Shotgun Clauses, Buy-Sell Terms and Rights of First Refusal: Exit Terms Explained

Most shareholders' agreements contain one or more exit mechanisms. They sit unused for years, then decide who owns the business, at what price, within weeks.

This article explains how the three most common mechanisms work, where they can favour one owner over another, and what to look at before anyone triggers one.

Why exit terms matter in a private company

Without an agreement, leaving a private company is not simple. Shares in a private company usually cannot be sold freely. Table 1 of BC's Business Corporations Regulation, a standard set of company articles, says in article 20.2 that no shares may be transferred without the directors' consent, and that the directors need not give a reason for refusing. Many private companies have a similar restriction in their articles.

So a co-owner who wants out may have no buyer and no way to force one, and a co-owner who wants the other gone may have no way to buy them out. Exit clauses in a shareholders' agreement fill that gap. For what else the agreement covers, see Shareholders' agreements in BC.

The shotgun clause

A shotgun (sometimes called a buy-sell or Russian roulette clause) lets one shareholder name a price for the shares. The other shareholder must then choose, within a set time, either to sell their shares to the first at that price or to buy the first shareholder's shares at the same price.

The idea is fairness by design: the person naming the price does not know which side of the deal they will end up on, so they have a reason to name a fair one. In practice, several things can tilt it:

• Money. If one owner can raise funds quickly and the other cannot, the wealthier owner can name a low price knowing the other cannot afford to buy.
• Information. The owner who runs the business day to day usually knows its value and prospects better than a passive owner.
• Timing. Short response and closing periods favour whoever has financing lined up before triggering.
• Unequal holdings. With unequal shareholdings, the clause has to say how the price applies to different-sized blocks.

Drafting points to check: who may trigger and when (for example, only after a set number of years), whether the price must be all cash, how long the recipient has to respond and to close, what happens if the buyer fails to close, and how personal guarantees of company debt are released.

The right of first refusal

A right of first refusal (ROFR) does not force anyone out. It controls who can come in. If a shareholder receives an offer from an outsider and wants to accept it, they must first offer the shares to the other shareholders on the same terms. Only if the others decline can the sale to the outsider go ahead, usually within a set period and on terms no better for the outsider.

A close cousin is the right of first offer, where the selling shareholder must offer the shares to the others before looking for an outside buyer at all.

Points that often cause trouble:

• Chilling effect. Outside buyers may not spend time and money on an offer that an insider can simply match.
• Matching non-cash terms. If the outsider offers shares, an earn-out or a job, the agreement needs to say how an insider matches that.
• Several shareholders. Does each take a pro rata share, and what if some decline?
• Related rights. Tag-along and drag-along clauses often sit next to a ROFR and change how a sale to an outsider plays out.

Buy-sell terms on death, disability or departure

These clauses say what happens to a shareholder's shares when a defined event occurs. Common triggers are death, long-term disability, retirement, the end of employment with the company, bankruptcy and, sometimes, marriage breakdown.

The key choices are:

• Mandatory or optional. Must the company or the other shareholders buy, or do they merely have the option?
• Price. A formula, a value the owners agree each year, or an independent valuation. An agreed value that nobody updates can be badly out of date when it is needed.
• Funding. Life or disability insurance owned for the purpose, payment by instalments, or a mix. A buy-out the buyers cannot fund helps no one.
• Definitions. What counts as disability, and who decides, matters a great deal.

These terms also need to line up with each owner's will and powers of attorney. We cover that side in Estate planning for BC business owners.

When a clause is triggered

Exit clauses usually run on strict notices and timelines, so the details decide the outcome. Notices must be in the required form, sent the required way, within the required time. A missed deadline can mean losing the right to buy, or being deemed to sell.

If an exit mechanism is used in a way that is oppressive or unfairly prejudicial to a shareholder, section 227 of the Business Corporations Act lets the shareholder apply to court. The court can make a wide range of orders, including setting aside a transaction or directing a shareholder to buy another's shares. Section 227(4) says the court may make an order if satisfied the application was brought in a timely manner, so delay can matter. Court is slow and uncertain, and it is not a substitute for a clause that works.

If you are already negotiating a departure, Buying Out a Business Partner in BC covers price, payment terms and releases.

Reviewing the agreement you already have

• Read the exit clauses with today's facts: who could fund a shotgun now, and who could not?
• Check that any agreed value or valuation formula still makes sense.
• Confirm insurance meant to fund a buy-out is still in place and in the right amounts.
• Make sure the agreement and the company's articles do not conflict on share transfers.

Signing or reviewing a shareholders' agreement? Check the exit terms first

Our business lawyers can explain how the exit clauses in your shareholders' agreement would work in practice, draft or revise them, and advise you before a clause is triggered or answered.

Call 604-259-2844 or send us a message to arrange a consultation at our Vancouver office.