What Is Shotgun Clause? Definition, How It's Used, and Downsides

What Is a Shotgun Clause?

A shotgun clause is a special provision that may be used in a partnership to force a partner to sell their stake or buy out an offering partner. In effect, it is both a form of dispute resolution and a pricing mechanism.

Most often, a shotgun clause is used to force a partner (or partners) into either buying out an offering partner or selling their shares to the offering partner. A shotgun clause may be written into a partnership's shareholder agreement and is sometimes referred to as a "buy-sell agreement."

Understanding Shotgun Clause

A shotgun clause may happen with a shareholder offering to buy the shares of other partners at a specific price. The target shareholders then have the option either accepting the offer and selling their shares or buying out the originating shareholder at the specified price.

The shotgun clause may also work in reverse when a shareholder offers to sell their shares to the other shareholders at a specific price. The target shareholders may then choose between buying out the originating shareholder or selling their shares to them. After a shotgun clause is enacted, the timeline for the completion can be less than a month to just a few months long.

Because the investor initially tendering the shares cannot be certain whether the shares will be purchased or rejected, the specified price must be considered carefully. After all, a rejection of the tendering creates an obligation for the offering party to buy the partner's portion at the same price at which they were originally willing to sell.

While a shotgun clause may sound fair because of its simplicity, it is considered a blunt instrument. As such, it is most likely to be enacted when the business operations of the partnership are in distress.

The clause favors partners who possess a better knowledge of business operations. A shotgun clause may be most helpful when there is more than one partner who wants to manage a business but neither wants to do it together. They thus need an efficient pricing mechanism to force either partner's hand to buy or sell. In effect, a shotgun clause may act as a form of dispute resolution.

Disadvantages of Shotgun Clauses

Some academics argue that shotgun clauses are inefficient and that the partner who winds up buying a company may not be the party that values it the most. As such, it has been suggested that pricing and purchasing should happen as the result of an ascending auction between interested partners. Additionally, the shotgun clause is sometimes seen as unfair because it can favor the partner with deeper pockets, as traditional bank financing can be hard to secure under the fast timeline associated with a shotgun clause.