Shotguns, Puts and Calls: The advantages of buy/sell agreements for closely held companies

Many of us have been in business with family and friends. Everything was great at the start, when respect, confidence, energy and even humour seemed never ending. There may even have been profits, calculated in creative ways, to flaunt before cynical relatives and former bosses who lectured us about cash flow and predicted we were going to go under. And possibly there was a sense of freedom, freedom to choose and not simply be chosen, no longer having to squeeze into a box on an organization chart.

Well, that was then, but what about now? Are we feeling a little trapped in the business? Wanting to get out, or at least get the others out?

Chances are that we decided, or our lawyers and accountants decided for us, to incorporate the business. Incorporation was supposed to provide us with an instant structure, governed by a comprehensive assortment of rules and standards, while letting us enjoy limited liability and a small business tax break. Each annual meeting was to be a great party at a pricey venue with the chance to play chairman of the board. All that extra paperwork, often lots starting up and not much less thereafter, was just a small price to pay for being able to play in the corporate world. At least some of that starting paperwork could serve as a useful reference guide to be consulted later on whenever we questioned how we should deal with each other.

A useful guide, maybe, if we wanted to stay together, but useless now that we're thinking of getting out.

Often a company's articles of incorporation will say that the shareholders can't sell their shares unless they get approval from a majority of the company's directors. If there is a shareholders agreement, it may allow shareholders to sell out to a third party if they have first offered their shares to the other shareholders and been turned down - but it may say nothing about selling to the others in the absence of a third party offer. If there is an employment contract with each shareholder, it may make acquiring shares cheap and easy but disposing of shares expensive and difficult.

So how does a shareholder of a closely held company get out, especially when holding only a minority of shares which an outside party is unlikely to buy?

Some shareholders end up going to court in search of a way out. Often alleging that they have been oppressed by their company and the other shareholders, or asserting that the company is really a deadlocked partnership deserving of being wound up, they run the risk that a judge may prescribe a result they don't really want. If the judge finds that they haven't been treated all that badly by the others, they may end up worse off.

A few recent cases are useful reminders of what can happen when going the litigation route. These cases all involved companies with only a few shareholders, whose conduct towards each other was held not to be oppressive, and whose relationships were not subject to any buy-sell agreements. The shareholders concerned did nothing wrong and weren't at fault, but nonetheless found themselves without a clear way to change their circumstances.

In the case of Wittlin v. Bergman, two brothers who owned 20% of a cookie business engaged in "a finger-pointing poisonous stand-off" with a husband and wife who owned the remaining 80%. Both sides wanted out but had no mechanism for selling their shares. The court imposed one, by ordering that they establish a two button buzzer system that would identify the first side to push its button while the share price would be dropping every six seconds from a specified starting value. The side that did not fix the price would have the option of requiring the other to buy or sell at the fixed price, although the party required to buy could decline by selling at a 20% discount. On appeal, this buzzer system was rejected, and the appeal court ordered the company to buy out the brothers' 20% interest at a value to be determined by an independent valuator.

Yet the parties each experienced the feeling of having an unexpected solution imposed upon them. Here are three more examples.

Re Lecce and Lecce dealt with four brothers who each owned 25% of a disposal services business. When the son of one them established a competing business, causing the "once harmonious relationship" among the brothers to be "irreparably broken down", the brother with the ambitious son asked the court to order the others to buy him out. The court refused, holding that their 20 year old shareholders agreement would not be amended to include a buy-sell provision.

Re Footitt and Gleason concerned a father and son who jointly owned two-thirds of a pharmacy business, with another pharmacist owning the remaining third. While the father and son wanted to buy out the pharmacist, and the pharmacist wanted to buy out the father and son, neither side could agree on how to proceed. The pharmacist ended up asking the court to order the entire business be sold by public auction. The court responded by ordering that his shares be purchased by the father and son at fair value.

And in Bellman v. Bellman, a husband and wife going through divorce proceedings lacked a mechanism for allowing one of them to sell out of the professional conference business which they owned 50-50. In finding that the wife "justifiably lost confidence" in her husband as a business partner, the court ordered a transfer of the husband's shares to the wife at fair market value.

Had the parties in these four cases entered into buy/sell agreements with each other before they realized they wanted to get out, they may have been able to go their separate ways a lot faster. And maybe a lot cheaper, depending on their legal fees and the court's award of costs. Because buy/sell agreements prescribe an exit mechanism that was lacking in the foregoing cases, the certainty they provide may be preferable to the uncertainty of going to court in search of a resolution.

There are lots of variations on the buy/sell theme, without any generally accepted standard form agreement. However, many buy/sell agreements contain a put, a call, and a method for share valuation. Some even contain a shotgun.

A put, or option to sell, gives a shareholder a right, but not an obligation, to sell his shares either to the company or to other shareholders in certain circumstances. Termination of employment, disability or even the failure of the company to meet specified financial targets are all events which might permit a shareholder to exercise his put.

As the opposite of a put, a call gives a shareholder or the company a right, but again not an obligation, to buy the shares of another shareholder in the event that, for example, such shareholder dies, leaves the company to work for a competitor, or becomes disabled, insolvent or bankrupt.

The method to be used in valuing the shares being sold usually follows one of three approaches. The first requires that a value initially agreed upon by the parties is reviewed and adjusted annually by them. The second involves an application of a specific formula, such as the net book value of the company's assets or a certain multiple of its recent earnings. The third entails the retention of an independent valuator.

A shotgun requires a shareholder to set a firm price at which he is willing to either sell his shares to the other shareholders or to buy their shares. The others then have the option of choosing whether to buy or sell at the specified price.

Granted, there are disadvantages to each of these provisions. While they afford the parties a mechanism for getting out, they don't guarantee either certainty or fairness of result.

Annual share value reviews usually stop after the second year. A decision to use book and not appraised asset values, or a multiple of recent earnings and not a discount of projected earnings, may appear misguided in hindsight and create resentment. Or the parties may fail to be unanimous in their choice of valuator.

Even if puts and calls are tied into a bullet proof valuation formula, they are still options and not binding agreements of purchase and sale. Though they can be written not as options but as obligations which must be satisfied upon the triggering event, the buying party can still become too broke to pay.

For shotguns, the ability of a buyer to pay when the time comes also represents a problem. Although shotguns impose an obvious deterrent on the offering shareholder against setting a price that is too high or too low, such deterrence breaks down when the other shareholders lack financial strength. And the attempt to give some certainty to the exit process is then made at the expense of fairness, because a low ball price becomes inevitable.

Consequently, shotguns are often used when there are just two equal shareholders with roughly comparable resources. For start up companies that need to keep their shareholders committed and must wait a while for a payback on whatever time and effort has been invested, shotguns are often exercisable only after a specified period has elapsed.

Yet despite these disadvantages, buy/sell agreements give comfort to those shareholders of closely held companies who recognize that they may want an out, sometime. No need to speculate whether negotiations with fellow shareholders will be pleasant or painful when the time comes. No need to worry which way the sympathies of a judge may go. No need to be nervous before cross-examination by lawyers. No need to have personal frailties exposed in a published court decision.

So for those of us who might want to change our family and friends in business, there is a way.

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Copyright 1997 A. Paul Mahaffy. Reproduction by any means in whole or in part without the author's written consent is strictly prohibited.

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