3 Mistakes You Might Be Making If You Have a Shotgun Clause

I got a frantic call from a client a few years back. Her business partners triggered their shotgun clause, and she had to figure out if she should accept the offer or buy out her other partners… in the next week.

“How much is this company worth? I’m not sure I can get financing to buy out the other shareholders. Is their offer a fair price?” She wondered anxiously.

She went on, “I’m locked out of the office and am trying to get my hands on the latest financial statements. I have ones from last year; can you just use those? What else do you need?”

I told my client that the three biggest mistakes I see people make when they have shotgun clauses are:

1. Not knowing the approximate value of their business at any moment

2. Not regularly surveying your access to funding

3. Not having all the monthly financial reporting saved offsite

First things first – what is a shotgun clause?

A shotgun clause is a clause in a partnership, joint venture or shareholders’ agreement that provides liquidity to the shareholders through a mechanism to buy your partner’s share or sell your share to your partner.

The person who triggers the shotgun clause provision is called the offering partner. They make an offer to buy the other’s interest at price X (the specified price) and, at the same time, are willing to be bought out for that same specific price.

The recipient of the offer decides whether they want to accept price X for their share or buy out the offering partner at the same price. Shotgun clauses can also be called a buy/sell clause or a buy/sell provision.

Know Your Company’s Valuation

People often fall under the false impression that the value of their shares is what someone is willing to pay for them. WRONG. If all of a sudden, your partner exercises the shotgun clause and you get an offer for your shares, you need an idea of what the fair market value of your shares is so that you can compare the price to the value.

When there is a shotgun clause, the offered price is considered a fair value if both parties have similar financing capabilities. More often than not, two parties do not have the same access to financing.

A key consideration will be how you and your partners view the future and, therefore, the approach value. If your business is on a significant upward trajectory, you and your partners will consider future cash flow projections and the risk of achieving those cash flows in the determination of value.

Conversely, if you are unable to project the future or think the future will be like the past, a multiple of historical earnings may make sense. In either case, if I were a shareholder and had a shotgun clause, I would want to have an idea of the value of the business and an idea of my partner's view of the pricing of the firm.

Know Your Financing Ability

Does the other shareholder have deeper pockets than you? If your shareholders’ agreement has a shotgun clause, it is prudent to be aware of the financial resources you have access to and at what cost.

If you end up in the position of buying out the other partner:

• Are you able to get that much financing from a bank?

• What will that do to the available cash flow from operations?

• How long will it take you to pay off financing?

These are all important considerations that should be contemplated well in advance of a transaction and considered on a regular cadence as the value of the firm increases, as cash flow from the business changes, and as the leverageable assets of the firm change.

Don’t Ignore Monthly Financials and Metrics

As a partner or shareholder in the business, you likely receive monthly financials, but do you take stock of what has happened in the last month? Do you save them offsite? If your partners want you out of the business, you might find yourself working from home with limited access to all the details that once were at your fingertips. While there may be legal remedies to obtain that information – wouldn’t it be helpful if you had your files up to date?

A lot of my clients don’t pay close attention to monthly data. Whether you’re short on time, don't think the monthly data has the same impact as quarterly or annual data or aren't the numbers person in the business - if there is a shotgun clause in your shareholders’ agreement, you can’t afford NOT to be on top of the data.

Conclusion

So – if you have a shotgun clause in the agreement that governs your business partnership – let this serve as a reminder to be prepared for the execution of a shotgun clause.

As your business grows in value, cash flow changes, and the value of your leverageable assets change, reconsider whether you are on top of your valuation, your financing ability and what's in your treasure chest of data.

Action Items

1. Those with shotgun clauses best be prepared for the unexpected. Make sure you’re regularly collecting and saving the data you need for a business valuation.

2. If you have a shotgun clause in your partnership or shareholders agreement, be prepared for its execution and how your business would be valued.

3. This information does not constitute legal advice! Talk to your legal counsel when in doubt.

4. Have you and the other shareholders agreed upon an exit strategy? If not, the Exit Strategy Formula training is a great place to start so that you're ready for the unexpected.