Business partnerships are hard. What if you and your business partners couldn’t get along? Or, what if you and your business partners couldn’t agree on a major business decision resulting in deadlock? How do you move past such a roadblock? A company’s well written operating agreement or buy-sell agreement should address these concerns. One possible solution to these potential issues is the “shotgun clause”, also referred to as a deadlock provision or a “Texas shoot-out”.
Although varying methods can break up a deadlock, a common method is a Texas shoot-out provision which states that an owner has the option to either (1) buy out the other owner or (2) be bought out and exit the business. A shotgun clause essentially operates as an “I cut, you choose” method. In this scenario, two individuals can agree to share a piece of cake by having one cut the cake and the other choose his piece. Likewise, in a deadlock situation, one owner sets the price for the company and “cuts the cake”, while the other owner “picks the piece of cake” and decides whether to buy or sell his ownership in the company. Specifically, the owner being presented with the offer has the option of either accepting the offer and selling his interest or purchasing the other owner’s interest at the same price.
In theory, the Texas shoot-out is an easy way to settle disputes and offer clarity during an impossible situation. In reality, it could lead to abuse by the owner with the most money. For example, if one owner was cash poor or otherwise did not have easy access to capital, the owner with more capital could simply set an offer price that the cash poor owner could not meet. The outcome could force an owner, who wants to remain with the company, to sell his interest in the company at a value that may or may not be the fair market value. On the flip side, the owner who wants to stay may receive a large payout to move onto his next venture.
One way to combat this possible abuse is to designate a valuation method for the company. You could either (1) choose a valuation equation to be used, or (2) elect to use a third party appraisal (or an average of several appraisals). Another way to limit abuse is to only use the Texas shoot-out to be invoked for certain key matters. The advantage being that a buyout could not be forced unless a true deadlock situation had occurred.
In addition to a pre-determined method to establishing purchase price, the owners should consider pre-determined terms of payment. This includes how long an owner has to make a decision once presented with a deadlock clause and how the payment will be made. For example, will the purchase price be payable immediately or will the purchase price be paid over time through a promissory note? If a promissory note can be used, then you should also determine the basic terms of the promissory note, such as the term, interest rate, and consequences of default.
The shotgun concept can be applied to a company with more than two owners, although this process is a bit more complicated. Each owner is offered the opportunity to purchase his pro rata share from a selling owner. If any owner chooses not to purchase his pro rata share, then the remaining owners have the opportunity to increase their percentage ownership interests by purchasing the remaining unpurchased interests. Several combinations of this method could be used as long as an owner is entirely bought out.
Aside from the Texas shoot-out, the owners could consider appointing a third or independent party to handle disputes, such as a trusted advisor, or the owners could divide the business in a split-off arrangement where each owner takes a piece of the business. The moral of the story is that you have options in the event of a deadlock. While you can’t have your cake and eat it too, you may be able to pick the piece.