Many lawyers recommend that small companies put forced buy-sell, i.e., ‘shotgun’, clauses into their founding agreements as a way to cover a business partner ‘divorce’.
In a typical shotgun clause, any partner can approach the other, at any time, with a forced offer to buy or sell their shares within a fixed deadline, at a named price per share. The person at the receiving end of the shotgun has only one choice: they can choose whether to buy all their partner’s shares, or sell all of their shares. One or the other transaction must happen, within the deadline (ranging from as short as 48 hours to 30 days), at the price named by the person who triggers the shotgun.
These forced buy-sell clauses are a bad idea for three reasons:
- they strongly favor the richer party: if you don’t have enough capital to buy out your partner, or have easy access to that capital, the triggering of a shotgun is a very dangerous event. If you are short of cash, don’t know people with money, and don’t know where to look, you have no choice but to sell. Even if you know where to look, people typically say it takes 3-6 months to raise financing for a small company: you’re being asked to do it in 30 days or even far less. As a result, you may be forced to sell at a cheap price, not because you want to, but because you can’t raise the cash to buy out your partner in the short time window you have.
- they are very disruptive to other shareholders: outside investors invest in a founding team. If there are troubles within the team, they want a mediated divorce settlement which is best for the company. They don’t want to wake up one day and discover that one person has forced the other out of the company, in a way that gives them zero incentive to keep supporting the company. If you have a shotgun clause in your shareholder agreement, new investors may force it to be removed. However, sometimes it is a side agreement between the two people involved: in which case investors who do not do detailed diligence may not discover it (in fact, I was in a company which went through detailed diligence from a government fund, where we had a shotgun side agreement between the founders – not with the company – which never came up in the questioning).
- they are an ongoing source of negative emotions: as I know from first-hand experience. First, they are stressful. Every time you have an argument you worry that your partner might ‘pull out the shotgun’. Given all the other stresses of running a small business, you don’t need the added stress of knowing that you can lose everything at any moment. Secondly, they encourage ‘evil fantasies’ where you dream of getting rid of your partner smoothly and easily, rather than working things out.
Vesting is a far better solution. With vesting, you are forced to cooperate for the benefit of the company. You both still have a stake in it, even if one person’s becomes much larger when the other person leaves. This encourages negotiated settlements, which benefit the other shareholders. If you want to walk away, you can still negotiate a sale agreement … failing which you can try to find an outside buyer for your shares. You have the luxury of time to negotiate this transaction.
And if someone isn’t contributing, you can take that conversation to where it belongs: to the board, rather than taking the person out ‘behind the woodshed’ with your ‘shotgun’.