What’s In and What’s Out: Designing Contribution Structures in Joint Ventures
A High-Level Overview
Considering the full venture lifecycle during the deal process may make it harder to close – but can help avoid problems down the road.
JULY 2015 — It is certainly possible to negotiate a Joint Venture Agreement without dwelling intensely on the future. Indeed, dealmakers have some very good reasons not to over-prescribe the future. After all, defining the future takes time, draws attention away from getting the deal done, and adds to non-closure risk. Defining the future can also introduce potential liabilities and limit future flexibility, as it may lock the company into commitments that do not make sense down the road.
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One dealmaker summed it up this way: I’m a dealmaker, not a soothsayer. It is dangerous to predict the future – and far wiser to let our executives overseeing the business address events and issues as they arise.
But the low success rates of joint ventures – and high level of post-close misalignment and exit issues – suggest that failing to think about the future may not always be the best way to approach joint venture dealmaking. Consider a few examples where incomplete thinking about the future caused severe and avoidable pain:
The low success rate of JVs suggests that failing to think about the future may not always be the best approach to joint venture dealmaking
We believe that companies need to expand the set of questions they ask during the deal process – and look out across the full venture lifecycle for more clues about what issues the parties will predictably confront in the JV. Dealmakers should address these issues pre-close, while they have all of the leverage, and none of the risks. Specifically, front-loading the future means having good answers to a number of questions, including:
The purpose of this note is to tackle the first question.Other Ankura articles, webinars, and roundtables have addressed or will address the other three questions. For example, on 25 June 2015, Ankura hosted a webinar, “Defining the Governance Model for … Continue reading
Companies need to expand the set of questions they ask during the deal process, including whether the company is disadvantaged by seemingly fair, boilerplate deal terms
Many dealmakers rely on standard terms or model-form agreements to expedite the dealmaking process, and limit the areas of negotiation. But in certain situations, such terms can be highly problematic for one of the partners if certain events occur – events that can be predicted during dealmaking. Therefore, a key element of front-loading the future is looking at these boilerplate terms, and testing whether standard language that seems eminently balanced and fair will actually disadvantage your company down the road. If the answer is yes, then dealmakers need to deviate from the traditional, timeworn path of the boilerplate, either by opting out of standard contractual language, deepening existing language, or developing additional agreements pre-close.
Boilerplate terms expedite the dealmaking process, but can be highly problematic for one of the partners if certain events occur – events that can be predicted during dealmaking
To illustrate this work, consider three deal terms, and how a deeper view of the future drives the company away from the boilerplate:
The typical JVA requires a supermajority vote of the JV’s Board of Directors (or equivalent) to approve any financial distribution to the shareholders. While this standard term may seem reasonable, it can disadvantage a shareholder in certain situations. For instance, if your company is entering into a 50:50 JV with an eye toward generating near-term financial returns, but the other shareholder is more interested in growth, building market share, or keeping profits within the venture for tax or other reasons, then this standard deal term is bad for you, as it creates a barrier to getting cash out of the business. Simply put: If the partner does not want to make a distribution, venture profits have nowhere to go but to sit in the JV.
Such a standard term can also materially reduce the overall level of capital discipline across a company’s portfolio. Consider a European chemical company, which owned more than ten JVs accounting for some 30% of its total capital spending. A meaningful portion of this capital spending was self-funded by the JVs. “Effectively what this means,” according to the company’s Finance Director, “is that our earnings from these ventures are not ‘re-competing’ for capital with our other businesses and projects, and therefore, our money may not be going to the best investments.”
Requiring supermajority approval of the Board to repatriate JV earnings to the shareholders can create a barrier to getting cash out of the business
If your company sees the future unfolding like this, you should consider deviating from the standard JVA voting provisions for dividend policies. As with a number of other standard boilerplate terms, we have developed a checklist of non-standard deal terms to consider, the relevance and feasibility of which will vary by the situation (Exhibit 1). For instance, in the situation described, the company might have proposed that the agreements be structured to provide an automatic payout of any earnings above a certain level (e.g., $10 million, or 20% of the JV’s annual operating costs), unless the Board agrees by unanimous vote to the contrary. Alternatively, you might structure some or all of the shareholders’ initial capital contributions to the JV in the form of a loan, with a pre-agreed repayment schedule linked to JV earnings (and where earnings are automatically used to repay lenders prior to making other capital investments in the venture).
In 50:50 JVs, it is common for the parties to agree to a buy-sell provision as a way to avoid prolonged deadlock, and prevent either party from being stuck in a business that is underperforming, or that no longer fits with its strategy. While there are different types of buy-sell provisions, the basic idea is that either party has the right to initiate a bidding process that will lead to a buyout, but does not know whether it will be the buyer or the seller of the venture. The industrial JV discussed above used a common buy-sell provision often referred to as Russian Roulette.Other common forms of buy-sell provisions in JVs include a Texas Shootout and the Dutch Auction (also known as a Mexican Shootout). Under the Texas Shootout, each partner submits a sealed bid … Continue reading Under this structure, either party has the right to trigger exit, with the initiating party offering a valuation at which the non-initiating party is then given the choice to either buy or sell.
On the surface, this pricing methodology seems fair, since the initiating party sets the valuation, but does not know whether it will be the buyer or the seller at that price. However, deeper thinking about the future could lead the company to see that this is a suboptimal structure. Specifically, if your company is the more natural seller of the venture (e.g., because it views the venture as a non-core business, because it is less strong financially than the counterparty, or because the venture has far greater operational integration with the counterparty), then a buy-sell provision disadvantages your company, since the counterparty knows it can offer below fair market value for the venture.
Russian Roulette disadvantages the natural seller, because the counterparty knows it can offer below fair market value for the venture
In such cases, you should consider different ways to deviate from standard buysell contractual terms (Exhibit 2). For example, you might propose extending the period within which the non-initiating partner has the right to decide whether to buy or sell (e.g., structure as a 12-month window rather than the more typical 1 to 3 months), thereby creating greater opportunity for the company to raise capital, seek third-party investors, etc. Alternatively, you might reject a standard buy-sell provision in favor of one linked to a pre-agreed pricing methodology. For example, the JV Agreement may allow either party to initiate exit, but require that the offer price must be at or above a specific earnings multiple, or fair market value as determined by an independent valuation firm. In a financial services joint venture we recently worked on, the natural seller successfully negotiated for a provision that went even further, requiring the partner initiating exit to make an offer at 20% above FMV, while the non-initiating partner had the right to sell at that price, or to buy at 20% below FMV.
JV Agreements generally do not place mandatory obligations on the shareholders to make additional capital contributions to the venture (beyond the initial capital contributions). Rather, Joint Venture Agreements typically treat future funding as a matter reserved for the shareholder companies, requiring each shareholder to independently decide whether to make such a capital investment, and only proceeding if all the shareholders agree to make such investments.
On the surface, this standard contractual term is reasonable, as one shareholder should not have the power to force the other to commit its capital. But there are plenty of circumstances where this structure might disadvantage one company – and its dealmakers would be wise to test alternatives. For example, your company might find itself in a situation where the counterparty’s strategy or balance sheet makes it unable or unwilling to make certain future capital investments – for instance, expanding the facility or investing in a new product or production line – that are reasonable, and that your company wants to make through the JV.
If your company is more likely than the partner to want to make capital investments, then treating future JV funding as a matter reserved for the shareholder companies can disadvantage you
If your company is more likely than your partner to want to make capital investments, you should look at a range of less standard deal terms (Exhibit 3). For example, you might seek to define investment criteria or similar principles, and embed these within the JV business plan (agreed-upon pre-close), or within a Governance Framework document (approved as a Day 1 Board resolution) A Governance Framework is a document that captures shareholder alignment on how the venture will operate – including dimensions that do not logically belong in a JV Agreement.. Going further, you might have the parties pre-agree to a three-year capital plan and budget that commits shareholders to specific capital investments. Or you might suggest funding an escrow account at deal close, where the funds are returned after a certain number of years, assuming shareholders vote not to make an investment. Or you might seek to establish a minimum re-investment rate linked to the JV’s annual cashflows, where shareholder payouts can only be made after the venture meets its re-investment target.
Alternatively, you could pursue creative deal structures where one company gains the freedom to pursue new investments alone if the other shareholder declines to fund the investment.
An interesting structure can be seen in a 50:50 biofuels JV to develop and commercialize a new technology (Exhibit 4). The deal was structured to enable potential future investments to be funded by only one shareholder, provided certain conditions were met. Specifically, the JV Agreement gave each shareholder the right to propose investments to commercialize the JV’s technology, products, or derivative products, which were to be approved by the JV Board. The shareholders agreed to a set of investment principles that stated that the preferred option was for the shareholders to each invest 50% of needed capital in new projects. But the agreements also allowed that if either shareholder wished to fund at a lower percentage, that shareholder had the right to subscribe to between 20% and 49% of the new investment, with a corresponding ownership percentage in a new entity created. If within three months after one shareholder had proposed such a project, the JV Board had not approved the proposal or some modification, then the initiating shareholder had the right to propose directly to the other shareholder to create a new entity to pursue the investment, or to pursue the investment on its own.
Additionally, the agreement stated that if a new entity was established, no third party could invest in that entity. And if the non-initiating shareholder invested at less than 50%, then no earlier than Year 3 and no later than Year 5, that shareholder had the right to increase its interest to up to 50% by purchasing equity interest at FMV.
Of course, front-loading the future involves more than just thinking beyond the boilerplate. But anticipating the future – and breaking from boilerplate contract language when needed – is one way to ensure better, longer-lasting, and fairer JV deals.
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|↑1||By “boilerplate,” we mean contractual arrangements that are fairly standard in Joint Venture Agreements, and are therefore viewed as the default option by dealmakers. Though boilerplate deal terms are often sufficient for satisfying both shareholders’ needs, there are many situations in which creative, non-standard deal terms should be preferred.|
|↑2||Other Ankura articles, webinars, and roundtables have addressed or will address the other three questions. For example, on 25 June 2015, Ankura hosted a webinar, “Defining the Governance Model for a JV,” which addressed aspects of the second question. A recording of that webinar is available to our members via the Joint Venture Advisory Group website.|
|↑3||Other common forms of buy-sell provisions in JVs include a Texas Shootout and the Dutch Auction (also known as a Mexican Shootout). Under the Texas Shootout, each partner submits a sealed bid containing its perceived value per share of the joint venture, and then the partner with the higher bid must buy out the other partner at that price. Under the Dutch Auction, each partner submits a sealed bid indicating the minimum price per share at which it would be prepared to sell its shares; whichever bid is higher wins, and that bidder then buys the loser’s share at the price indicated in the loser’s bid. All three of these common types of buy-sell provisions disadvantage the natural seller.|
|↑4||A Governance Framework is a document that captures shareholder alignment on how the venture will operate – including dimensions that do not logically belong in a JV Agreement.|
We understand that succeeding in joint ventures and partnerships requires a blend of hard facts and analysis, with an ability to align partners around a common vision and practical solutions that reflect their different interests and constraints. Our team is composed of strategy consultants, transaction attorneys, and investment bankers with significant experience on joint ventures and partnerships – reflecting the unique skillset required to design and evolve these ventures. We also bring an unrivaled database of deal terms and governance practices in joint ventures and partnerships, as well as proprietary standards, which allow us to benchmark transaction structures and existing ventures, and thus better identify and build alignment around gaps and potential solutions. Contact us to learn more about how we can help you.