Ten Things: What In-House Lawyers Need to Know About Joint Ventures

You’re sitting at your desk, slurping down a big mug of coffee, when the CEO stops by your door.  “Guess what,” she says. “We’re going to do a joint venture with Mega Corp! I need you and your team to get right on it.”  You say, “You’re [messing] with me, right?  Joint ventures are where good business ideas go to die.”  Well, you don’t say it, but you sure are thinking it because you know that most joint ventures never perform as expected, many severely underperform, and most terminate early because the parties cannot agree on some issue.  Regardless, joint ventures are not going away – CEO’s just seem to love them.   And when the business wants to move forward with a perfectly legal idea, in-house counsel fall in line and do their utmost to make the deal happen (and draft documents that help minimize problems down the road).   While it is impossible to consider every possible problem that might arise over the course of the joint venture, you can set up a process that will allow the parties to minimize potential issues.  How?  By spending a lot of time upfront thinking about the key considerations of putting the venture together.  This edition of “Ten Things” walks you through the basics of setting up a joint venture:

1.  Why?  You must get inside the head of the executive team and understand the “why?”  Why does the business want to enter into a joint venture?  There are many reasons but primarily it comes down to being able to accomplish something that each party feels they cannot get done alone.  It may be creating a new product using the patented technology of one party or the market experience of the other.  It could be entering new markets where one party already has a foothold (or is better able to cope with the political realities of entering that market).   Joint ventures may have access to better third-party funding vs. each party by itself, or one party may have a strong brand name that the other party can use to its advantage.  Lastly, it just may be neither party wants to take all the risk on its own shoulders and seeks to share that burden.  Whatever the reason, your first job as in-house counsel is to fully understand the “why” of any joint venture you are called upon to create.

2.  Planning the joint venture.  Once you know why the joint venture is needed, you can use that knowledge for the next phase – the planning.  Insert yourself early and fully into this process.  Don’t the let the joint venture become fait accompli before the legal team even pulls a chair up to the table.  If there was ever a time to put your foot down, this is it because if you shortchange the planning process the odds of a JV disaster go up exponentially.  Here are the key things to do during the planning phase:

  • Get a clear business rationale and business plan for the joint venture and work to ensure there is internal alignment around it.  This is the “why” question – what are the parties trying to accomplish with the joint venture?  Getting a business plan laid out is the only way you can successfully draft an agreement that will allow the joint venture to function the way the parties want it to function (and produce the results the parties want to see).
  • Don’t skimp on due diligence of the other party (parties) to the joint venture.  Know who you are getting into bed with.  What is their financial standing, litigation history, reputation in the business community?
  • Decide on a fair and functional entity structure.
  • Consider all the reasons the parties might want to/need to get out of the joint venture.
  • Plan out the governance of the venture based on the needs and contributions of the parties, one that will allow proper and quick decisions to be made.
  • Set up a strong internal process to review each of these as you work your way through the creation of the joint venture.  This will ensure everything is properly thought out and there is organizational alignment around how the venture will operate.

3.  Go slow setting it up.  Even though most in-house lawyers know the key steps above, it is usually the case that they do not get followed.  This is because of the pressure to “move fast.”  The business seems to believe that these complicated deals can magically be negotiated overnight. Unfortunately, when moving fast, best practices and key steps often get missed.  Joint ventures are complex creations with lots of points of failure.  Anything you can do to convince your management that taking the right amount of time to get things right means the odds of your joint venture succeeding go up dramatically. Arbitrary deadlines give you arbitrary results.  If you meet with resistance, try giving some examples of failed joint ventures (just Google “failed joint ventures and look at the wreckage) and ask if it’s not worth taking the time to ensure that the company’s investment is well-protected and the venture is given a real chance to succeed?

4.  Think through the regulatory issues.  You may not think of joint ventures as subject to a lot of regulatory issues, but they are.  Dealing with these issues in your documentation is very important. Here’s just a partial list of regulatory concerns to work through:

  • Antitrust – believe or not, joint ventures are treated just like mergers and under the right circumstances need to be notified to the appropriate regulatory authorities for approval.
  • Anti-Bribery laws –   anti-bribery and anti-corruption laws will apply to the joint venture and its owners.  Consequently, it is extremely important that you do thorough due-diligence on your partners in the venture and that you ensure the venture operates within the law at all times, especially when your venture is operating in countries where the risk of corruption is high.
  • Industry regulations – your joint venture may operate in markets where it’s business is regulated.  As you form your joint venture identify all the markets where it will operate and make sure you understand any industry-specific regulations.
  • Employment law – employment laws may be very different in the markets where the joint venture will operate.  This can be a major surprise, especially if the owners are loaning their employees to work for the joint venture.
  • Taxes – you cannot get away from the tax man (Sorry, Beatles).  Be sure you understand how the operations of the joint venture will be taxed (and don’t forget tax planning for distributions and proceeds on termination or exit from the venture).  Taxation issues are a primary factor in determining the corporate structure of the venture.
  • Market entry – if you are contemplating a cross-border joint venture, you need to consider any laws or regulations limiting the ability of foreign companies to operate in a particular country.  The easiest example I can think of is China and its requirements around ownership percentage and access to intellectual property.

5.  Get the structure right.  One of the first important decisions you will need to make regarding your joint venture is about the structure.  There are two paths: (a) you can simply sign an agreement between the parties to do “X” without setting up a separate entity, or (b) you set up a separate entity that will be owned by the parties to the joint venture.  As to the former, this works when the plans for the joint venture are very simple and do not warrant the expense and hassle of setting up a new company.  As to the latter, and though the names may vary a bit by country, you have several choices including a corporation, a partnership, a limited partnership, and a limited liability company (“LLC”).  The drivers of which entity you use come down to several key factors: complexity of the business the venture will operate, the desire to limit the exposure of the parties, where the business will operate, how the venture will end (e.g., an IPO?), what the parties are contributing to it, and taxes.  You will need to analyze these factors and others during the initial planning phase.  My advice is to focus on the “end” and work back from there to figure out the right structure.

6.  How will the governance work?  Figuring out the governance of the joint venture is worth every hour spent.  Get it wrong, and the venture will likely end up in deadlock and unable to function.  Consequently (and depending on your structure), you need to consider a lot of variables.  If the venture is owned equally by the parties, then you need to have a process to break ties.  If there are minority owners, then you likely need to identify items that require a “super majority” vote to approve, such as setting the annual budget, borrowing money, issuing dividends.  As to dividends, consider how the parties will get paid out from the proceeds of the venture or will those proceeds be reinvested?  Will the joint venture hire its own employees to operate the company or will the owners contribute employees? How will the owners manage the management?  You will likely need board meetings and regular informal update meetings.  What type of reports will the owners want from the venture and how often?  What is the dispute resolution process? Another problem is that the senior management of the owner companies will have a tough time understanding that the joint venture is not a subsidiary of their company.  They will get frustrated because of the slow pace of decisions and the fact that they cannot simply command the venture to do something.  Walk your executives through these potential problems upfront and get their input into how they want governance to work.  Setting up governance in a legal vacuum will probably mean painful moments the first-time things aren’t going well.  Likewise, must deal with the needs of the other owner companies as well.  One idea to help ensure you have it right is to walk your senior management team through an imaginary year of the joint venture and point out the cadence of meetings, reports, and even come up with different scenarios that might put the parties at odds.  Then you can show them how the voting works (or doesn’t work).  The feedback you get will make you better informed as you negotiate the agreement.

7.  Contributions of the parties.  Parties to a joint venture usually contribute different things.  It can be anything from cash to customer contracts, local market “know-how” to IP, or hard assets to real estate.  You must fully flesh out what each party is contributing and find a process to fairly value those contributions.  What is the value of the IP contributed? The contracts? The machinery?  The “know how?”  If you do not get the valuation right you will see trouble down the road figuring out how each party gets paid or paid out by the venture.  Additionally, are the contributions all going to equity or is some debt?  Similarly, if someone is contributing hard assets, run a title search and look for liens.  If IP is on the table, what type of warranties are you getting about non-infringement?  Will one of the parties provide services to the joint venture (accounting, legal, HR), and how will they get reimbursed?  Finally, once the initial contributions are made, what if more money is needed later on?  Can the joint venture take on third-party debt? Are the owners expected to pony up?  Ultimately, how much each party to the venture owns is dependent on the valuation of their contributions.  Which makes this exercise very important.

8.  Getting out.  As my dad used to tell me, “always leave yourself an out.”  Great advice and the same principle applies to joint ventures.  You must plan for how the venture will end or how a party can leave.  There are a number of things to consider:

  • Is the end of the venture tied to a key event (e.g., an IPO) or a date?
  • Can a party simply terminate for convenience after a certain date?
  • Will a party have the ability to “put” their interest to – or “call” the interests of – the other party?  If so, what is the formula to calculate the value of the shares?
  • Is there a right of first refusal if a party wishes to sell their shares to a third party (or are sales to third parties prohibited)? Will there be “tag along” rights so that if the majority shareholder sells, the minority shareholders can sell on the same terms?
  • What happens if there is a change of control at one of the parties (or the new owner is a competitor of one of the other parties)?
  • Do you have a mechanism to deal with deadlock and what happens if the parties simply don’t want to work with each other any longer?
  • What if one party defaults on its obligations to the joint venture?

9.  Restrictive covenants.  Once the joint venture starts to operate, will you allow the owner parties to compete against it?  Many ventures are set up to operate in specific geographic areas or in specific markets and the owners, as a way of helping the joint venture succeed refrain against competing against it in those countries or in those markets.  On the other hand, many owner companies don’t refrain.  Whether such a restrictive covenant makes sense is something you will determine early in the planning process.  Likewise, will the agreements require the owners to present new business opportunities to the venture first or are the owners free to take advantage of those themselves?  Consider what happens to the employees a party contributes to the joint venture – are they off limits to the other parties and can they return to their original employer without restriction?  Are customers of the venture off-limits to the owner parties?  These and other common restrictive covenant considerations need to be thought through and addressed at formation as they can cause serious problems if they arise and the owners have not already agreed on how they will be handled.

10.  Role of in-house counsel.  Lastly, consider the role of in-house counsel in the creation and operation of a joint venture.  Start with engaging outside counsel with deep experience with such ventures to help you.  Unless you have the requisite experience, trying to go cheap when setting up a joint venture can come back to haunt you.  Additionally, in-house lawyers must ensure they stay on top of the transaction and documents from start to finish.  You need to be knee-deep in the issues because only you truly understand the legal and business issues at stake.  Likewise, it is your job to help ensure the business thinks through what it wants to accomplish with the venture along with taking a leading role in the core planning activities.  And most importantly, if you see something “wrong” that you speak up early and often.  Additionally, get yourself a good joint venture checklist or other planning document and make it your job to see that everything on that list is debated and completed (or discarded if not applicable).  Finally, if you begin to do legal work for the venture (as often happens) your client is now the venture and not your company.  Understand the ethical obligations in this situation as they can be very tricky.

*****

Of course, there is way more to setting up a joint venture than I can set out in an article like this.  But, you now have the basics and a list of the things you need to ask – and think – about.  And when the CEO pops her head in with her next “great” joint venture idea, you can invite them to sit down to “go over” a few things.  Having the right initial conversation will set the proper course and put the company on the path to setting up a successful joint venture.

Sterling Miller

August 1, 2018

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