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“Let’s Make a Deal”: Top 10 Issues in Forming a Joint Venture
The Joint Venture as a vehicle for doing business has increased dramatically in popularity recently as businesses constantly seek the most effective and efficient production and sales approaches for each business line.
For example, a Joint Venture might be ideal where two or more companies have complementary strengths which can be combined for maximum effect, or where one has the brains and the other the money, or where one has some proprietary intellectual property and wants a business relationship beyond the usual licensing deal with royalties.
If two or more businesses decide that a JV might work, what then? What are the basic deal points which must be resolved if the combination is to work for the maximum benefit of all participants?
It’s simply not realistic to think that dealing with only 10 topics can capture every nuance of every deal, but if the JV partners can resolve and agree on the following areas, their chances of a successful deal increase dramatically.
The Exit Mechanism. Starting a deal by thinking about how to end it might seem counter-intuitive, but the vast majority of all Joint Ventures terminate within 5 years of formation, usually by one partner buying out the other. And since the partners are usually very positive about their prospects at the outset, the exit mechanisms often are dealt with only in summary, if at all.
Rights of First Refusal and Tag-Along of Drag-Along Rights are typical if there is a third-party offer, but more likely one partner wishes to exit and the other wishes to remain, therefore causing difficult valuation issues that often consume a large part of the negotiations.
Agreed prices, or formula provisions, or third-party expert appraisals are common solutions, and “You Cut the Cake” clauses are also common, with one partner naming a price and the other then electing either to buy or sell at that price, or else require a dissolution, either by agreement or under Court control. Deferred payment terms are also commonly negotiated.
Structure of the Venture and Limited Liability. Tax and liability concerns usually dictate the organizational structure of the JV, whether it’s to be a corporation (C or Sub S), or a partnership, or a limited partnership, or very often a limited liability company, since the LLC gives the benefits of limited liability with pass-through tax treatment for the partners. Name and venue of organization, principal place of business and other premises must be determined. Allocations of earnings, tax reporting, record-keeping (and access to records) and audit requirements should be agreed and described.
Remember that the Venture should be adequately capitalized and the usual formalities should always be respected to assure that the liability shield is not pierced on a “mere instrumentality” or “alter ego” theory. Always use the “LLC” identification, and always sign only as the venture representative and never sign anything in an individual or personal capacity.
Formalities are important. If the Venture has to sue in a particular state, to enforce a contract for example, be sure that all of that state’s taxes have been paid and that all required reports have been filed.
Financing the Joint Venture. Will the initial capital requirements be partner contributions via equity, debt, preferred shares, or a combination? Will all contributions be due at the outset or in tranches? Will third-party debt be project finance (with the project financing itself in effect) or will it be guaranteed in whole or part by the partners? How will additional capital requirements be met?
Will one partner contribute property (which raises valuation issues), or services (which requires agreement on the value of the carried interest)? A “standard promotion” from oil and gas deals is one-quarter of the equity for each one-third of the capital, with the carried partners receiving one-quarter, but this is all subject to negotiation, and assumes that the carried partners are not otherwise compensated.
The respective obligations of each party as to capital and services should be clearly delineated, as well as penalties for breaches and defaults, including indemnities with negotiated baskets and limits.
Remember that having adequate capital is a key factor in a court possibly piercing the veil and imposing liability on the members or shareholders. This happens rarely, but it does happen.
Scope. Typically, a JV is a limited purpose combination, but sometimes the venturers contemplate a longer-term relationship, with obligations to make future contributions of capital, technology, or other efforts, or even to expand eventually into other areas. Can the partners engage in other and possibly competing businesses without first offering opportunities to the JV? These are key areas necessary to resolve at the beginning so as to avoid future debates.
Conditions to the Business. Are there tax or other regulatory requirements to be satisfied prior to doing business? Is a Hart-Scott-Rodino pre-merger notice required? Are there any required acquisitions of third-party rights, IP or other assets? Employment Agreements? Services Agreement by one or both partners to the JV? Typically one of the venturers would provide the usual overhead services, at least during the start-up period, and sales, distribution, or other assistance from one participant to the new company is typical of JV arrangements.
Managing the Joint Venture. Usually one venturer has day-to-day operating responsibility, subject to the other participant’s veto over substantial matters, such as change of basic documents, sale of assets, change of business, new debt, new ventures, new partners or change of control of an existing partner, affiliated party transactions, compensation levels, change of accounting methods, etc. Will there be a business plan to be followed unless mutually changed? When and where will management meetings be held? Who pays management fees and expenses? Who will be the Board and the Officers, the Auditors and Counsel? These may seem like details at the outset, but agreement now avoids debate in the future.
Cash and Other Distributions. Specific agreement is important on the expected timing and amount of cash distributions, whether quantified reserves will be required, and whether all earnings above that level will be distributed or partially retained. If a tax pass-through vehicle is elected, distributions should at a minimum cover taxes.
Deadlock Resolution. This is often the trickiest provision to negotiate -- what if the venturers simply disagree on an important matter? Ideally, there should be levels of deadlock resolution, perhaps first good faith negotiations, then involvement of senior officers on both sides, then perhaps mediation, but if there is a deadlock, then third-party resolution (which leaves the parties somewhat a hostage to fortune) or triggering the exit mechanism may well be the final alternatives. Some States provide for appointment of a receiver to manage a deadlocked business, but this is a terrible remedy and rarely employed.
The “Standard” Clauses. It is often important to read the footnotes -- the “standard” provisions in a JV Agreement can turn out to be extremely important if there is a dispute. How will debates, short of deadlock, be resolved -- arbitration or litigation? Are the interests assignable (and specifically, what if control of one party changes?) and do the obligations travel as well -- is the assigning party relieved of them? Choice of law and forum can be critical. “Deal” expenses are often borne by the JV and “Negotiation” expenses by each partner separately. When will the JV end? Should certain events, such as ongoing losses, dictate termination? What if one party goes bankrupt, and how might the Bankruptcy Laws complicate what the parties’ Agreement says? Confidentiality provisions and press release approvals are standard. If there is a Letter of Intent then it should be specifically non-binding except for certain provisions (e.g., expenses, confidentiality) and should have a deadline for negotiation of the definitive agreement, and undertakings to negotiate exclusively with each other during that period.
Specific Aspects of the Transaction. Every deal is different and has its unique requirements and issues. Understanding the proposed business and the goals of the partners is an essential prerequisite to any business formation, and the first few pages of the Agreement usually state the deal followed by the balance of the Agreement, which discusses what happens if the deal goes wrong.
In Japan they say that they make contracts for marriages; and in America they say we make contracts for divorces. Usually if the business and the goals are clearly understood from the outset, there is less chance of ever reading the balance of the Agreement again. Resolving these 10 basic areas will go a long way toward successfully reaching that goal.
Questions regarding this advisory should be addressed to Robert A. McTamaney (212-238-8711, firstname.lastname@example.org).
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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