Shotgun Buy-Sell Agreements – Solution to Deadlock

Well-drafted business governance documents include buy-sell agreements to address deadlock among the owners.

A shotgun buy-sell is an offer that sets only the price.  It can be accepted as either an offer to buy out the other side or to sell to the other side at the price in the offer.

Shotgun buy-sells are an efficient means to set the price of a transaction, but may be flawed when the owners have unequal knowledge of the business or inadequate financial resources.

What happens when the owners of a business can’t come to an agreement on an issue that is critical to the business? This happens when neither side has a majority. For example, when there are two 50-50 owners or when unanimous agreement is required and there are holdouts. Our discussion today concerns how the owners of a small business may use contractual arrangements to address this problem.

These contracts are known generally as buy-sell agreements, and that is that they require one party to sell and the other to buy. Now, buy-sell agreements can also include shotgun sales, which is a buy-sell agreement that’s triggered by a deadlock. And we’re going to focus today on the shotgun sale. That refers to the type of agreement that allows one party to set the price and then allows the other the party to decide whether, based on that price, they’re going to buy or sell.

We’re also going to look at an auction sale that offers owners a chance to sweeten their offers to buy. Both of these are related. The well-drafted agreement between the owners of a business will address the issue of what to do in the event that they become deadlocked. This is true of effective shareholder agreements or corporate bylaws, or limited liability company operating agreements, or partnership agreements.

The deadlock is broken by one or more of the owners leaving the business and having their shares purchased. The effective buy-sell, therefore, has two aspects. The first is the obligation to buy or sell. The second is an effective and, to the extent possible, fair means of setting the price. Shotgun agreements are intended to prevent deadlock or to resolve a deadlock.

They encourage compromise. Owners of a closely held business have an emotional as well as a financial investment in the business. And triggering a process in which they may be forced to sell will be seen as a very unwelcome choice.

Let’s look at what the shotgun buy-sell agreement is. What is unique about shotgun buy-sells as a resolution of deadlock is that one doesn’t know when going into the process, who’s going to buy and who’s going to sell.

Shotgun mechanisms provide a means to set a price independently of the determination of who will buy and who will sell. This process is often referred to as cutting-the-cake dispute resolution. One party cuts the cake by setting the price. The other party chooses which piece it wants, by deciding whether to buy or sell. How it works in practice is that most shotgun buy-sell agreements allow a party to declare a deadlock and then to make a purchase or sale proposal by stating only the amount of this sale.

So, a party in a 50-50 percent closely held corporation, for example, may declare deadlock and then set the price per share at $1,000. If the total shares issued are 1000, then that price for a 50% share comes to $500,000. That’s 500 times 1000. The party making the demand has valued the entire business at $1 million. The non-offering party in this scenario is presented with a shotgun demand and now must decide whether it will buy or sell.

The non-offering party in this scenario, presented with the shotgun demand, now must decide whether it will buy the other side’s interests at that price or sell its entire interest in the business at that same $500,000 price.

Typically, if the non-offering party fails to make an election to buy, it will be deemed an offer to sell. In this case, if the offering party thinks the business is worth $1,000,000, then he or she normally would make the demand for a 50% interest at $500,000.

If the non-offering party thinks the company is worth more than the $1 million valuation, then he or she should respond to the demand with an election to purchase the other’s interest at a discount to its value.

If the number is believed to be more than the value of the enterprise, then the non-offering party should elect to sell, here at a premium. Shotgun buy-sell agreements are favored by many drafters of corporate documents because they keep the parties honest and because they are efficient. Cut the cake too cheaply and the other side will choose to bu. Make too rich of an offer and you’re going to get a decision to sell.

Shotguns, however, are based on two assumptions that may not always be accurate. The first is that the parties have equal access to information, and the second is that both have the same resources to make the purchase, if that’s their preference. It may be of little benefit to one party if the slice of cake that’s being offered is really unknown in value, or if the price at which the slice of cake is being offered is simply beyond his or her means, no matter how attractively it’s priced.

One of the principal benefits to a shotgun is that it curtails a nagging aspect about the way we see our world. The things that I have are worth more than the things that you have, solely by virtue of the fact that these are mine and those are yours. That comes up a lot in business divorce cases. Let me give you an example.

A number of years ago, I represented one of two equal owners in a business. We agreed that the relationship could not be salvaged, and the business needed to be sold. Both of the owners wanted to be the buyer. However, the owners both valued their interest more than they valued the other’s interest. The offer that each made to sell was 50% higher than their offer to buy, and both sides had justifications of why they should receive a premium if they sold, including past expenditures of time, money and a claimed superiority in management.

It was fairly clear, however, that the premium requested by each was the consideration they wanted for the emotional price of walking away. In dealing with breakups of a closely held business, particularly those in which the owners are employed, this is a relative phenomenon. Studies have shown that we value our own possessions more highly than we value those of others, and there are a few reasons for this. We worry not just that we may have chosen badly, but we also fear that the other side will unfairly benefit from the bargain. There have been studies that have shown that we will overestimate the value of a $1 lottery ticket, notwithstanding the infinitesimal probability that it has any value. Psychologists refer to aspects of this phenomenon as avoidance of future regret.

We don’t want to feel bad about something in the future, so we worry that we may have given away that winning lottery ticket. And subconsciously we worry about how we might feel about the loss. We worry so much about that remotely possible future event that we will not act in our own self-interest today. The error in this thinking could be addressed by the mechanics of the shotgun offer.

One side cuts the cake, the other side chooses the piece. The premium that one side may place on their interest may inflate the price at which they are obliged to sell out. The process should, under reasonably favorable circumstances, keep the parties honest and on the same page. You’ll also see some of the same benefits when the owners of a business participate in an auction to buy the remaining interest of a business.

It keeps the process grounded in money and not the emotion. The biggest drawback to the shotgun approach to resolving a business divorce dispute is information and liquidity. In many cases, the parties simply don’t have the same information about the business. The offering party maybe works in the business, has better information about the value of the enterprise. And that information may be hidden, or it can be manipulated to cause the other side to make an unwise choice on whether to buy or sell.

And the fact is that most shotgun provisions do not adequately address the problems of inequality in resources. These agreements typically set a timetable or require a deposit and impose pretty stringent penalties for failing to close. They don’t typically address financing or the other issues that are likely to become a factor. They contemplate a cash purchase. Some may provide for terms, but even then, the security arrangements are rarely specified in detail.

Finally, it’s worth noting that shotguns in auctions can often play a role in quickly resolving a lawsuit. Lawsuits can reward extremism. The parties recognize, and often with good justification, that the courts are fairly susceptible to being anchored by proposals that are outside the realm of ordinary results. That’s particularly the case when the litigation will follow the traditional battle of the experts.

And the fact is that in litigation, there’s often very little downside to casting an anchor. — that’s an extreme settlement position. There is no real possibility that the party making the offer may have to accept the terms proposed for the other side. If a court uses a buy-sell, this is a way to focus on a valuation that could be more realistic.

The same is true if the court uses an auction. Shotguns in auctions create the risk that the unreasonable offer will be treated as reasonable and real. Again, that reins in the parties’ behavior.