The Business Divorce Law Report
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Buy-sell agreements, like a shotgun sale triggered by a deadlock, are the principal means by which the owners of closely held businesses protect against the worst consequences of deadlock.
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Commonly used shotgun provisions allow one party to set the price and allow the other party to decided whether to buy or sell at the offered price. Closely related to the shotgun is an auction that allows offerors a chance to sweeten their offers to buy.
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The compelled sale of an equity interest triggered by a buy-sell agreement will be subject to the fiduciary duty of loyalty and the implied covenant of good faith and fair dealing.
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Courts may apply shotgun or auction techniques when compelling the sale of a business as a going concern.
A well-drafted agreement between the owners of a business will address the issue of what to do in the event they become deadlocked. This is true of effective shareholder agreements or corporate by-laws, limited liability company operating agreements or partnership agreements.
Agreements that are intended to prevent or resolve a deadlock in most circumstances will contain language that in some circumstances will require the exit of one person from the business. This exit, in turn, requires payment of the value of the equity interest of the departing owner.
In this post, the last in a series on deadlock in the closely held business, we look at buy-sell agreements as a means of breaking deadlocks without litigation and, in particular, a form of buy-sell often referred to as a shotgun. A buy-sell often avoids or greatly simplifies litigation between the deadlock owners of a business, sure. It also has the effect of avoiding deadlock in the first instance.
A Series Examining Deadlock Among the Owners of Closely Held Corporations, Limited Liability Companies and Partnerships
Shotgun provisions are a form of weapons control, like the mutually assured destruction that has – thankfully so far, at least – kept the world powers from global conflagration. Owners of a closely held business have an emotional as well as a financial investment in a business and triggering a process in which they may be forced to sell will be seen as a very unwelcome choice. In many cases, shotgun language in governing documents triggers compromise among the owners of a closely held business.
Buy-Sell Agreements Triggered by Deadlock
Most agreements that are intended to address deadlock are in the form of a buy-sell agreement that commits one party to buy and the other to sell. What is unique about buy-sells as a resolution of deadlock is that one doesn’t know when going into the process who will buy and who will sell.
Perhaps the most common provision that is intended to prevent litigation over deadlock is the shotgun provision. Shotgun mechanisms provide a means to set a price independently of the determination of who will buy and who will sell. The process is often referred to as cake-cutting 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 make a purchase or sell proposal by stating the amount of the sale. A party in a 50-50 owned closely held corporation, for example, may declare a deadlock and set the price per share at $1,000. If the total shares issued are 1,000, then the number is $500,000 (500 times $1,000.) The party making the demand, therefore, values the entire business at $1 million.
The non-offering party in this scenario presented with a shotgun demand now must decide whether it will buy or sell its entire interest in the business at that $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 million, he or she should normally make the demand for a 50 percent interest at $500,000. If the non-offering party thinks the company is worth more than the $1 million proposed, he or she will 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, the non-offeror will elect to sell — at a premium.
Knowledge is the Currency of Buy-Sell Agreements
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 buy; too rich an offer will bring a decision to sell.
Shotguns, however, are based on two assumptions that may not be accurate, that the parties both have equal access to information and that both have equal resources to make the purchase if that is their preference. It may of little benefit to one party if the slice of cake that is being offered in an unknown value or if the price at which it is being offered is beyond his or her means, no matter how attractively it is priced.
One of the principal benefits to a shotgun is that it curtails a nagging aspect of the way we see our world: the things that I have are worth more than the things you have, solely by virtue of the fact that these are mine and those are yours. Here’s 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 buy.
The owners valued their interests more than they valued the other’s interest. The offer that each made to sell was almost 50 percent higher than their offer to buy. Both sides had justifications why they should receive a premium to sell, including past expenditures of time and money and a claimed superiority in management ability, it was fairly clear was that the premium requested by each was the consideration 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 relatively common phenomenon.
Studies have shown, first, that we value our own possessions more highly than others. There are a few reasons for this. We worry not just that we have chosen badly, but we also fear that the other side will unfairly benefit from the bargain. The same studies show that we will over-estimate the value of a $1 lottery ticket, notwithstanding the infinitesimal probability that it has any value. Psychologists refer to aspects of this phenomena as avoidance of future regret. We don’t want to feel bad about something in the future, and so we worry that we may have given away that winning lottery ticket and subconsciously how we would feel at the loss. We worry so much about that remotely possible future even that we will not act in our self-interest today.
Moreover, many closely held businesses represent not just an investment to their owners, but their employment. Owners typically work in and derive their income from the business, and will have a difficult time separating the value of the income they provide — a salary for the work they perform — from the owner’s equity.
The owner of a business that takes $200,000 a year from a business doing work that it would cost $190,000 to replace is invariably reluctant to admit that his or her equity only generates $10,000 a year in income. There is a fear, of course, that the work will not be available. But there is still an unwillingness to distinguish between the value as owner (the goodwill that is in the business) and the value of steady employment.
These errors are readily exposed by the mechanics of the shotgun offer. One side cuts the cake and the other chooses the piece. The premium that one side may place on their interest may inflate the price at which they are obliged to buy out their partner. The process should, under reasonably favorable circumstances, keep the parties honest.
Fairness Considerations in Shotgun Buy-Sell Agreements
In some cases, the parties may have unequal information about the business. The offering party may work in the business and have better information about the true value of the enterprise, information that may be hidden or that can be manipulated to cause the other side to make an unwise choice on whether to buy or sell.
The party that makes and then takes advantage of an unfair offer, however, will invariably breach a fiduciary duty. Once the breach is discovered, a not so very unlikely event, litigation will follow and the abuse should ultimately be remedied.
Unequal resources among the parties, however, are likely to form an impediment to a truly objective valuation and, moreover, are not so likely to trigger a fiduciary duty. It is one thing to cut the cake fairly, but if one of the parties cannot access the resources to choose a piece, then the process may be decidedly unfair.
Most shotgun provisions do not adequately address the problems of inequality in resources. These agreements typically set a timetable, require a deposit and impose penalty provisions for failing to close. They rarely address financing or other issues that are likely to be a factor.
The Problems with an All-Cash Shotgun Deal
Most shotgun provisions contemplate a cash purchase. Some will provide for terms, but even then, the security arrangements are rarely specified in detail. In an arms-length sale of a business, it is common that the buyer will make use of the cash flow the business to finance the sale. It is also common that at least some of the consideration for the sale of a closely held business will be in the form of payments for consulting services, as consideration for an agreement not to compete and as interest on a note, all of which may be a deductible business expense.
Purchasing equity in a business typically means a cash purchase with after-tax dollars. To buy a company for $1 million will often mean that the purchaser had to earn $1.5 million. In the acquisition of many closely held businesses in which the cash flow of the business provides a source for payment of the purchase price, that tax bite is a significant consideration and a source of significant negotiation.
In considering whether to make or how to accept a shotgun offer, however, the availability of liquid resources is a key consideration. If the non-offering party cannot raise the cash to elect the purchase of an interest, it may not matter that the offering party has made a fair offer, or even an unfairly low offer, Many small businesses cannot raise the funds for such an acquisition through a loan at reasonable rates, and the non-offering party that wants to buy may have difficulty putting together the financing.
Does the tendering of a shotgun offer knowing that the other party cannot possibly raise the money to accept it as an offer to purchase raise the issue of a fiduciary duty of fairness? In those cases in which there is a bona fide deadlock, the court is likely to enforce the agreement as it is written. Most judges adhere to the maxim that it is not for a court to write a better contract than the parties wrote for themselves.
Pulling the Trigger of the Shotgun
One of the ways in which the unequal resources of the parties may come to the surface is when there is a basis to believe that the demand for a buyout was not made in good faith. Such circumstances might exist, for example, if one owner contrives a deadlock or makes a demand under questionable circumstances and the effect is to coerce a purchase and sale at a price that is overly favorable to the party making the demand.
The owner of a business that is subjected to such tactics should litigate. A court will examine the circumstances underlying the claim of deadlock determine whether there is a valid claim of deadlock — that is the inability to make decisions in such a way that the welfare of the business is jeopardized — and look at other issues such as materiality of the issues on which the parties are deadlocked.
A court is much more likely to look closely at a claimed deadlock when there is the potential that one side is going to benefit from the shotgun transaction at the detriment of the other. The owners of a business are in both a contractual and a fiduciary relationship, and a judge will look closely at the implied covenant of good faith and fair dealing when it appears that one side is trying to deprive the other of the full value of the business.
Nonetheless, if the offering party acted in good faith, even if self-interested, and if the shotgun provision was validly invoked, then the mere fact that the outcome is harsh is not likely to trigger direct intervention.
Auctions as Variations of the Shotgun Sale
In some circumstances, an auction between or among the members, with or without the involvement of third parties, may provide the best method of identifying the buying and selling parties and of assuring a fair price. Certainly, the process is more transparent. There is a downside to an auction, however. It is well-recognized that auctions often fail to realize the maximum return for the owners without sufficient interest from buyers. Indeed buyers attend auctions in the hope of buying an asset for less than its realizable value. The market generated in an auction sale may be at a discount to other measures of value.
When two or more owners are in competition for control of a business, an auction is often a very suitable solution, however. It is closely related to a shotgun in that the offering party may have the opportunity to pay a price of his or her own choosing, even to pay a premium. It is also a process that presumes a cash purchase price and which gives the liquid party leverage over those with less resources.
It is very different from the shotgun, however, because the auction process does not penalize the party making a low offer since one only has to make a higher offer to avoid an unfair transaction.
An auction, particularly between owners, also allows the parties to put a number on aspects of the transaction that do not fit into a third-party valuation. If, for example, one of the parties to the auction places greater value on their continued employment, or if one of the parties simply wants to keep the business in the family, then those desires can be expressed in a higher bid.
I have seen auctions used to their best effect when the parties all want the business but cannot agree on a price. In fact, in the case that I discussed earlier involving the owners insisting on a premium to sell their own interest, an auction provided the best solution. The court simply ordered the auction, and the parties agreed on the terms in advance. Nonetheless, while the auction is simple in concept, the application can be more nettlesome, and judicial intervention may be required.
Shotgun Sales in the Course of Dissolution Litigation
It is important to recognize the distinction between the shotgun and auction methods on the one hand, which approximate a market value for the business, and the concept of fair value, which can be a calculation very different from fair market value.
Market values presume a willing buyer and a willing seller. Experts calculate market value based on the assumption of a buyer and seller and, in so doing, apply discounts for marketability — the difficulty in finding someone willing to purchase — and discounts for lack of control — the inability of the minority to set corporate policy.
Fair value uses many of the same tools to estimate the value of an interest, but it operates in a different manner. Fair value approximates the value of a business based on many of the same tools that are incorporated in the fair market value analysis, but it looks at the value of the enterprise as a whole. Fair then apportions individual values according to proportionate ownership interest. As with the shotgun offer, the shares of the cake are all equal, even if the method used to cut the cake is different. Fair is also the standard of value applied by statute in many states in cases involving the compelled sale of an equity interest.
In a fair market valuation, the sizes of the pieces of the cake are likely to be different depending on who owns them. Fair market value is used by the IRS, in estate and gift tax calculations, and of course in market transactions. The majority interests in a business will be subject to a premium and the marketability of the individual interest will be a key consideration. Discounts for lack of marketability or control can be significant, reducing the value of an individual minority interest.
A buy-sell agreement contained in an agreement among the owners that is triggered by a deadlock may provide for a valuation by a third-party, or even leave it to the entity to establish its own valuation. Such provisions will contain a variety of formats for the selection of the valuation expert, none of which is inherently preferable to the others.
An agreement may provide for selection by the company or by the parties, or in some cases by persons delegated by the parties — I.e., each party selects its own professional; the professionals then jointly select an independent professional. The agreement may also make the valuation binding, or not. In this way, the approach of determining value through a current appraisal is very much like the process a court will follow when it is setting the value for the compelled sale of an interest.
The manner of selecting the valuation expert is less likely to be a source of controversy when it is executed in good faith. Courts will, however, intervene when the buy-sell agreement is being used as an instrument of oppression. A judge will look at whether a majority party is attempting to use the process to unfairly buy out a minority interest at a premium. For example, when the claim of deadlock that leads to the buyout of a minority interest at fair market value (that is with discounts in value) is suspect or is the result of some unfair conduct by the majority, a court is less likely to enforce the buy-sell valuation.
Application of Shotgun and Auctions in Litigated Sales
In a judicial dissolution litigation arising from a deadlock, a court may order a sale of the assets or of the business as a going concern. All states provide some form of dissolution remedy, and courts have traditionally had wide discretion in formulating a remedy. And while the traditional method of valuing a business in a dissolution has been for the court to consider the testimony of competing experts, particularly when the sale is from owner to another, there are cases in which courts use an auction or shotgun approach to resolve a dispute.
Under most state statutes, dissolution requires that the enterprise cease doing business, except to wind up its existing business, that it marshal its assets, pay its creditors and, when all the creditors have been paid, distribute what is left to its equity holders.
Courts do not, however, break up a profitable business and sell its assets because that process rarely will yield the best return for the owners. A business usually is worth more as a going concern, so a court that finds a compelled dissolution is warranted will normally look for a way to sell the business rather than just its assets.
It is in this context, the sale of the business as a going concern, that one sees the use of auctions or shotgun techniques. An example is v. Fulk Washington Service Assocs., in which the Chancery Court in Delaware adopted the recommendation of a liquidating custodian that the sale of the business would be based on a shotgun proposal. In that case, there were a number of issues that interfered with the sale to a third party. The court held that it could enjoin the non-selling party from competing with the enterprise and that the recommendation of the custodian for a process in which either party purchase at a common price was within the court’s authority.
In the high-profile Delaware case of Shaw v. Elting, in a series of decisions (See Deadlock Resolved by Appointment of Custodian), the Delaware courts approved the compelled sale of a successful business in which the two 50-50 owners were deadlocked with prejudice. Ultimately the liquidating custodian negotiated a sale with one of the parties in a form of an auction process. While the other party objected, the court in approving the sale noted that she had not made a competitive bid. (Opinion here.)
In those jurisdictions that practice that have statutory dissociation (or expulsion) provisions, courts often assign a value for a compulsory buyout of an interest based on competing expert testimony about fair value. In my experience, however, one of the best defenses to a low-ball valuation proposal is a bona-fide offer at a greater price. My experience with business valuators is that this will often cause a significant change in their assessment of the value of a business, and will be persuasive evidence to a judge.
In many cases we argue for a shotgun value that treats the buyer and the seller equally by leaving until later the role that the other will play. This strategy works, however, only when there are two equally competent, equally interested parties with comparable financial resources.
Lawsuits often reward extremism. The parties recognize, and often with good justification, that courts are fairly reliably susceptible to being anchored by proposals that are outside the realm of ordinary results. This is particularly the case when the litigation will follow the traditional battle of the experts.
There may be little downside to casting an anchor — an extreme settlement position — as there is no real possibility that the party making the offer may have to accept the terms proposed for the other side. Courts use buy-sell terms as a way to focus on a valuation that is more likely to be realistic.