If you own shares in a private corporation, you have likely heard of the “shotgun buy-sell” mechanism. What is it? Why have one? Is it a good thing to have? How does it work?
I’ll give you a brief overview of this important and practical legal provision in this and the next article.
What is it? A “shotgun buy-sell” is a provision in a shareholders’ agreement that sets out a detailed procedure to follow if at least one of the shareholders doesn’t want to carry on business with the other shareholders anymore. The wording has become fairly standardized and is usually about two to four pages long.
The shotgun buy-sell is one type of buy-sell that can be used. There are various other, less drastic, buy-sell clauses that are sometimes used, and each has its pros and cons. However, the shotgun buy-sell has continued to be a favourite choice of business law specialists for corporations having two or three shareholders (not many shareholders, for reasons that will be obvious once I explain how it works). If you are, or are thinking of soon becoming a shareholder of a private corporation with at least one other shareholder other than your spouse, you should understand the why and how of ‘the shotgun’.
But first, let’s consider why you might want or need such a provision. Basically, it’s because once you’re a shareholder of a private corporation (one that is not listed for trading on an exchange), you have virtually no way to get out of that corporation unless you have a specific, express written exit provision. Really. There is no active or legal market for your shares. There are legal restrictions in the constitution (articles and by-laws) of the corporation. The approval of the Board of Directors or a majority of shareholders is customarily required on the proposed sale of your shares. Ontario securities laws also severely limit the way private company shares can be sold.
Besides, the other shareholders of your corporation won’t allow you to sell to just anyone – they likely have a veto over any proposed transfer. There could be a shareholders’ agreement in place that restricts any sale, without providing for a way out for you. The other shareholders don’t have any legal duty to buy your shares.
Guess what? You’re stuck! … for life – or longer. After you die, your estate will be stuck with the shares unless there is a mechanism for forcing a deal on the death of a shareholder. Corporations have perpetual existence – that is one of their foremost unique features, as contrasted to sole proprietorships and partnerships, which can disappear or dissolve by virtue of certain actions, omissions or events.
But surely, you can buy out the other shareholders of the corporation? No. They have no obligation to sell to you. They can stick around perpetually, too.
Well then, can you go to Court and get a judge to unravel the ownership? Probably not. There is a process for getting a corporation wound-up by a Court if the “corporate partnership” has broken down, but this rather draconian relief power is rarely exercised by the Courts. Winding-up an operating business with employees to distribute its assets amongst its bickering shareholders is considered to be harsh medicine.
Courts don’t like to interfere with private business dealings unless there is no alternative and some grave injustice is occurring. The Courts are especially reluctant to intervene if there is any agreement in place amongst the shareholders, even if that agreement is deficient or unfair (in hindsight).
It’s capital incarceration. The restrictions described above apply to the founding principals of a corporation, and also, contrary to the wishful thinking of many people, to the employees, friends and relatives of the owners. All of the shareholders are stuck together for perpetuity. How scary is that?
So, I think I’ve demonstrated why you need some kind of buy-sell provision as a shareholder in a private corporation, assuming you don’t like the idea of being trapped perpetually in a corporation. The question is, “Why use a shotgun buy-sell provision?”
Stay tuned to this space next update, when I’ll talk about how the shotgun works and why it is the preferred method of providing an exit.