Peter Mahler’s recent post, “Aim Carefully Before Pulling Trigger on Shotgun Buy-Sell Agreement,” reminded me that there are still some shotgun buy-sell agreements out there in the world.
You can read about the case at the link above. It ended up somewhat surprising, as virtually all shotgun agreements do. Mahler begins the post as follows:
At least on paper, shotgun provisions in shareholder and operating agreements provide an elegant and efficient buy-out solution when business owners can’t get along and need a divorce.
Today we use Mahler’s shotgun buy-sell agreement case as a spring board to discuss this form of buy-sell agreements. At the outset, let me say that I do not recommend shotgun agreements to clients. Excerpting from Buy-Sell Agreements for Closely Held Business Owners, you will see why as you read on.
Shotgun agreements are found in some buy-sell agreements, but we do not see them regularly. Often used to break deadlocks between owners, a shotgun buy-sell agreement is an agreement where, upon the occurrence of a trigger event, one party makes a determination of price and the other party chooses whether to buy or sell at the given price.
- Require agreement at a point in time, usually between shareholders of a corporation, or else between corporate joint venture partners.
- Relate to transactions that may or will occur at future points in time between the shareholders, or between the shareholders and corporate joint venture partners, or between corporate joint venture partners.
- Define the conditions that will cause the buy-sell provisions to be triggered. These are the business conditions that will trigger the operation of the buy-sell agreement, and the obligation to purchase shares pursuant to the agreement.
- Determine the price (per share, per unit, or per member interest) at which the identified future transactions will occur. The shotgun process will determine the price at which future transactions will occur, but no one knows until an offer is made what that price will be.
One version of a shotgun agreement might require that:
- One party is called upon to offer a price at which he or she will buy or sell.
- The other party then has the right to buy or sell at that price.
- In either event, the “shotgun” aspect of the agreement requires that there be a transaction, but the initial offeror does not know whether he or she will be a seller or a buyer at the time the offer is made.
- The concept is quite simple. The initial offering side (which will that be?) virtually has to name a reasonable price, since it is a price at which that side must be willing to sell or to buy. However, there are two implicit assumptions with these agreements that may not be met:
- Both sides have sufficient financial capacity to engage in the transaction, and
- Both sides are sufficiently knowledgeable about the business and are able to make an informed offer or to evaluate the offer made.
“Advantages” of Shotgun Agreements
As with formula and fixed price agreements, shotgun agreements appear simple. Advantages include:
- Easy to understand. Once the shotgun mechanism is decided upon, the parties know that it may be invoked at a point in the future upon the occurrence of a trigger event.
- Easy to negotiate. The logic of shotguns can seem compelling. All we have to do today is to agree that one party will have to name a price at which they will be willing to sell or to buy, and the other party has to similarly agree that they will buy or sell at that named price.
- Inexpensive. The agreement requires less legal documentation and no appraisers to determine the price.
- Pressure for reasonable price. As we have already noted, there should be pressure on the initial offering party to establish a reasonable price.
There are definitely some disadvantages to shotgun buy-sell agreements, which include:
- Implicit assumptions may not hold. The parties seldom have equal financial capacities and may have different knowledge about the business. For example, a non-operating shareholder may be at a distinct disadvantage in terms of making an offer to buy. Assume there are two operating partners, each owning 50%. Certainly a shotgun agreement is fair, or is it? Assume further that one partner dies. The surviving spouse is not active in management and might be at a distinct disadvantage.
- Minority shareholders may be at a disadvantage. It is easier for a 90% shareholder to acquire a 10% interest than vice-versa. A smaller shareholder, unable to swing the big deal, may have to offer a relatively low price in order to ensure his/her capability to either buy or sell, thereby increasing the odds that the other side will buy.
- Uncertainty as to final outcome. Relative to fixed price and formula agreements, there is great uncertainty as to what will happen when a shotgun agreement is triggered. Sellers usually don’t want to become buyers, or vice versa.
Parties engaging in shotgun agreements need to be sure they have thought through the implications of a trigger event under all reasonably possible scenarios. Even if this is done, I am hard-pressed to think of an ideal situation for a shotgun buy-sell agreement. The first exception that comes to mind might involve large corporate venture partners. However, even with such partners, one would be at a distinct disadvantage relative to the other if it were undergoing difficult financial circumstances at the time of a trigger event.
If your buy-sell agreement includes a shotgun provision, it would be a good idea to “repeal and replace” that provision with a workable pricing mechanism. To read more about buy-sell agreements, take a look at my Kindle book, Buy-Sell Agreements for Baby Boomer Business Owners. It is priced for immediate download and is a full length book.
For more information, take a look at the Ownership Transition Bundle, which includes (print books) Buy-Sell Agreements for Closely Held and Family Business Owners and Unlocking Private Company Wealth for a bargain price of $35 (plus shipping of your choice).
Later this week, we will continue with the #5 post in the Handbook on Business Valuation for Business Owners (see #4 here).