Give Me My Money

Which corporate owner gets its way with the money depends heavily on negotiated distribution terms in the JV agreement or other documents governing the JV, as well as on powers to approve the budget and capital spending decisions. Indeed, Verizon Wireless initially had a distribution policy that tried to satisfy Vodafone’s need for payouts and Verizon’s desire to pay down the venture’s debt. The policy mandated a payout of 70% of the venture’s net income provided the venture did not exceed a target debt level.^[1]Cellco Partnership Amended and Restated Partnership Agreement, April 3, 2000, www.sec.gov This policy, however, expired at the venture’s fifth anniversary, leaving distribution decisions to the board – and allowing Verizon Communications to exercise its 55% voting interest to prevent distributions in favor of using the free cash flow generated by the venture to pay down the venture’s debt.^[2]“Verizon signals mobile unit dividends from 2012,” Telecompaper Americas, September 24, 2010; “Vodafone eyes dividend of USD 5.5 bln from Verizon,” Telecompaper World, June 30, 2011

Vodafone’s predicament is not unique.

The owner companies of many joint ventures have been similarly frustrated by their inability to take cash out of their joint ventures, sometimes even needing to cover flow-through tax obligations when the joint venture has made paper profits but no actual distributions. Conversely, other companies have entered ventures with the idea of reinvesting to grow the business, only to find its partners owner using contractual rights to force dividends, thus making the joint venture re-compete for capital with other owner-company investment opportunities and not make timely or needed investments.

It does not have to be this way.

We recently reviewed the distribution and dividend terms in the legal agreements for 51 U.S. joint ventures to: (i) understand the different approaches and specific terms associated with dividend and distribution provisions in joint venture agreements, (ii) generate benchmarking data on what approaches are most and least common, and (iii) provide guidance on how to select an approach.

Our analysis led to an unsettling finding: 35% of all joint venture agreements, and 76% of ventures legally-structured as corporations, do not have a default distribution policy. Lacking an agreed way to get money out of the venture, the parties are exposed to the very real risk of cash being “stuck” inside it. In our experience, at least one partner is always better off with a default distribution policy defined upfront, as that partner has greater exposure to trapped cash risk due to less voting control (like Vodafone), greater need for dividends, or less automatic enthusiasm for investing in the business. More importantly, in most cases, all the partners are better off with some pre-agreed policy to distribute some or all funds, which the JV board can override by supermajority or unanimous approval.^[3]Companies often misunderstand the implications of voting provisions in joint venture agreements, assuming that, say, a 67% board approval requirement for distributions provides a high level of … Continue reading These pre-agreed distributions might be limited to cash needed to cover owner flow-through tax obligations or, more expansively, all funds above a certain level not needed for anticipated investments.

APPROACHES TO DISTRIBUTION TERMS

Companies all over the world enter into joint ventures to access capabilities, gain scale, meet regulatory requirements for local ownership, develop and commercialize new products and technologies, share risks, and access capital. Today, many global companies – including British Aerospace, General Motors, Dow Chemical, and Royal Dutch Shell – are party to multiple joint ventures which collectively account for 10-40% or more of their capital spending, revenues, or earnings. The earnings from these joint ventures are material to these companies and their shareholders.

Joint ventures can be structured in many different ways – including as true P&L entities designed to generate financial returns to be distributed to the shareholders. In some JVs, however, the legal structure and financial arrangements are crafted in a manner to not generate financial distributions^[4]In general, the term “distributions” applies to entities structured as LLCs and partnerships, while the term “dividends” applies to corporations. For simplicity, we use the term … Continue reading to the owners. For instance, in many manufacturing, production, and refining JVs, the owners fund capital and operating budgets and, in exchange, receive their proportionate share of offtake – which individual owners then consume or sell. In other ventures, such as back-office shared service JVs found in the banking industry, the owners might be customers of the venture and, in exchange for funding the operations, receive services from the JV on a privileged pricing basis – typically set so the JV generates a modest margin or operates just above breakeven.

When companies enter into JVs designed to generate financial distributions to the owners, those negotiating and drafting the legal agreements need to contemplate two contractual elements: (1) what triggers a distribution and (2) the way the amount of the distribution is calculated.

Distribution Triggers

Joint venture agreements provide that distributions must be made upon the occurrence of certain events. These events, or “triggers”, fall into four categories: (1) regular intervals of time, (2) satisfaction of one or more conditions, (3) action of a single owner, or (4) board^[5]We use the term “board” as a shorthand to refer to the main governance body of the joint venture which, depending on corporate form, may be called the Board of Directors, Board of Managers, … Continue reading approval (Exhibit 1).

---

---

Within each broad category, several alternative approaches may exist. These specific distribution triggers can relate to owner activities (e.g., a partner decreasing its interest in the JV) or JV activities (e.g., the JV meeting a milestone). Similarly, the trigger can be qualitative (e.g., the JV has sufficient capital to grow) or quantitative (e.g., the JV has a debt-to-equity ratio of at least 0.3). Distribution triggers can be “positive” in that they cause a distribution to be made or “negative” in that they prevent a distribution from being made. And they may be optional, mandatory, or mandatory with the opportunity for the board to over-turn by supermajority or unanimous approval.

Distribution triggers can be mixed and matched, with one JV agreement containing multiple triggers. Take the example of an aerospace and defense JV. The JV agreement requires cash distributions not more frequently than monthly and not less frequently than quarterly. However, it stipulates that no cash distributions shall be made which will (i) impair the ability of the JV to pay its debts as they mature, (ii) result in an excess of the JV’s liabilities over its assets, (iii) reduce the working capital of the JV to a level that would jeopardize performance of its on­going obligations, or (iv) violate the requirements of its lenders. Thus, the agreement has two “positive” triggers that cause distributions to be made: a time-based trigger (quarterly) and a board decision-based trigger (if the board decides to make distributions more frequently than quarterly). The agreement also has two “negative” triggers: a conditional trigger regarding timing (if distributions are made more frequently than monthly) and a conditional trigger regarding the ability of the JV to meet various obligations (if the distribution causes the JV to violate its lenders’ requirements etc.).

Similarly, distribution triggers may change over the life of a venture. This was the case in the Verizon Wireless JV, where payouts were required annually for the first five years, while the decision thereafter was left to the board, which Verizon controlled.

Including a specific distribution trigger in the JV agreement comes with certain benefits and risks. For example, annually requiring distributions of all of the JV’s available cash promotes payouts to an owner with a desire for distributions. It also promotes capital stewardship at the portfolio level, forcing the joint venture to re-compete for investment dollars with other corporate projects. On the flip side, if these required distributions are for all or a significant portion of the JV’s cash, this trigger will force the joint venture to go through the owners’ corporate funding approval process, which can be time-consuming and uncertain.

Distribution Calculations

The second contractual provision is how the amount of the distribution will be calculated, which can vary widely – from simple tax distributions to all available cash (Exhibit 2).

---

---

Just as the distribution trigger selected can help owners achieve certain goals for the JV or themselves, the specified amount of the distribution can be a tool for owner companies. For example, owners in one financial services JV required the distribution of all excess after-tax income over the amount required to maintain total shareholders’ equity at the Target Capital Requirement for the following year. The Target Capital Requirement for the venture, which was active in the business of derivatives trading, included risk buffers for losses modeled against different scenarios. Through this approach to how the amount of distribution was calculated, owners were able to ensure that the venture had appropriate reserves to meet unanticipated liabilities.

There can be multiple ways of calculating distributions specified in the same JV agreement, such as if the agreement requires a payout equal to an owner’s tax liability and then a different amount as set by the board.

BENCHMARKS

We analyzed the distribution and dividend terms in 51 U.S. joint venture agreements. Of these joint ventures, 35% allow the board to decide both the timing and amount of any distributions – i.e., have a discretionary distribution policy (Exhibit 3). The remaining 65% have other means of triggering and calculating distributions. – i.e., include a default distribution policy.

Joint ventures organized as pass-through entities (i.e., LLCs or partnerships) are far more likely than those organized as corporations to have a pre-agreed distributions policy, with 85% of pass-through entities having a default distribution provision compared to 24% of corporations (Exhibit 4).

One explanation for this discrepancy is that owners of JVs structured as LLCs and partnerships have tax obligations on the profits of the JV, regardless of whether those profits are distributed to the owners. By contrast, owners of corporations are only taxed on profits when they are distributed. Therefore, distribution provisions governing pass-through JVs are often designed to ensure that the owners, at a minimum, receive cash to cover their flow-through tax obligations. In fact, 45% of the pass-through JVs with a default distribution requirement specifically require tax distributions (Exhibit 5). Many of the JVs in the remaining 55% require distribution of all available cash and thus owners would also have cash to cover their JV-related tax liabilities. Owners of corporations do not have a similar need for cash as taxes are only due when dividends are paid and thus may not need a default distribution policy to cover tax obligations.

In terms of distribution triggers for pass-through JVs, the most common trigger is an interval of time – with quarterly and annual intervals being prevalent. Time is a particularly common trigger for tax distributions, which are typically required to be paid quarterly because of the quarterly tax cycle for U.S. businesses. A subset of JV agreements with time-based triggers allow the board to withhold distributions^[6]While not observed in the ventures within our sample set, such a provision can be structured such that the Board can withhold distributions except those required to fulfil owners’ tax obligations … Continue reading that are otherwise slated for use by the JV or to pay JV debt. The second most common trigger is agreement of the board (typically at a simple-majority passmark). Board action is the trigger for distributions in most JV corporations, as most have a discretionary distribution policy.

---

---

Satisfaction of a condition and action of a single owner are less common triggers, and generally are used as supplementary or negative triggers. For example, one agreement provided that if other distributions are insufficient to cover the tax obligations of the owners, a tax distribution will be made. This conditional trigger supplements other triggers that allow distributions to be made in the first case. Another agreement prohibited distributions if, after giving effect to a proposed distribution, the liabilities of the JV exceed the fair market value of the JV’s assets. Thus the condition was a negative conditional trigger, prohibiting a distribution in the case the condition was met.

In terms of distribution calculations, almost all the benchmarked JVs measure the amount that can be distributed in terms of available cash minus allowances for reserves. However, the precise calculation formula for available cash and reserves varies considerably (Exhibit 6).

---

---

Agreements make the calculation of available cash based on some definition of (i) cash flow (e.g., cash on hand and at bank, all money market assets, and all instruments readily convertible into cash), (ii) profits (e.g., GAAP earnings before amortization of intangibles), or (iii) revenues (e.g., gross amount billed to customers less sales, excise, and value added taxes). The cash-flows approach is most prevalent among the agreements we analyzed.

Similarly, deductions for reserves are a fixed percent (e.g., 125% of cash needed to fund operations for following 12 months), based on budgeted / anticipated expenditure (e.g., operating and capital expenses, payments on external debt, cash required for compliance with loan covenants), or simply determined by the board. Most JVs have a combined approach to providing for reserves: where a subset of the budgeted / anticipated expenditures are listed, and the board determine reasonable reserves for these and other expenditure.

OPTIONS AND INPUTS FOR SELECTING AN APPROACH

Options

The approach to distributions for a particular JV needs to be fit-for-purpose, taking into consideration the desires and constraints of the owners and the needs of the JV to achieve owners’ objectives. In our experience, it is essential for the counterparties to explicitly and preemptively define their views on future joint venture distributions. In simple terms, the available option set distills into one of four choices:

1. Keep the money in the JV- i.e., no default policy
2. Distribute to cover owner taxes (especially if an LLC)
3. Take money out, but allow the JV to retain some cash for growth (i.e., distribute 50-75% of available cash less reserves as a default)
4. Distribute all available cash

Inputs

While there’s no mathematical formula to determine how to choose among these four high-level options, or how to draft specific contractual terms within the preferred option, those negotiating and drafting joint venture agreements should holistically consider a basket of inputs, which include:

Input 1: Owner payout needs under different scenarios

First, dealmakers should identify and pressure test owner payout needs under different scenarios to determine distribution-related preferences of each owner. Does one owner need to get cash out of the venture (e.g., for tax purposes, to use in other parts of its business, or to distribute to the owner’s shareholders)? Alternatively, does an owner want to ensure profits are reinvested in the company, say, because that owner’s preferred strategy is for the JV to grow using retained earnings? Does either owner anticipate that its preferred approach will change over time or if the JV performs in a particular manner, such as if it meets certain performance standards or has a particular capital structure?

Input 2: JV capital needs

Next, dealmakers should understand the cash the JV will likely need to compete in its authorized market and to meet agreed objectives. If the JV will have significant ongoing capital needs, the parties may want to intentionally and structurally insulate management from being required to secure additional owner capital, such as by requiring in the JV agreement that a certain amount of cash is not available for distribution. Such an approach would isolate management from the vagaries of owner capital demands and misalignment except with respect to exceptional capital needs. On the other hand, if the owners anticipate the JV will not need additional cash to reinvest on a regular basis, keeping cash in the business as opposed to distributing it could be a burden on management. It could harm the JV’s capital structure and distract management from running the core business to find a means for putting reinvested cash to use. Thus, dealmakers should consider the effects of various distribution schemes on JV management.

Input 3: Impact of different triggers and calculations on needs.

Dealmakers should assess whether and how different contractual distribution triggers and calculations either satisfy or undermine an owner’s or the JV’s preferences.

• Distribution Triggers: The timing with which owners need payouts and whether they want distributions at all are the two primary drivers of distribution triggers. However, distribution triggers can also be used to incentivize JV management to act in a particular manner or to address a change in JV or owner circumstances. Take the scenarios to the right; in each scenario owner or JV needs drive the selection of a particular distribution trigger (Exhibit 7).
• Distribution Calculations: Distribution calculations are typically driven by the amount of cash owners need to satisfy their objectives outside the JV and/or the JV’s need for cash. The need to make tax payments if the JV has pass-through taxation often leads to a distribution calculation that allows the owners to meet this need – the distribution being calculated as an amount equal to a specific tax rate (for example, 40%, or current maximum marginal federal income tax rate in the U.S.) applied to the joint venture’s taxable income or P&L allocations to the owners. The tax payouts to each owner are made using the same imputed tax rate. If the owners have asymmetric tax rates, the amount of the distribution may tie to the owner with the highest tax obligations from joint venture allocated income, with a proportionate distribution to other owners to the extent required to keep capital accounts in balance.

---

---

Distribution calculations that are focused on the JV’s need for cash typically allow the board to determine the amount of distribution. This is because it is often difficult to determine at the time of JV formation how much cash the venture will need to reinvest to achieve its purpose.

Input 4: Availability of and influence on other terms impacting distributions

A range of other terms may have a direct or indirect impact on distributions and will need to be contemplated when drafting the agreements.

The two most direct terms are passmark voting levels: (i) to approve or amend the distribution policy and (ii) to approve individual distribution decisions consistent with that policy. Our analysis shows that establishing or amending the JV’s distribution policy is a reserved shareholder matter in 80% of JVs in the data set, and generally requires unanimous approval of the shareholders.^[7]Includes amendments to or deviations from that policy. In most instances, passmark is implicit as would constitute amendment to the legal agreements Meanwhile, making individual distribution decisions is a board matter in 80% of sampled JVs, with the approval threshold driven in part by the venture’s ownership structure. For instance, the median 50:50 JV requires effectively unanimous board approval for distribution decisions,^[8]“Effectively Unanimous” includes instances where the passmark is less than 100% but is at such a level that all owners with current ownership percentages have approval or veto rights while the median JV with three or more partners, none of which has a controlling interest, requires simple majority (51%) board approval to make such decisions.^[9]Our dataset also includes numerous less-traditional structures. For instance, a subset of 50:50 JVs have a simple majority passmark for individual distribution decisions, but require that the Board … Continue reading In 20% of JVs in our data set, controlling owners have the power to force distributions either because the threshold is set at simple majority or because of specially negotiated rights to make.

An equally important – but less direct – contractual provision relates to approval of the capital and operating budgets. Clearly, the amount of money available for owner distributions is a residual of the venture’s profits, which flows directly from operating and capital plans and budgets. This means that an owner (or set of owners in a multi-owner venture) which has control over those budgetary decisions can effectively manage – or sidestep – distribution outcomes. In a majority of the ventures in our dataset with a default distribution requirement, operating and capex budgets require the approval of multiple owners. For companies looking to actively manage cash out, approval/veto rights on the capital and operating budgets are essential levers.

Input 5: Precedent language from different contractual archetypes

Dealmakers should additionally review sample language from other venture agreements. A sample of relevant contractual provisions drawn from our database of roughly 2000 joint venture agreements is captured below, reflecting different deal archetypes related to distribution terms:

Input 6: Creative, non-standard terms and provisions

Beyond traditional contractual terms, dealmakers should also consider creative solutions that use unique combinations of distribution triggers and calculations and may leverage other provisions in the JV agreement.

For instance, in a financial services joint venture, a minority partner gained leverage over distributions through means of voting rights on the annual budget. The minority partner’s right to approve the annual budget was explicitly linked to the amount of prior and projected distributions. If distributions in either the immediately preceding year, or projected for the current budget year, were less than a threshold percentage of the joint venture’s EBITDA, approval of the budget required the affirmative vote of the minority owner. The budget otherwise could be passed by the controlling owner. Thus the majority owner was incentivized to approve distributions above the threshold percentage of the venture’s EBITDA in order to prevent the minority owner from needing to approve the JV’s annual budget, which it viewed as more invasive.

In a different financial services JV, the owners structured the agreement to keep some cash in the venture unless otherwise determined by the board, while still requiring some payouts to the owners. Specifically, the agreement requires quarterly distributions of 70% of Distributable Cash and permits other distributions determined by the board. However, the agreement includes an additional right for each owner to direct the venture to distribute its percentage interest in the remainder of Distributable Cash for the quarter not previously paid out if the aggregate amount of Non-Paid Distributable Cash exceeds a pre-determined amount. If an owner triggers such payment, other owners can elect to also receive their percentage interest of remaining Distributable Cash for the quarter or they are deemed to have received the distribution and reinvested it in the venture (i.e., it increases their ownership in the venture).

Or consider a semiconductor joint venture that manufactures memory products. The JV agreement provides that an owner can elect to accumulate its share of annual, mandatory distributions in a special purpose account instead of receiving cash. Subsequently, when the owner was required to make a capital contribution to the venture, it could instruct the joint venture to draw down the cash accumulated in its special purpose account instead of going through the owner’s complex internal treasury process. The special purpose account gave this owner, a large and global technology company that was cash-rich, but less keen on continuing to invest capital into the venture, the control over future investments it desired (the owner could empty the special purpose account at will), while mitigating the burden on the JV for future capital calls, especially given that the owners anticipated there would be ongoing investments in order to ramp-up the JV’s capacity and broaden its product suite quickly to stay competitive.

By looking holistically at a set of inputs, those negotiating and drafting joint venture agreements are more likely to find the optimal combination of distribution triggers and calculations for a particular venture.

---

Distribution policies deserve the same level of attention in joint venture negotiations as other critical deal terms, such as contributions, scope and exclusivity, voting and control, and exit. Owners companies almost always have asymmetric needs for cash from their joint ventures, and a different level of appetite for reinvestments through the joint venture. A well-designed, and potentially creative, distribution policy can contribute towards reconciling these divergent needs.