Building successful joint ventures


Financier Worldwide Magazine

March 2014 Issue

March 2014 Issue

Companies and investors are increasingly looking beyond the traditional acquisition and disposal model of M&A, and using joint ventures and partnerships to achieve their objectives. Joint ventures can be a rapid and effective mechanism for growth, enabling easy access to new skills, technologies and markets, with a raft of opportunities and advantages. However, such corporate ventures regularly fall apart – revenues decline, disputes erupt, and irreconcilable differences emerge. What pressures do firms face when entering into such business agreements, and how can they navigate these challenges to form a lasting and beneficial partnership?

Trends and drivers

Since the financial crisis, there has been an emerging trend toward firms entering into joint ventures and business alliances, rather than outright acquisitions. This has been seen most prominently in Europe, the Middle East, North Africa and South Asia. In today’s market, transactions of any form have become more complex, difficult to execute and harder to sustain than ever before, so, given the fragile nature of joint ventures, why are they so popular?

Despite their complexities, the increased incidence of joint ventures has been driven by a number of business motives, primarily revolving around the increasing complexities and exposures associated with today’s business environment. “There are two major benefits to owning assets in a joint venture,” says Sheri Chromow, a partner at Katten Muchin Rosenman who focuses on real estate transactions. “First, a joint venture is a private vehicle, which does not require securities filings or public reporting. While managers of joint ventures must report to owners, such reports are available only to the owners, permitting the entity to operate with less scrutiny. Second, a joint venture is virtually always a pass-through entity for tax purposes. Owners of interests in ventures pay tax only on their share of income and profits. By contrast, a corporate vehicle pays tax on all income and profits. The funds available after tax that are distributed to the shareholders as dividends are then taxed as income of the shareholders.”

A further driver of joint ventures is that they can provide an entry point into strategic markets. The growing challenges faced by firms trying to establish a footing in high growth emerging markets, for instance, makes joint ventures an attractive option, especially given the risk and regulatory issues associated with these regions. “Joint ventures are certainly becoming an increasingly popular method of achieving firms’ business goals,” says John Keffer, a partner at King & Spalding. “The use of joint ventures as a means of gaining entry into foreign and, in particular, emerging markets, is one which is becoming ever more common. In some cases, these countries require that a foreign company seeking entry to the market enters into a JV with a local partner. Another noticeable trend is that of companies using a joint venture to ‘test the waters’ in a particular product or market before committing substantial resources. As always, joint ventures make the most sense when each partner brings complementary expertise.

Factors to take into consideration include the length of the business relationship and the goals of the partnership, tax implications, management preferences, and funding requirements.

Structuring the venture

The term ‘joint venture’ can be applied to many types of structures. For instance, in its simplest form a joint venture is simply an arrangement between two parties – a common example being an arrangement between a developer and a capital source. “In this type of venture, the developer would be the managing partner, handling the day-to-day operations of the property,” says Ms Chromow. “The investor would protect its investment by retaining voting rights over major decisions. The developer and the owner may each own their interests in different types of entities. The venture itself can be formed as a joint venture between the parties. In the case of a joint venture, many states will view the parties as tenants in common. In order to have title held in a legal entity, it’s likely that the venture will be a partnership, limited partnership or limited liability company.”

The structure of a joint venture can have a huge impact on its economic success. From the outset, potential partners should discuss the direction they wish the business venture to take. Factors to take into consideration include the length of the business relationship and the goals of the partnership, tax implications, management preferences, and funding requirements. Joint ventures can therefore take a variety of forms. Limited liability entities are often used for larger ventures whereas smaller projects tend to favour the non-corporate structure and the reduced governance this entails. LLPs are increasingly popular for joint ventures between individuals and for their tax flexibility.

Furthermore, the structure of the venture will be shaped by additional factors including associated risks and the parties’ need to limit liability. “The general partner in a limited partnership will be liable for the obligations of the limited partnership, so the general partner itself may be a limited liability company. A venture can also be a trust, which shields the maker from liability,” says Ms Chromow. “A ‘fund’ or joint venture with more than two partners or members can contain a number of different types of members. In an investment fund, the promoters of the fund will likely be general partners or managing members, the investors, limited partners. Funds are traditionally set up as limited partnerships.”

There are a number of reasons why parties might opt for a contractual arrangement rather than a separate legal entity. For example, the businesses may have proprietary information that they are willing to use in the joint venture, but are unwilling to completely transfer to their partner. Additionally, rules regarding employees and their pension rights might make it difficult to operate a new legal entity. The joint venture’s structure will also have implications for the management and regulatory structure of the venture. Regarding management structure, corporate joint ventures are required to have a board of directors and executives. In this regard, they have the least flexible management structures. Unincorporated joint ventures enjoy greater flexibility.

The structure of joint ventures can also be shaped by regulatory requirements, and such concerns are particularly pertinent if the joint venture will operate across borders. Certain structures may raise competition issues, and a further consideration to make is whether the individual parent companies will be prohibited from competing with the joint venture.

Whatever form they take, joint ventures offer a number of advantages over traditional business partnerships, though they bring their own unique challenges. “Unlike an M&A deal, joint ventures enable the entities involved to pool their resources to meet a common business goal whilst maintaining their separate identities,” says Mr Keffer. “Joint ventures are a particularly useful means of carrying out fixed-term, specific projects. Joint ventures are not always plain sailing, however, and some of the common challenges include difficulties in negotiating the agreement and differences in the culture, objectives and management styles of the parties.” Indeed, such challenges can, and regularly do, threaten the business partnership, and though joint ventures are a popular means of conducting business, they are by no means foolproof.

Common challenges

Joint ventures frequently fail as a result of disputes arising from a mismatch between the two parties. Commonly, arguments arise over control of the venture, operational issues, business strategy and performance expectations. A clash of cultures can contribute to difficulties in international joint ventures.

While it is impossible to foresee future problems, many issues can be avoided if firms take the time to ensure any potential partner is a suitable match. A good start is to consider whether the partner is already known and trusted as a result of prior dealings. Parent companies regularly overlook this aspect of planning. It is all too easy to avoid conflict with a prospective partner and reach mutually agreeable terms – even if those terms are not best for either the joint venture or its parents. However, such issues often come to light after launch, increasing in severity once operations are underway, and ultimately undermining the long-term success of the joint venture.

While it is important to clearly understand a partner’s motives and objectives, companies should also consider their abilities and limitations, as well as their own. “One common reason that ventures dissolve is because of economic inequality,” notes Ms Chromow. “This has happened in a residential building as a townhouse where one owner wanted improvements to the property and a higher level of security of which the other could not afford. The venture failed. The best way to avoid problems is to know your co-venturer before you commit to a major transaction. You should have a clear sense of their expectations for a project. You should also have a clear sense of their integrity. Spell out a budget and put checks and balances into play.” Partnerships work best when each party complements the other’s strengths and weaknesses. Joint ventures should represent a coming together of two entities to achieve marketplace goals that neither could achieve alone.

However, even with an ideal partner locked in, the seeds of failure can still be sown in the early stages of the deal. Many firms find themselves under great pressure, often from investors, senior executives and the board, to get deals done quickly. Today’s stakeholders are eager to stay ahead of the competition and meet financial deadlines. But, in the rush to complete, even experienced joint venture managers can overlook best practices or skip steps, and often the planning process lacks discipline. When the pressure for speed meets the complexity of a joint venture process, it can overwhelm experienced practitioners, and any mistakes that are overlooked when signing the deal will likely rear their head at the most inopportune moment. To avoid such scenarios, companies have to find ways to balance the pressure for speed with the demands of planning a healthy joint venture – especially when allocating their time and resources in line with the potential for value and impact.

If a joint venture is set up correctly it should be able to withstand most disagreements between its parent companies. Mechanisms to consider include release valves in service-level agreements, partner-performance management, or dynamic value-sharing arrangements. Such devices can allow a joint venture to maintain balance in spite of partners’ different or evolving priorities and risks. Furthermore, mechanisms for regular performance monitoring are essential, as are governance agreements that establish when parent companies can exert influence over the decisions of the joint venture management team. But even these cannot guarantee the success of the venture.

No matter the strength of a partnership, or the expertise and care with which the deal is drafted, external influences can put paid to even the most successful joint venture. The economic crisis, for instance, has placed huge pressures on partnerships in the past few years. There is, then, no one-size-fits-all approach to establishing joint ventures, though parties can keep a few pointers in mind. “The optimum approach for success will vary depending on the transaction, but key lessons include selecting the right partner, which is often the difference between success and failure, and being flexible with respect to the deal structure,” says Mr Keffer. Changes in circumstance that may not have been envisaged by either party at the outset may necessitate changes to the JV structure. In this regard, it is important to maintain an open and direct dialogue between the partners at senior level.

Ending the venture

Given the challenges faced by joint ventures, it would be wise for firms to consider the worst case scenarios as part of their planning. Firms should end the relationship once it becomes clear that there are irreconcilable differences between the parties or the joint venture no longer has a prospect of achieving its goals. And when the partnership seems to be coming to an end, the parties must consider a number of factors, depending upon the structure of the venture. “Most joint ventures will ultimately end up in some form of dissolution or buy out,” says Mr Keffer. “It is essential that the joint venture agreement addresses these concerns in sufficient detail to address all possible outcomes. In addition, ensure that you have a contingency plan for the ongoing operation of the business post-termination on the joint venture.”

In most instances, the business of the joint venture will continue and one party will simply acquire the joint venture completely and go it alone. In this case, the acquiring firm must assess whether it has the knowledge and experience to carry on the venture. Key considerations include any commercial contracts with suppliers and customers, which may need to be renegotiated or terminated; the fate of assets owned by the exiting party, such as intellectual property, and how the joint venture will operate without these; the responsibility of parent firms to the staff employed by the joint venture; any pension arrangements put in place for the joint venture’s staff; and the tax implications of the joint venture’s termination.

The impact of terminating a joint venture can be far reaching, and parent firms should consider the wide range of commercial, operational, legal and practical issues which can arise. Indeed, where the intention is to continue the business, joint venture parties are well advised to carry out thorough due diligence in advance of any termination to ensure that the joint venture is sustainable, that the value of the joint venture business will not be materially eroded, and that there are no unwanted surprises following termination.

© Financier Worldwide


Matt Atkins

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