In today’s global business environment, market participants continuously seek innovative ways to grow their businesses, obtain capital to execute their business plans and leverage shared resources. One popular strategy is forming a joint venture, which is a business arrangement where two or more parties pool resources to achieve a common commercial goal. Structuring a JV is complex, and success hinges on careful planning, negotiation and management, as poorly structured JVs can lead to conflicts, inefficiencies and ultimately failed outcomes.
This article explores several key issues to be addressed when forming a joint venture and provides a roadmap for avoiding some common pitfalls that derail many partnerships. By carefully defining a JV’s scope, negotiating for appropriate consent rights, protecting against leakage from affiliate agreements, addressing fiduciary duties and establishing clear transfer provisions, parties can create a JV structure that helps to ensure alignment and maximizes the likelihood of success for all involved.
Defining the Purpose and Scope of a Joint Venture
The success of a JV depends in part on how well the parties define the JV’s business purpose. This is the cornerstone of any joint venture agreement, setting clear objectives for what the JV will achieve and how, and potentially creating parameters for what the JV partners can do outside the JV. A well-articulated business purpose aligns the interests of all parties involved, ensuring that there are no ambiguities about the scope of the JV’s business activities and what the JV partners can and cannot do beyond the JV.
In practice, JV partners often have existing businesses they need to account for, including ensuring that the JV does not conflict with or cannibalize their own operations. For example, if a JV is designed to enter the European market, and one JV partner has existing operations in Western Europe and the other in Eastern Europe, the JV’s sales could cannibalize the partners’ revenue streams, reducing the overall benefits of the joint venture arrangement. In this situation, carefully delineating the geographic boundaries applicable to the JV’s operations would be key.
The scope and purpose of the JV should also be crafted with an eye towards how this language may influence the other provisions in the JV agreement. For instance, a JV partner may be incentivized to define the scope and purpose broadly as a means to impose commensurately broad noncompete and business-opportunities covenants that protect the JV but also hamstring the other partner’s business plans outside the JV. From a negotiating perspective, a JV partner desiring greater flexibility for non-JV activities may find it difficult to narrow those covenants after agreeing to a broad scope and purpose of the JV. Ideally, the parties should carefully define the purpose and scope of the JV, including in respect of specific projects, products, services and geographies, in a manner that can be replicated in the noncompete and business opportunities covenants so there is alignment among the provisions.
Consent Rights: Balancing Control and Flexibility
Once the scope and purpose of a joint venture are defined, the next step is establishing protections that safeguard the interests of the JV partners. These protections help to protect the partners’ investment, promote collaboration and ensure that the JV remains focused on its objectives without undermining the individual partners’ interests.
Consent rights are one of the most essential partner protection mechanisms in a joint venture. They ensure that key decisions within the JV require approval from key partners. The extent of consent rights often depends on the nature of the relationship between the JV partners and the level of control each partner wishes to exert. For instance, a minority partner may push for broader consent rights to ensure that its interests are not sidelined by the majority partner. On the other hand, the majority partner may seek to limit these rights to retain flexibility in managing the JV’s operations.
Common areas where consent rights come into play include issuances of additional equity in the JV, incurrences of debt, entry into new lines of business, adoption of the annual budget and entry into material transactions. For example, partners often seek a consent right over the issuance of additional equity in the JV to prevent the dilution of their existing equity stake. However, if the partners have preemptive rights under the JV agreement in respect of additional equity issuances, they may agree that no partner has the right to block an issuance because everyone has the right to participate and, in doing so, prevent dilution.
In a similar vein, a JV taking on substantial debt could negatively impact the financial health of the JV and its partners’ investments, which is why partners may seek a consent right over the incurrence of debt, though the consent right may be qualified by a negotiated basket amount (i.e., the JV would be permitted to incur debt up to the basket amount, but any additional incurrences would be subject to partner approval).
A JV’s entry into a new line of business is another situation where partners may have a consent right. As a JV progresses, one or more partners may desire for the JV to expand into other areas beyond its initial focus; consent rights help ensure that the partners agree on any major shifts in strategy.
For JVs where both partners want to be heavily involved in making decisions, the partners may seek a consent right over the annual budget or material transactions, such as entry into significant contracts, which helps ensure that both partners have oversight and control in key operational areas of the JV.
Practitioners should keep in mind that the longer the list of consent rights, the greater the chance of a disagreement between the partners, which could grind the JV to a halt. For every consent right, the parties should understand what will happen if the requisite consent is not obtained: Will the JV be able to proceed with its business anyway, should there be some mechanism to resolve the impasse, or should a buy-out or other JV termination provision be triggered?
Affiliate Agreement Protections
Affiliate agreements — agreements between the JV on one hand and a JV partner or one of its affiliates on the other hand — are a common feature of many joint ventures. Affiliate agreements can lead to concerns about fairness to the JV and value leakage from the JV to the benefit of the affiliate.
For instance, a JV partner might seek to channel certain transactions, such as supply or service contracts, through an affiliated company of the JV partner. While those sorts of transactions are not inherently disadvantageous to the JV, particularly if a JV partner has a certain expertise in a supply chain that benefits the JV, they should be scrutinized because, if the terms favor the JV partner unduly, they have the potential to lead to one partner benefitting disproportionately at the expense of the JV or the other partners, resulting in value leakage from the JV.
To mitigate this concern, JV agreements may include protections such as a requirement that nonaffiliated partners must consent to the JV’s entry into an affiliate transaction or to significant modifications of an existing affiliate agreement. For example, a JV that was formed for the purpose of developing renewable energy products could have a key supplier agreement with one of the JV partners, in which case any material changes to the pricing of that supply agreement may require the consent of the other JV partner.
In addition to consent rights over affiliate agreements, the nonaffiliated JV partners may negotiate for the ability to exercise the JV’s rights under affiliate agreements. For instance, if a JV is controlled by a majority partner and that partner also has an affiliate arrangement with the JV, then the minority partner may seek to have the ability to enforce the affiliate agreement on behalf of the JV because the JV is controlled by the majority partner who would not otherwise enforce the agreement against itself. This construct helps to ensure that breaches of affiliate agreements are properly addressed on an arm’s-length basis.
Fiduciary Duties: Protecting Minority Interests
JV partners should consider whether, in the context of a JV that is a limited liability company, fiduciary duties should apply or be waived, and for whom. Fiduciary duties require board members of the JV (and in some instances, officers) to act in the best interest of the JV rather than the partner that appointed them.
Fiduciary duties may be particularly important when there is a power imbalance between the JV partners, such as when one partner holds a majority stake. A majority partner may attempt to include a waiver of fiduciary duties for the board members they appoint, allowing those individuals to act in the best interest of the appointing partner rather than the JV as a whole. The majority partner may take the position that the JV partners should only be entitled to rely on their contractual rights under the JV agreement, and there should not be a fiduciary duty “overlay” protecting the JV partners.
While a fiduciary duties waiver may be beneficial for the majority partner, it can create risks for minority partners, who may be left vulnerable to self-serving decisions by the majority partner. Minority partners may seek to preserve fiduciary duties to ensure that they are treated fairly and that the JV operates in a way that benefits all partners. For example, they may push for board members to be subject to the same fiduciary duties that would apply to directors of a Delaware corporation, which generally requires that board members act in the best interest of the corporation and its shareholders, rather than their personal interests.
While there may be debate about the application of fiduciary duties in the case of board members of the JV, the partners should also consider whether fiduciary duties should apply to the JV’s officers. When drafting the fiduciary duties waiver, practitioners should take care not to make it so broad that it unintentionally applies to officers, especially if the intent is for officers to remain subject to fiduciary duties. Subjecting the officers to fiduciary duties helps ensure the officers overseeing the day-to-day management of the JV remain focused on the JV’s best interests.
Addressing Exculpation and Indemnification Provisions
Exculpation and indemnification provisions are vital components of any JV agreement, providing liability protection for the JV’s board members and officers involved in the JV’s operations and, in some instances, the JV partners themselves. These provisions outline the extent to which individuals and entities are shielded from personal liability for their actions in relation to the JV.
Exculpation provisions typically limit the liability of board members and officers for decisions made in good faith while carrying out their duties. This protection encourages individuals to take necessary risks in managing the JV without the fear of personal liability. However, practitioners should take care to ensure the exceptions to the exculpation provisions, which may include gross negligence, fraud or willful misconduct, do not create a “back door” override of the waiver of fiduciary duties applicable to board members. In other words, practitioners should draft these provisions with an eye towards potential differences in treatment between board members and officers in terms of the application of fiduciary duties. For example, in the case of board members who are not subject to fiduciary duties, an exception to the exculpation provision for gross negligence may not be appropriate because it may imply that board members are liable for breaches of the duty of care.
Indemnification provisions go hand in hand with exculpation by ensuring that the JV covers the costs of claims made against individuals in connection with the JV’s operations. This can include legal fees, settlements and damages.
JV partners should consider carefully whether the partners should be subject to exculpation and indemnification provisions when the JV is structured as a limited liability company. If JV partners are included, one potential pitfall is the risk of “circular indemnification” between partners. For example, if one partner sues another in relation to the JV, indemnification provisions could create a situation where the JV itself bears the costs of the dispute, effectively making both partners pay for the loss caused by one of the partners. The same issue could exist if the JV makes a claim against a JV partner.
Crafting Transfer Provisions to Safeguard Interests
Transfer provisions govern the sale or transfer of a partner’s interests in the JV, ensuring that the venture remains stable and that new, unwanted parties do not become partners. Without well-defined transfer provisions, partners may unintentionally breach the terms of the JV agreement through upstream transfers or face the risk of competitors acquiring a stake in the JV through indirect means.
Public companies and private equity firms often face unique challenges with indirect transfers, where changes in ownership of the parent company of a JV partner can implicate the transfer restrictions in the JV agreement. For instance, if the transfer restrictions in the JV agreement apply to indirect transfers, a public company partner in a JV that experiences a change in its shareholder base could inadvertently violate the JV’s transfer restrictions. Similarly, private equity firms should be cautious about how changes in their limited partner base might constitute an indirect transfer in violation of the JV agreement.
To address these challenges, JV agreements may include provisions that clearly define what constitutes a transfer and under what circumstances an indirect transfer is permitted. This can include carve-outs for routine changes in ownership or investor base.
One strategy to avoid an unwanted party from becoming a partner in the JV is to include in the JV agreement a “blacklist” of competitors who are explicitly barred from acquiring an interest in the JV. While this may seem like a straightforward means to prevent a rival from becoming a partner, if the JV agreement restricts indirect transfers, a JV partner should consider whether a prohibition on an upstream sale of the interests in the JV partner to a rival could impede a sale to a logical buyer of the upstream parent.
Key Takeaways
Joint ventures offer significant opportunities for businesses to collaborate and achieve goals that may be difficult or impossible to reach independently. However, the complexity and long-term nature of these partnerships require meticulous planning, negotiation and ongoing management to avoid common pitfalls.
By clearly defining the JV’s business purpose, establishing appropriate consent rights, safeguarding against affiliate agreement issues, addressing fiduciary duties and carefully crafting transfer provisions, partners can create a robust framework for their joint venture.
Ultimately, successful joint ventures are built on a foundation of trust, transparency and well-defined agreements. By paying careful attention to these key issues, companies can unlock the full potential of their partnerships and achieve lasting success.