Shotgun Clause

What is a shotgun clause?

Shotgun clause (German: Shotgun-Klausel, also Russian roulette clause) refers to a provision for resolving a deadlock between two shareholders: one names a price, and the other must buy or sell at that price. A deadlock is a tie in votes in which neither side can push through resolutions. Some contracts also speak of a buy-sell clause.

The principle corresponds to a familiar rule for dividing a cake: one cuts, the other chooses first. Whoever cuts has every reason to divide fairly.

The clause is found in companies with two equally sized shareholders. These are above all joint ventures, which two companies establish and run together, for example for an industrial or real estate project, and founder companies with two founders at 50% each. It is regulated in the shareholders' agreement (a contract of the shareholders alongside the articles of association), in the articles of association themselves or in a founders' agreement (founders agreement). In companies with several investors it is rare; there, obligations to co-sell (drag-along) and co-sale rights (tag-along) govern the exit.

Course of the shotgun procedure

Trigger

The clause may be triggered only in a contractually defined deadlock, for example if a resolution on the budget, business plan or management fails in two consecutive shareholders' meetings because of a tied vote. An escalation stage is often placed beforehand, that is, an intermediate step in which an agreement is first attempted. Examples are discussions between the senior managements of the parent companies or a mediation, that is, conciliation by a neutral third party. In the first years after incorporation, the clause is often excluded.

Offer and right of choice

The triggering shareholder submits an offer with a price per share (Geschäftsanteil). The price applies in both directions: at that price, the offeror must buy the other's shares or sell its own. The recipient decides within a deadline which role to take on. Deadlines of a few weeks up to three months are common, because during this time the recipient must secure the financing of a purchase. If the recipient remains silent, many clauses treat the sale as having been chosen.

Completion

The shares are then transferred against payment. The clause should regulate by when payment is made and whether shareholder loans are transferred along with the shares or repaid. It must also be clarified who replaces security that the departing party provided for the company, for example guarantees to the bank, and what applies if the buying side does not pay.

Economic logic and risks

The mechanism is intended to force a fair price. Because the offeror does not know whether it will end up buying or selling, it must name a price at which both are acceptable. A price that is too low invites the other side to buy cheaply, one that is too high invites it to sell dearly. The clause also works without being triggered: because both sides know the risk of the procedure, it promotes agreement.

However, the logic holds only if both sides can raise the purchase price. If the financially stronger shareholder knows the limits of the other, it can name a price below value that the other nevertheless cannot finance. The recipient is then left only with selling below value. An advantage also goes to whoever runs the operating business and knows its development better. The same applies to the side that chooses the timing, for example a phase of weak figures or tight liquidity of the other.

Admissibility and implementation in Germany

In the prevailing view in the literature and published case law, the clause is in principle effective under German law. It must be distinguished from clauses allowing expulsion without cause (Hinauskündigungsklauseln). These are rules that allow a shareholder to push another out of the company without a substantive reason. Case law in principle regards such clauses as contrary to public policy and therefore void (Section 138 of the German Civil Code, BGB), apart from narrowly limited exceptions. With the shotgun clause, by contrast, both sides have the same rights. The triggering party bears the risk of having to sell itself, and the procedure serves to resolve a deadlock.

This does not secure effectiveness for every design, however. In an individual case, the exercise may be an abuse of rights, for example if a party brings about the deadlock only in order to trigger the procedure. Whether a considerable inequality of financial strength affects the effectiveness or the exercise is assessed differently in the literature. A design that also protects unequally strong partners reduces this risk.

Notarial certification, consents and ancillary consequences

The clause creates conditional obligations to transfer shares, that is, obligations that take effect only when the procedure is triggered. The agreement containing it therefore requires notarial certification under Section 15(4) of the German Limited Liability Companies Act (GmbHG), and the subsequent assignment likewise under Section 15(3) GmbHG. Depending on the design, the declaration by which the recipient chooses its role may also require notarial form. To avoid risks as to form, the clause can provide that all declarations in the procedure are notarially certified.

If the articles of association make the assignment subject to consent (transfer restriction, Vinkulierung, Section 15(5) GmbHG), the consent for the procedure should be granted in advance. If a company acquires sole control of a joint venture, a notification to the competition authority may become necessary. If the company holds real estate, the combination of at least 90% of the shares in one hand may trigger real estate transfer tax (Grunderwerbsteuer).

Protective mechanisms in the design

• Defined trigger: clear deadlock, upstream escalation and a lock-up period after incorporation.
• Appropriate deadlines: enough time to finance the purchase price, plus blackout periods, for example around public holidays.
• Proof of financing: bank confirmation or security provided by the triggering party on an escrow account.
• Minimum price: lower limit based on a business valuation by an expert.
• Naming a third party: right of the recipient to put forward a buyer who acquires in its place.

Worked example: shotgun clause with unequal financial strength

A software company in the legal form of a GmbH (German limited liability company) is owned 50% each by a founder and by the investment company of an industrial group. An expert opinion from the previous year determines an equity value of EUR 6.0 million, that is, the value of all shares after deducting debt. After two failed votes on the business plan and an unsuccessful mediation, the industrial company triggers the clause. The founder has 60 days.

• Balanced case: The offer is based on an equity value of EUR 6.0 million, so EUR 3.0 million per half. The founder values the company at EUR 7.0 million and buys. He pays EUR 3.0 million for a half that he values at EUR 3.5 million; by his own assessment, his advantage is EUR 0.5 million.
• Unequal financial strength: The industrial company knows that the founder can raise at most EUR 2.0 million in 60 days. It bids on the basis of EUR 4.4 million, so EUR 2.2 million per half.
• The founder cannot finance EUR 2.2 million and must sell. Measured against the expert value of EUR 3.0 million per half, he receives EUR 0.8 million less.
• With a minimum price: If the lower limit is 90% of the expert value, that is 0.9 × EUR 6.0 million = EUR 5.4 million, so EUR 2.7 million per half. The offer based on EUR 4.4 million would be inadmissible. If the founder sells at the minimum price, the gap to the expert value is EUR 0.3 million.

The minimum price does not remove the disparity in financial strength; the founder must sell at EUR 2.7 million as well. It does, however, limit the discount against the expert value from EUR 0.8 million to EUR 0.3 million. Further protection is offered by longer financing deadlines or the right to name a third party as buyer. If the founder holds the shares privately, then with an interest of at least 1%, 60% of the disposal gain is taxable under Section 17 of the German Income Tax Act (Einkommensteuergesetz, EStG) (partial income method, Teileinkünfteverfahren).

Distinctions: shotgun clause, Texas shootout and expulsion clause

• Texas shootout: Both shareholders submit sealed bids, and the higher bid buys. The price emerges through competition, not through the offer of one side.
• Drag-along rights: oblige minority shareholders to sell along when a sale to a third party takes place. They enable the sale of the whole company but do not resolve a deadlock.
• Expulsion clause (Hinauskündigungsklausel): allows one shareholder to exclude another unilaterally and without substantive reason, and is in principle void. The shotgun clause, by contrast, gives both sides the same rights.

Common mistakes

• Vague trigger. Without a clear definition of the deadlock, the procedure can be used as a means of pressure in ordinary disagreements.
• Financial strength ignored. Between shareholders of unequal financial strength, the clause without a minimum price or sufficient deadlines favours the stronger side.
• Missing certification. A shotgun clause in a shareholders' agreement in private written form only is invalid for lack of form.
• Ancillary consequences unregulated. Shareholder loans, security and non-competition obligations after departure otherwise remain open.

Frequently asked questions

Is a shotgun clause permissible in Germany?

In principle yes. The prevailing view in the literature and published case law regards it as effective because both sides have the same rights and the clause resolves a deadlock. Limits arise from the prohibition of arrangements contrary to public policy and of abusive exercise.

Are the shotgun clause and the Russian roulette clause the same thing?

For the most part yes. Both terms generally refer to the procedure in which one side names the price and the other chooses its role. Because contracts and the literature do not distinguish them consistently, what counts is the procedure as regulated, not the label.

What alternatives are there to the shotgun clause?

Above all the Texas shootout, call and put options at a valuation expert's value, and rules that resolve the dispute without separation. In a Texas shootout both sides bid in sealed form. Without separation, an escalation up to mediation or the casting vote of a neutral advisory board chair come into consideration. The last stage is the joint sale to a third party or the dissolution of the company.

How long does the other shareholder have to decide?

As long as the clause provides, often a few weeks up to three months. Shorter deadlines disadvantage the recipient if it has to finance a purchase. If it does not respond in time, many clauses treat the sale as having been chosen, and it must transfer its shares at the stated price.

Does a shotgun clause have to be notarially certified?

For a GmbH, yes. Because the clause can oblige a party to transfer shares, the agreement requires notarial form (Section 15(4) GmbHG). A shareholders' agreement in private written form only is not sufficient for this.

The Roemer Capital view

We encounter the clause above all in companies with two equally strong shareholders and in joint ventures. If such a company is preparing a financing round or a sale, we check whether the clause fits the future shareholder structure. When new investors enter, it is often abolished or replaced by drag-along and tag-along rights.

If the procedure is triggered, we calculate for the client, before the client decides, the valuation range and the affordable upper limit of the purchase price, and we examine how a purchase can be financed. Legal questions, from effectiveness to certification, are clarified by the client's law firm.