Shotgun Clauses – Beware of Shooting Yourself in the Foot (Or Worse!)

October 2018 – Unanimous shareholders’ agreements frequently include a buy/sell clause, commonly known as a shotgun clause, which provides that a shareholder (the “Offering Shareholder”) may send a notice to another shareholder (the “Offeree Shareholder”), whereby the Offering Shareholder offers to purchase the shares of the Offeree Shareholder at a specified price per share and also offers to sell to the Offeree Shareholder the Offering Shareholder’s shares at the same price per share. This is a very effective method to end a co-shareholder relationship when the parties have major disputes regarding the operation of the business and can’t agree on the purchase by one shareholder of the shares of the other shareholder. It presumably keeps the parties “honest”, as the Offering Shareholder will not offer too low a price for the Offeree Shareholder’s shares since the Offeree Shareholder could always accept the alternative offer and purchase the Offering Shareholder’s shares at the same (too low) price per share being offered.

This process, however, is only fair and equitable when the parties are in equilibrium. For example, the Offering Shareholder could offer a less than fair value for the Offeree Shareholder’s shares and try to take advantage of the Offeree Shareholder in the following situations on the premise that it is unlikely that the Offeree Shareholder would accept the offer to purchase the shares of the Offering Shareholder:

1. The Offering Shareholder is operating the company, and the Offeree Shareholder is a “silent partner” who is not able to operate the business;
2. The Offering Shareholder owns a far greater percentage of the shares of the company or has lent a significantly higher amount to it, and the Offeree Shareholder, if it purchases the shares and loans of the Offering Shareholder, would thus have to pay a far greater amount than the Offering Shareholder would if it bought the shares and loans of the Offeree Shareholder;
3. The Offeree Shareholder does not in any event have the resources to purchase the shares and loans of the Offering Shareholder.

The Offering Shareholder should be wary, however, of trying to take advantage of a situation where it believes that the Offeree Shareholder will not purchase its shares. For example, an Offeree Shareholder who is a “silent partner” may be able to hire someone with expertise to run the business, and a shareholder who does not personally have the financial resources to purchase the shares of the other shareholder may be able to obtain financing from a bank or other third party to do so.

The writer has personally seen situations whereby a shareholder offered a price that was significantly less than the fair market value of the shares it wished to purchase on the assumption that the other shareholder would not accept the offer.  In one case, the shareholder assumed that his co-shareholder, being older, would not be interested in running the business, only to find that the Offeree Shareholder’s children were interested in running the business, and the Offeree Shareholder accepted the offer to purchase the shares of the Offering Shareholder.  In another instance, the shareholder assumed that his co-shareholder, being a “silent partner”, did not have the business acumen to run the operations. He was shocked to receive a response that his “silent partner” would purchase the offered shares and take advantage of the timing of the shotgun notice. It turned out that the timing of the shotgun notice would allow the Offeree Shareholder to simply ship the goods in inventory and receive net proceeds from the sale of the inventory in an amount that would make it more beneficial for him to purchase the shares of the Offering Shareholder, sell the inventory and then liquidate the assets of the company.

Careful consideration should thus be given when the unanimous shareholders agreement is being drafted as to whether the parties want a shotgun clause to be inserted in the agreement at all.  If one is included, consideration should also be given as to whether there should be a moratorium period before the shotgun right may be exercised, whether there should be a minimum purchase price per share and whether there should be a limitation on the right of the Offering Shareholder to stipulate certain conditions in the shogun offer, such as amending the non-competition provisions contained in the agreement.  In addition, the risk of setting too low a price for the shares of the co-shareholder when a shotgun notice is being sent should be carefully evaluated.