Joint ventures should be considered as an alternative to an acquisition if the acquiring party feels it does not have the experience or the business risk appetite to do it individually. They have the benefit of allowing parties to have greater success working together on a specific project than if they did it themselves.
Benefits of a joint venture
There are many benefits of entering into a joint venture. Some of them include:
- Allowing the parties to share management experience and expertise, industry knowledge, and technological capabilities
- Allowing the parties to share costs, particularly beneficial in those instances in which one party could not afford the costs independent of the joint venture
- Affording the joint venture parties the opportunity to access new markets that they would not otherwise have access
- Permitting a business to diversify its own businesses with the potential for improved cash flow
- Sharing collective tangible and intangible assets
Funding the joint venture
Parties to a joint venture generally contribute cash and/or assets to the joint venture to fund the joint venture’s business. In return, they receive interests in the joint venture entity, evidenced by either their capital accounts or equity.
As a drafter of a joint venture agreement, it is important to memorialize when mandatory initial capital contributions and any mandatory additional capital contributions must be made. It is important to provide details on specific circumstances under which mandatory capital contributions must be made, including the timing and amounts of such contributions. The drafter should also provide details on the procedures by which such contributions may be made. In addition, it is important to memorialize any consequences or penalties which may arise if a joint venture party fails to make any required contributions in the future. Mandatory contributions constitute the minimum amount of capital the joint venture needs for the success of the joint venture for its foreseeable future.
It is important to include the following with respect to initial capital contributions:
- The form and amount of the initial capital contributions
- The timing of such contributions (prior to the date the business commences)
- The type and amount of interest in the joint venture entity that will be received for each contribution
If the joint venture agreement permits optional future contributions, the specific instances in which such contributions are permitted should be set forth, including when such contributions may be made and the amounts that are permissible. Such optional contributions represent all funding in excess of the mandatory contributions that the managing member or board of managers/directors of the joint venture determines is prudent to support the joint venture’s operations.
If any capital contributions are in the form of assets, the joint venture agreement should provide the manner in which, and the values at which, such non-cash capital contributions will be converted into cash. Alternative valuation methodologies include to value the non-cash assets by an agreement negotiated at arms’ length or to have an investment banking firm do an independent valuation of the non-cash assets.
With respect to future contributions, the drafter of a joint venture agreement should draft provisions dealing with the following issues:
- The circumstances under which additional capital calls may be made, including the times of the calls and the amounts that may be called
- Usually mandatory additional capital contributions are made pro rata based on the joint venture parties’ percentage interests in the joint venture entity at the time of the contribution
- Caps on the amounts of additional capital contributions are prudent to avoid a joint venture party being responsible for unlimited mandatory capital contributions in the future; alternatively, the drafter can provide that additional capital contributions may be approved by a supermajority or unanimous vote of the board of managers/directors or the joint venture parties
- Limitations on the frequency of capital calls so that they are only made when they are required
- Advance notice requirements to the joint venture parties stating the aggregate amount of the additional capital call, the joint venture party’s share of the aggregate amount and the date on which such contribution is payable
- When a joint venture party’s obligation to make additional capital contributions will cease, which generally occurs when a party has paid out its entire commitment or an earlier trigger date
- The amount of additional equity interests to be issued to the joint venture parties as additional contributions are made
A drafter of a joint venture agreement should also draft provisions to address the consequences or penalties associated with a joint venture party’s failure to made mandatory capital contributions. These provisions can include the following issues:
- A dilution in the interest of the defaulting joint venture party
- Another joint venture party may be able to make a loan to the joint venture entity to cover the defaulted capital contribution at a specified interest rate and receive a priority return
- Loss of voting rights or rights to receive distributions until the default is cured
- The joint venture entity may be permitted to receive a security interest in the defaulting joint venture party’s interest to assure the defaulting joint venture party pays the obligated amount plus a percentage of interest from any profits arising from a sale of the defaulting joint venture party’s interest
- Forfeiture of the defaulting joint venture party’s interest in the joint venture entity
Control of the joint venture
For a joint venture to be success, the capital structure and management provisions set forth in the joint venture agreement must work together. Generally, the joint venture party who contributes the most cash and/or assets holds the most equity in the joint venture entity and would therefore be entitled to receive a majority of the management and voting power as well as most of the distributions or allocations of profit and losses and liquidation preferences.
The drafter of a joint venture agreement needs to consider how the joint venture entity will be managed. For example, will control be vested in one joint venture party or will a board of managers/directors be formed? If the latter, provisions need to address how member of the board of managers/directors will be appointed and how they may be removed.
A determination needs to be made with respect to how votes will be allocated among the joint venture parties. Will one joint venture party have a veto right with respect to particular issues?
Depending on the capital structure of the joint venture entity, consideration needs to be given as to whether there is a deadlock risk. If so, deadlocks can be resolved through a tie-breaking vote or another form dispute resolution methodology. Alternative forms of dispute resolution can take the form of mediation or arbitration. Often deadlocks require the acceleration of a buy/sell provision or dissolution of the joint venture.
The joint venture agreement
In drafting a joint venture agreement, it is important to draft provisions that address how often profits will be distributed and on what basis. In addition, will estimated tax distributions be made to members?
The joint venture agreement should describe the purpose of the joint venture and what action or agreement is required to change the fundamental scope of the joint venture.
The joint venture agreement should provide for a business plan and budget which would be approved by the board of managers/directors or by a supermajority of the joint venture parties.
The drafter of a joint venture agreement needs to consider whether non-compete covenants apply to the joint venture parties. Would those some covenants apply to a joint venture party’s affiliates?
Joint venture parties typically indemnify the joint venture entity for their own breaches of the joint venture agreement or for losses taken in their management roles.
Under a joint venture agreement, consideration should be given as to whether a joint venture party may transfer its interest in the joint venture entity. If so, what limitations should apply? For example, often transfers to affiliates are permitted for business purposes but the definition of an “affiliate” should be carefully drafted. Consideration should also be given to any rights of first refusal or refusal to sale with respect to a joint venture party’s interest. If a transfer is proposed, does another joint venture party have the right to “call” the interest and would another joint venture party have the right to “put” its interest to another party? What are the pricing conditions applicable to a transfer of a joint venture party’s interest?
Dissolution of the joint venture
The joint venture agreement should set forth the conditions under which the joint venture will be terminated and the joint venture entity dissolved. Generally, the reasons for a termination and liquidation include:
- Expiration of a definitive term
- Deadlock among the board of managers/directors which is not resolved within a reasonable period of time
- A change of control or insolvency of a joint venture party
- Events of dissolution set forth under applicable law
The joint venture agreement needs to set forth who will oversee the liquidation and disposal of the joint venture entity’s assets. Generally provisions such as expense allocation and reimbursement, governing laws, liquidation process, notice and jurisdiction, and restrictive covenants survive a termination and liquidation.