A business partnership pre-nup is always a good idea — but not all agreements are as fair as they seem.
You may have heard that Al and Tipper Gore are getting divorced after what most observers assumed was a blissful 40-year union.
No matter how solid they seem, some partnerships are destined to fail—which is why you should be concerned if your shareholders agreement includes a shotgun clause.
A shotgun clause is a blunt legal agreement between shareholders in a business that allows one partner to put a price on the table for the value of the business and leave it up to the other partner to take the money or match the offer in a short period of time (usually 20–40 days).
Given its speed and simplicity, a shotgun agreement sounds fair, but I have found that it favors the partner with more cash and operating experience.
To illustrate the downsides, let's imagine a hypothetical partnership between Norm and Steve, who agree to go into the cabinetmaking business together.
At 56, Norm is a seasoned entrepreneur who has cashed out of two other businesses. His house is paid for, and he has $2 million in his investment account.
At 31, Steve is just starting out in his professional life. He and his wife of two years are expecting their first child, so they have recently cashed in their investments and put all the money into a $42,000 down payment on their first home.
Norm had been making cabinets for friends and family for years before he decided to make it a business and invite Steve to join as a full 50 percent owner. Norm explained to Steve that he would have to work hard to learn the business.
The simple partnership agreement drafted by Norm's lawyer featured a shotgun clause with a 20-day resolution period should their partnership hit the skids. Given its apparent simplicity and fairness, Steve signed the agreement, papering what he thought would be a blissful marriage.
The first few years were good, with Norm teaching Steve the business and Steve working 16-hour days to get up to speed. Most days Norm would slip out early to go to the golf course, leaving Steve toiling away.
After a few years, Steve began to tire of what he saw as Norm's lax work schedule. Likewise, Norm got frustrated with what he saw as Steve's lack of appreciation for the opportunity he had been given. Tensions rose over a series of months to a point where neither party could take it any longer.
At this point, what seemed like a fair deal for everyone has tilted in Norm's favor. Steve has only a few thousand dollars of equity in his home and no other assets to speak of. Steve's wife is at home caring for their child. Steve is still learning the business and would have trouble running it without Norm, one of several reasons Steve would have trouble borrowing money to keep it.
Norm knows Steve's situation and can use it to his advantage to attempt to buy the business back at a steep discount. Given their shotgun agreement has a 20-day resolution period, Steve has a few short weeks to cobble together some cash or allow all of his equity to be bought for pennies on the hour.
A pre-nup for your business is always a good idea, but I'd recommend you agree to a valuation formula in your shareholders agreement instead of relying on a shotgun clause if you and your partner have vastly different economic resources.