using a shotgun clause in a shareholders' agreement
What is a shotgun clause
The purpose of a shotgun clause in a shareholders' agreement is to provide a mechanism where a shareholder can at short notice fully exit the company, or buy out the others completely.
The shareholder who triggers the clause offers the other shareholders a specific price at which she is willing to buy out all the others, or at which they must buy his or her shares completely.
Some shotgun clauses may allow other shareholders to make counter offers.
The entire process, from triggering the clause to completing the sale is usually given a short deadline. How long it takes depends on the wishes of the shareholders when they agree to the provision, but it can be as little as a couple of months.
The name "shotgun clause" reflects the speed at which the buyout happens and that the event is "terminal" to the majority of shareholders.
Why include it as a provision within a shareholders' agreement?
One reason for including such a provision is that it is a means of resolving a complete breakdown in relations between shareholders. When shareholders are no longer talking to each other - especially when one is active in the management of the company, but the other is not - the business may suffer, reducing the valuation for all shareholders. A quick exit should have less negative impact on the performance of the company.
Are they common?
Shotgun clauses are fairly unusual because although in theory it is beneficial for the company and neutral for the shareholders, in practice, there are a number of disadvantages.
Pricing is difficult
In theory, the shareholder who exercises the clause should pick a price that values the company fairly - one at which she would find it as fair to buy as to sell.
However, valuing shares is an art rather than a science.
Intellectual property and other intangible assets are often given conservative or zero values on the books under accounting rules. The true value of these is often not recognised in the offer price. Additionally, some valuations can be "asymmetrical" in that the value of intangibles to different shareholders may be different. For example, the customer database may be more valuable to a shareholder who has a contact to whom he or she can sell it, than another shareholder who has no such contacts.
There are many valuation methods, from discounted cash flow to net assets. None of these is "correct" and depending on which is used, the valuation for the company will vary enormously. If shareholders use different methods, the share price offered won't reflect the true "economic" value of the company.
The price offered can only be as good as the information that the shareholder has about the business. Accounts are typically produced for shareholders at longer periods, certainly annually, possibly quarterly. Much can change within the business in a short time, and since the shotgun clause can be triggered and completed within a matter of months, shareholders may not have the information they need to be able to decide whether to sell or buy.
Shotgun clauses tend to favour director-shareholders
Since all other shareholders are bought out, the one who remains tends to be one who is confident he or she can run the business herself. Running a business on a day to day basis, especially after upheaval of other investors leaving is very different from being a less active shareholder. Therefore, it tends to be senior director-shareholders who are the ones left with the business.
Shareholder-directors also have the advantage of being closer to the business on a day-to-day basis, and more able to determine the current value of the business. They may also have closer working relationships with employees that they can persuade to stay on. Since the disruption tends to be less, the company is worth more to them than other investors.
A shareholder-director may be approached by a third party willing to buy the company at a much higher price than the shareholder would have to buy out the other investors. He or she could keep the offer secret, exercise the shotgun provision, and profit greatly.
Knowing that a fellow shareholder cannot run the business by himself or herself (for instance, following accident or inheritance) can allow another to take advantage of that situation and trigger the shotgun clause at a lower price than if the shareholder was able to run the company. The price of the shares then becomes heavily influenced by each shareholders' inability to run the company, not the performance of the company.
Shotgun clauses favour shareholders with access to finance
Buying out other investors may not be possible if one shareholder does not have the cash to do so. So the clause might not be triggered unless the one triggering it knows that he or she has the cash to buy out the other, and the other has the cash to buy out him or her.
Alternatively, he or she might trigger it knowing that the others might not be able to buy out him or her at any price she offers - giving him or her an advantage in being able to buy the others out at a "lower than true value" price.
Or more than one might have access to finance, but one at a preferential rate of interest to the others. Provided all can run the business effectively, the "winner" is the one with access to the best rate of finance, not the one who is best placed to run the company.
Should you include a shotgun clause in your shareholders' agreement
At Net Lawman, our belief is that shotgun clauses are not in the interests of most shareholders, which is why we don't include them in our shareholder agreement templates.
In theory, such a clause offers a solution to deadlock, but we believe in practice that there is rarely a situation where shareholders in dispute wouldn't be open to an offer to be bought out if the relationship had soured by that much. Shotgun clauses are not "fair" as a exit mechanism in practice and can be taken advantage of far too easily. There are better alternative ways of controlling ownership such as drag along (explained here) and tag along clauses (explained here).
Please note that the information provided on this page:
- Does not provide a complete or authoritative statement of the law;
- Does not constitute legal advice by Net Lawman;
- Does not create a contractual relationship;
- Does not form part of any other advice, whether paid or free.
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