Shotgun Provision

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                             James R. McMaster and Michael Dubetz
                                    Sherman & Howard L.L.C.
                               (303) 299-8005
                                (303) 299-8164

                                           January 2006

       Limited liability companies, also known as “LLCs”, and their members can benefit from
the same types of provisions that are found in the shareholder agreements of corporations;
however, care must be used when applying shareholder agreement-type provisions to agreements
in the LLC context to ensure that valuation formulae work when there are variances in capital
accounts and other attributes of the members.

         Ever since the limited liability company was first officially recognized by the Internal
Revenue Service in 1988 as a “pass through” entity for federal tax purposes, the LLC has
become more and more popular as a vehicle for new businesses. The primary reason for this
trend is the flexibility the LLC provides, particularly with respect to tax planning; however, the
flip side to this increased flexibility is that when the governing documents of the LLC do not
address an issue, there is much less statutory and common law guidance upon which to rely.
Additionally, the fungibility of stock that is ubiquitous in the context of corporations does not
necessarily apply in the context of LLCs, where different membership interests may have vastly
different values per profit interest as a result of differences in capital accounts, management
rights, contribution obligations, tax attributes and other rights and obligations.

       Below are descriptions of several types of provisions commonly used in shareholder
agreements that can also be useful to limited liability companies, along with valuation specific
items to consider when applying these concepts in the LLC context. These provisions can be
incorporated in a member’s agreement, but the more common practice is to include them in the
LLC’s operating agreement.

       In reviewing these various provisions, keep in mind new members should always be
required to sign the LLC operating agreement to ensure that all the operating agreement
provisions are enforceable against them.


       The term “buy-sell” is often used loosely in the context of shareholder agreements to
include two different concepts. The first of these is the obligation of a member to sell, and/or the
company to buy, the interest of a member upon an involuntary transfer of that member’s interest,
usually upon death, and frequently, upon divorce, bankruptcy or termination of employment.
These provisions are often used as an estate planning tool to provide a way to monetize a
member’s interest in a limited liability company upon death for purposes of paying estate taxes.
In order to fund the buy-out, corresponding life insurance policies may be purchased by the
company that give the company the financial wherewithal to purchase the interests of the
deceased member. The same goal may also be accomplished by the use of a sinking fund
whereby the company, or other members, pay into a fund that is used to purchase a member’s
interest upon that member’s death. Similar provisions may apply, at the company’s option, upon
other involuntary transfers such as the divorce or bankruptcy of a member or upon the
termination of a member’s employment by the LLC. The purpose of these provisions is to keep
the transferring member’s interest from transferring to (or in the case of a termination, staying
with) a party with whom the other members would prefer not to be associated.

        In both the corporate shareholder agreement and the LLC operating agreement context,
these types of buy-sell provisions will require either a set formula agreed to beforehand in the
agreement, or an appraisal at the time of the transfer, to value the interest because there is no
third party valuation upon which to base a valuation of the interests. If a formula is used, it
needs to take into account capital accounts and other unique attributes of the interest being
purchased. Such a formula can be based on a number of benchmarks. Book value is often used
but is usually punitive as it does not take into account the going concern value of an entity. A
multiple of trailing earnings is often a more fair approach but a multiple chosen of one point in
time may not be accurate at another time when risks and market conditions are much different. It
is also possible to use different formulae in different circumstances. For instance, book value
might be used for a buy-out when an employee leaves voluntarily or is dismissed for cause but a
multiple of earnings could be used for termination without cause or death. In each case,
however, one should consider whether a capital account adjustment is necessary in applying a

                         TEXAS SHOTGUN (YOU CUT I CHOOSE)

        The second type of “buy-sell” clause, is also referred to as a “Texas shotgun.” In a Texas
shotgun, one member picks a price at which he will buy out the other member. The other
member can either accept the offer and sell his interest at that price or buy the offering member’s
interest at the same pro rata price. A Texas shotgun can be used in a two member corporation or
LLC to provide a way for either owner to buy out the other. The arrangement can also be used
where there are more than two members but its application becomes much more cumbersome.
Often, but not always, the provision requires some type of deadlock before the procedure can be
invoked. In the corporate situation, valuation of the purchased interest is relatively easy because
a per share price can be used; however, in the context of an LLC, there may be variations in
capital accounts, voting rights, rights to losses and so forth that do not make a percentage profits
interest of one partner readily comparable to the valuation of the second member’s interest. This
is best dealt with in an LLC by requiring the offering member to make an offer based on the
value of the entire entity. Then, the sale price of a member’s interest can be calculated by using
the distribution upon liquidation mechanism contained in the operating agreement to determine
what the selling member would receive had the business been sold for the entire amount. If the
members do not believe that the liquidation provisions provide the appropriate mechanism for
valuing the selling member’s interest in this scenario, one of the formulae described below in the
description of tag-along and drag-along provisions could be used.

        Another issue to keep in mind in determining whether to use a Texas shotgun arises when
there is a disparity of economic means between the members. If one member does not have the
means to make a purchase at anywhere near the actual value, it puts the other member at a

tremendous advantage. This can, however, be mitigated by using earnouts or notes payable to
finance the purchase, but these should be called out in the agreement.


        The problem of valuing a selling member’s interest is most difficult in the context of
drag-along and tag-along provisions. A drag-along provision provides that, if members with
greater than a specified threshold of ownership in the entity, usually 50%, have identified a buyer
and desire to sell their outstanding interests in the company to that buyer, then those selling
members can force the other members to sell their interests at the same pro rata price. This
mechanism prevents minority shareholders from “holding out” thereby derailing a transaction
when a buyer does not want to be subject to the interest of minority owners. Conversely, a tag-
along allows a minority owner the right to participate in a transaction at the same pro rata price
of other owners where a threshold interest is being transferred. This allows a minority member
to have the opportunity to monetize his interests along with the majority owners. The rub in each
case is determining what the “same pro rata price” is where the membership interests have
varying capital accounts, management rights and other features. An appraisal based on the price
for which the buyer is willing to purchase the selling member’s interest adjusted for the differing
features is the most accurate approach, but this adds additional time and cost to a transaction.
Another approach is to use a variation on the liquidation valuation described above with respect
to Texas shotgun provisions. To apply this approach one must calculate the full entity valuation
based on the value of the interest being sold that is triggering the drag along; in other words,
what full entity valuation would result in a liquidation value of the seller’s interest equal to the
offer the seller has received? Once this whole entity value is established, then the value of the
interest being dragged along can be determined applying the liquidation provisions. If more than
one member is part of the selling group and they are not receiving proportional offers for their
interests then a weighted average based on profits interests can be used.

       A straight percentage profits interest approach which does not take capital accounts into
consideration may also be used, but this can produce a windfall for “sweat equity” members who
have not contributed a proportional amount of the company’s financial capital.

        To make the drag-along and tag-along arrangements work, some method for valuing the
interest should be agreed to in advance. An “agreement to agree” on the price at the time the
deal is made is a recipe for litigation because it tends to give hold out power to minority

                                  RIGHTS OF FIRST REFUSAL

         The limited liability company ownership interest right of first refusal is the provision of
this type that is least different from its corporate counterpart. A right of first refusal means, as
the name implies, that if a party receives an offer from a third party to purchase its interest in the
entity, it must first offer that interest to the other members of the entity, or to the entity itself, on
the same terms that it wishes to sell to the third party buyer. Valuation issues pertaining to
capital accounts and various management rights are not implicated in this scenario because the
price is for just that set of rights and no other; therefore adjustments are not required. The same

is true of a right of first offer whereby a selling member must offer the interest to other members
before offering it for sale to third parties.


        Shareholder agreement-type provisions can be very helpful in the context of an LLC;
however, these provisions cannot be cut and pasted directly into the LLC’s operating agreement;
drafters must be careful to address areas where stock and LLC profit interests are different to
ensure appropriate results arise from the application of these provisions.


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