When Partners Can Punt Disputes to a Third Party
A neutral third party can be highly effective in resolving JV disputes – and can also fall flat.
Most JVs can and should lean on their owner companies for a variety of support – but the benefits may come with costs, risks, and potential conflicts. Here’s our advice on managing these complex commercial relationships.
DECEMBER 2021 – Joint ventures are a critical tool for companies to access or commercialize new technologies and capabilities, share risk, meet local regulatory requirements, gain scale, and pursue capital-light growth. The number of joint ventures (JVs) formed each year is three times higher than a decade ago, while the overall performance of such ventures has improved during that period. Today, companies as diverse as HSBC, Volkswagen, Siemens, ExxonMobil, and Vodafone hold dozens of JVs, and often depend on such structures for close to 25% of their revenue or net income.
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However, joint ventures often include complex commercial relationships with their owner companies. A JV might rely on its owners to supply key inputs, including components, feedstocks, technologies, brands, trademarks, people, or financing; to provide access to parent-owned infrastructure and other assets; and to purchase products or services from the JV – all of which might include volume commitments, pricing discounts, or special rebates (Exhibit 1). Within this swirl of interdependencies, JVs often receive back-office services like finance, accounting, or legal, and may rely on a parent to provide a core part of the value chain – like sales and marketing, or operations and maintenance – as a service. Our analysis shows that over 85% of JVs depend on their owners for at least some services, with reliance often heavier at the start of the JV.
Sadara Chemicals, a 65:35 JV formed in 2011 between Saudi Aramaco and Dow that is the world’s largest single-phase chemical complex, is an example of a venture relying on its owners for services. Sadara depends on Aramco or affiliates for on-site services, such as maintenance, utilities, and feedstock, and uses Dow’s marketing and technical services to support product sales and JV operations. Or consider the North American Coffee Partnership, a 50:50 JV between Starbucks and PepsiCo that has invaded grocery and convenience store shelves worldwide. Formed in 1994 and now with more than $1.5 billion in annual sales, the JV is the companies’ play in the ready-to-drink coffee market, and is behind such brands as Frappuccino and Doubleshot. The JV develops new branded products and handles production, but is otherwise highly dependent on its owners for many functions and services along the value chain, with Starbucks providing coffee bean procurement, roasting, marketing support, and in-store sales support, while PepsiCo provides bottling, distribution, tax, retailer management, and logistics support.
Leveraging owner companies for services offers great promise. When leaning on their owners for services, JVs have the potential to launch faster, gain access to highly distinctive capabilities and technologies, secure added scale and lower costs, and allow their management teams to focus on the core business rather than standing up and managing less-critical or highly specialized functions. At the same time, the provision of services allows the owners to gain added transparency and increased comfort with the business and how their money is being spent, while gaining their own economic benefits from service provision.
But the benefits may come with costs and risks. In general, our work shows that when JVs rely on their owner companies for services, there is a risk that such services introduce asymmetric economic benefits and influence to the service-providing parent – and suspicions and animosity from the other owners. For example, Airbus Industrie, when it was a JV, suffered from the complexities and inherent conflicts of being heavily dependent on its four owners for all manufacturing services. Airbus’ annual pricing meeting was famously referred to as “the liars’ club,” with its members trying to smoke-out pricing bluffs as each tried to maximize individual profits by inflating the cost of parts and manufacturing services provided to each product line. The lack of transparency on the actual costs of owner-provided services and other inputs meant that no one actually knew whether the business of selling an individual commercial airliner was profitable.
Reliance on parent-provided services also creates the potential for conflicts of interest, owner company overreach, and IP leakage. Our benchmarking shows that the median voting threshold to approve, alter, or exit affiliated-party transactions (including owner-provided services) is effectively unanimous in 70% of JVs, thus creating inherent conflicts of interest in situations where employees of the parent service provider vote to approve, alter, or exit transactions related to their parent company. Meanwhile, for the JV management team, owner-provided services can bring welcome support, but can also undermine true accountability for the business by limiting levers management has at its disposal to control costs and performance, and by giving owners a way to reach into day-to-day operations. For a JV CEO, it is a highly sensitive matter to question service quality and seek to performance manage services from an owner company – especially when the owner executives accountable for those internal functions also serve on the JV Board. Our work has shown that 50% of JV CEOs would terminate owner-provided services if they had the freedom to do so – yet many cannot.
Below, we share perspectives on three topics critical to getting owner-provided services right in JVs: (1) strategic considerations about how such services should be designed, (2) legal drafting considerations to ensure the right incentives, flexibility, and tools are in place to manage them, and (3) governance and management considerations, including best practices that enable transparency and efficiency in managing owner-provided services. What follows draws on interviews with 30 JV CEOs and our benchmarking of 39 JV service agreements (e.g., Master Service Agreements, individual service-level agreements), as well as our broader experience serving on hundreds of joint ventures over the years.
Optimizing the benefits of owner-provided services starts with clear answers to a set of strategic design questions at the negotiating table, including:
The answers to these questions hinge on a set of factors – including owner strategy, venture intent, relative ownership and control levels, venture materiality, and owner contributions and other commercial flows. For instance, 50:50 consolidation JVs that combine mature business units of two companies typically are better off with limited reliance on owner-provided services. Such ventures tend to have the scale to support functions in-house, and the desire to create a separate, leaner, and more entrepreneurial culture can be impaired by reliance on owner-provided services. In contrast, JVs to develop and commercialize new technologies may be wise to leverage owner-provided services that allow the venture to move quickly and avoid the sunk costs of building a full organization for an undertaking with highly uncertain prospects and dynamic needs. Similarly, JVs that are majority-owned or operated by one partner will typically rely on their controlling partner for finance, tax, accounting, audit, and other back-office services as that partner will financially consolidate the venture on its books.
For JVs that are not majority-owned by one partner, our data shows that JVs tend to reduce owner-company services over time – a natural progression as these ventures grow, prove themselves, and seek greater independence and less politicization of decision making. Our benchmarking of 244 JVs shows that 42% of JVs five years or older operate as independent companies with limited interdependencies with, including services from, their owners.
Typically, the counterparties in a potential JV will define and negotiate the use of owner-provided services upfront, incorporating key service assumptions in the business plan, financial model, and organizational design, and memorializing key terms in the legal agreements. Unfortunately, the contractual terms in such agreements are often not well-conceived or defined. Our recent benchmarking of 25 service-related terms in 39 cross-industry JV agreements shows that while some deals contain strong or creative terms that may serve as inspiration for others negotiating and drafting such provisions, overall there are widespread gaps. An assessment against our best-practice standards shows the median agreement scores just 5.2 on our 10-point scale, driven by key clauses either being totally absent or falling short of best practice (See Appendix: Benchmarking Analysis). These gaps not only raise the specter of misalignment, but they also create risk exposures for the parent companies and hamstring the ability of JV CEOs to effectively manage and grow the business.
Below, we illustrate some of the typical gaps and offer guidance on a few provisions in owner-provided service agreements.
Ideally, agreements will explicitly define whether an owner will have the exclusive or non-exclusive right to provide an agreed service to the JV and whether such exclusivity is contingent on performance, time, or other factors. We found that 46% of agreements failed to define any terms related to service-provider exclusivity. This matters because the provision of services can become highly politicized in JVs. A lack of clarity on exclusivity can create a minefield for a JV CEO or Board seeking to terminate, renegotiate, or performance manage services from an owner underdelivering on service quality, responsiveness, or costs. Meanwhile, 23% of agreements provided the owners with the exclusive right to provide services while 31% deemed the owner to be a non-exclusive provider. R&D and supply chain related services were typically provided on an exclusive basis while IT and marketing services were typically non-exclusive (Exhibit 2).
Service agreements ought to specify the pricing structure employed to charge the JV as well as the budgeting and reimbursement process. On pricing, 31% of agreements required the owner to provide services for an agreed fixed-fee per service domain, 47% at cost, 13% at cost-plus, 3% at market, and 6% using some other mechanisms such as a percentage of revenue or dollars per employee, or a hybrid structure that varied across services (Exhibit 3). This suggests that half the owner companies are generally not using services as a means to generate meaningful direct financial returns. That said, such services may indirectly contribute to owners’ bottom lines, for instance by adding scale and lower per-unit costs to their internal functions as well as providing added data, competitive market intelligence, and leverage. These services can also provide added data, competitive market intelligence, and leverage that owners can exploit in their wholly-owned operations, say, through negotiating greater discounts from third-party suppliers or optimizing customer targeting, sales, and marketing activities.
To the extent that the pricing model is cost or cost-plus, the agreements fall short in providing sufficient specificity on the underlying cost structure and the elements for which the owner company can charge the JV. For example, most service agreements (e.g., Master Service Agreements) allow the parent company to charge the JV for overhead costs incurred but fail to define how such overheads are to be calculated and what is to be included in them. As a general matter, companies are better off being very clear as to what is and is not included in “cost” calculations.
Any service agreement – whether with an owner or third-party vendor – should define performance expectations for all parties relative to the provision of such services. In our benchmarking, 46% of the JV service agreements only provide boilerplate language such as “appropriate standards of care” with respect to performance standards, while only 36% require any sort of periodic performance reviews, and just 21% establish any incentives or penalties to drive owner performance. Furthermore, only 34% of agreements provide the JV with the right to access the provider’s accounts, and less than a quarter provide the JV with other information rights to query owners for additional financial, legal, operational, or tax documentation. Simply put, the agreements need to do more to provide JV management with the basic tools to manage its owner service providers like a vendor when acting as a vendor.
No legal agreement would be complete without provisions related to term, dispute resolution, and termination. Roughly half the service agreements provided for a fixed duration, ranging from 1 to 20 years with a median of 4 years; the remainder had an open-ended term. In our experience, it is generally better to structure agreements with defined and shorter durations (e.g., 2-3 years), with the mutual option to renew, as this creates implicit incentives for performance. Meanwhile, close to 10% of agreements did not define any triggers for the JV or the parent to terminate the agreements prior to the end of the term. When termination triggers were present, 45% allowed for termination only in the event of material breach, while nearly 40% gave both the parent and the JV the right to terminate without cause. In our view, agreements should provide the JV with the right to terminate when performance standards are not met, typically with some notice period (e.g., 90 days).
Legal agreements may include other terms, including related to liability, IP ownership, confidentiality, and obligation of the JV. Terms related to liability, when structured correctly, further incentivize good performance. However, 32% of agreements limit the liability of the service-providing parent from any losses or damages, even in cases of negligence or willful misconduct. Additionally, approximately 10% of agreements cap the liability of the service provider at a specific dollar amount, and only 26% of agreements address liability clauses in case of third-party damages in instances where the parent subcontracts with another party to provide services. Meanwhile, 34% of agreements do not define terms related to ownership of foreground IP developed while services are rendered, which does not meet our best practice standards.
In sum, while drafting legal agreements, JV dealmakers should ensure the presence of key terms, define them with sufficient clarity, and make certain they conform to best practices.
What should JV Boards or CEOs do to better manage owner-provided services in the context of existing – and likely flawed – legal agreements? Our experience points to five actions:
For many JVs, owner-provided services continue to be a constant source of tension, albeit one that rarely gets center stage until things go terribly wrong, despite having a significant impact on the economic and operational viability of the JV and returns to the owners. JV dealmakers, Boards, and CEOs need to shine a brighter light on owner-provided services, put in place best practices, improve the governance of such arrangements, and optimize the benefits that they provide.
The authors would like to thank Peter Daniel, Kira Medish, Tracy Branding Pyle, and Ryan Tabor for their contributions to this article.
To understand how well-structured joint venture legal agreements are with regard to owner-provided services, we evaluated the service-related terms in 39 joint venture service agreements (including Master Service Agreements and individual service-level agreements) against an independent set of standards of excellence. Our standards establish specific tests in 25 contractual areas common in owner-provided service agreements in joint ventures. These standards test for the presence and appropriate specificity of rights and obligations within each area, as well as whether the legal terms provide JV management with sufficient levers to hold an owner service-provider accountable for performance delivery. Within each of the 25 terms, we scored individual agreements on how well they met each standard, with scores ranging from fully meeting, mostly meeting, somewhat meeting, and not meeting. We then aggregated these scores into an overall scorecard, showing how the 25th, median, 75th, and 95th percentile agreement performed against these standards (Exhibit A).
|↑1||A Governance Framework will cover topics like the role and workings of the Board and committees, management of conflicts of interest and competitively sensitive information, management delegations, reporting and information processes, audit procedures, and secondee appointments and management; See James Bamford, “Operationalizing JV Governance,” The Joint Venture Exchange, August 2017.|
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.