The Shotgun Clause

“Shotgun” weddings are described by my dictionary as forced or hurried.  It is the creation of a union in circumstances where the parties may not be entirely committed to the relationship. 

“Shotgun” clauses in commercial agreements are clauses to deal with the destruction of the relationship, usually when one party is no longer committed to the relationship. 

The shotgun clause is usually designed such that the person triggering the clause offers to either sell all of their shares to the second party for a certain price per share.  The second party then has the right to choose whether to buy the shares or to force the first party to buy the second party’s shares for the same price per share. 

The mechanism can be used vice versa as well, such that the first offer is to buy the second party out.  The ultimate idea is that one person has either buy out the other or sell out to the other at the price set by the triggering party. 

Because the triggering party does not know whether he will be buying or selling, he has to pick a share price that is fair.  If he picks a price that is too low for a buyout of the partner, he takes the risk that the partner will turn it around and buy him out, and vice versa. 

In 2007 or so, the Nobel Prize in economics was handed out for work in mechanism design theory, which includes the study of the ways to optimize trade.  One of the laureates theorized that the fairest way to divide an asset is like cutting a pie in half:  you ask one person to make the cut and the second person chooses which half to take for himself, forcing the first person to make the cut fairly.

The shotgun clause is an extension of the same principles, except that it doesn’t matter where the first person cuts the pie.  The “cut” is what the first party says the shares are worth. 

In theory, it works perfectly.  The theory assumes that both parties have the financial wherewithal to buy out the other. 

However, in practice, it is less than perfect.  Rarely do the parties have the cash laying around to buy out the other.  Rarely do both parties have the same ability to borrow.  The party who is planning to trigger the clause has an advantage in that he can plan for the event, while the surprised party has very little time to exercise his option.

Even though the shotgun clause is not a perfect mechanism for breaking up a partnership, it is one of the best we have.  There are variations, in which the parties agree in advance on an accounting method to value the shares.

Of course, all this discussion presumes that people will actually have a partnership or shareholders’ agreement that they have signed.  Unfortunately, that is all too often not the case.  Those situations make for expensive litigation, which is great, but only if spending thousands on unnecessary litigation is your priority.

Ian Johncox, Civil Litigation/Employment Lawyer/Mediator

Ian Johncox, Civil Litigation/Employment Lawyer/Mediator

Ian practices in the areas of employment law, occupier liability defence, franchise litigation and contract litigation. Ian is a trained mediator and conducts mediations in a wide range of civil (non-family) cases. His employment law practice includes acting for employers and employees, which gives him a balanced perspective to his clients’ issues.

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