While business partners will usually be totally optimistic at the time of start-up, it is important to provide for a solution to unresolvable disagreements. This post considers three different solutions by which business partners can go their separate ways. Each of these establishes a procedure whereby one shareholder can buy out the other shareholder(s) or force the other shareholder(s) to buy, or require the other shareholders to co-operate in a sale of all shares in the business.
1) Shotgun Provision
The “shotgun” is the most commonly used provisions in shareholder agreements and works best with two shareholders, although it can work with more shareholders. Under this provision, one shareholder presents another shareholder with an offer to purchase all of the other shareholder’s shares in the business at a specified price. The other shareholder then has two options:
i) sell all of the other shareholder’s shares in the business to the offering shareholder at the specified price; (or)
ii) buy all of the offering shareholder’s shares in the business at the same price.
This result is that the offering shareholder is either bought out or ends up owning 100% of the business. The shareholders’ agreement will usually, or should, set out all of the terms that will apply to any sale.
There are some potential disadvantages of shotgun provisions. First and foremost, they are not ideal if there is disparity between the economic strength of the shareholders. If one shareholder has considerably more financial means than the other(s), a shotgun provision can result in a situation where a stronger party can effectively force a weaker party to sell shares to the stronger party for consideration below market value. Another issue to be considered is where one of the shareholders has considerable operating knowledge about the business that might put the other partner, especially a passive partner, at a disadvantage by having to step into managing the business when they have no past experience or contacts with the customers or suppliers.
Furthermore, a shotgun provision may not be ideal in the early stages of a business. One party could choose to exit or force another party out before the business has gained much value. To avoid this, it is recommended that a provision be included in the agreement that states that the “shotgun” provision, or for that matter any similar provision, may not be exercised until after the business has been operating for a certain period of time, say three to five years.
2) Put option, with option to buy or cause sale of 100% of business
One alternative to the shotgun provision is to provide the shareholders with a ‘put option’. This enables a shareholder (an “Offering Shareholder”) to request that the other shareholder(s) purchase the shares owned by the Offering Shareholder at a price specified by the Offering Shareholder. If the other shareholder(s) decide not to buy the Offering Shareholder’s shares, the Offering Shareholder has the option to buy the shares owned by the other shareholder(s) or cause the sale of 100% of the shares of the company.
The advantage of this provision over the shotgun provision is that the Offering Shareholder cannot find himself forced to be the buyer. There is, however, still a risk that the other shareholder(s) may refuse to co-operate in a sale of 100% of the shares of the Company, however the agreement can contain penalties for refusal to co-operate.
3) Private Auction Provision
Under a private auction, one shareholder can require that all shares in the business be placed on auction. Only the shareholders can bid at the auction. A minimum starting price and minimum bid increments can be set. The auction continues until one shareholder’s bid is accepted by the other shareholder(s) or the other shareholder(s) do not respond with a higher bid.
Essentially this is a variation of the shotgun provision, that provides all shareholders with more control over the price at which shares in the business are ultimately bought or sold. The private auction also reduces the risk of stronger economic parties taking advantage of weaker economic parties because it increases the likelihood that a buyout will occur close to the market value of the shares.
There are a variety of provisions that can be used in shareholder agreements to govern shareholder buyouts or provide for the sale of a company in the event of a breakdown in the relationship between shareholders. To further discuss these provisions or other aspects of shareholder agreements, please contact Frank Shostack, senior corporate and tax lawyer at Devry Smith Frank LLP. You can reach him directly at 416-446-5818 or by email at email@example.com
“This article is intended to inform. Its content does not constitute legal advice and should not be relied upon by readers as such. If you require legal assistance, please see a lawyer. Each case is unique and a lawyer with good training and sound judgment can provide you with advice tailored to your specific situation and needs.”