New England Biz Law Update
Under certain circumstances, business considerations suggest that a company should pursue a new opportunity with one or more collaborators rather than alone.
A businessperson might want to enter a new line of business or to conduct a business in a new geographic market, while mitigating the risk by sharing it with other participants. Alternatively, a businessperson might want to acquire a business currently owned by someone who is willing to share the risks and rewards of the business, but is not ready to sell it completely.
In such cases, a joint venture may make sense.
"Joint venture" refers generally to an association of two or more persons who combine their respective properties, efforts and/or know how to carry out a specific enterprise. The term encompasses many different types of legal relationships, including closely held business organizations, contractual "strategic alliances," risk and revenue sharing agreements, licensing arrangements, franchises and distributorships.
In this article, "joint venture" refers only to a closely held business organization that is owned by two or more persons and that the owners organize for the purpose of conducting a business with a limited scope.
Even as so limited, the term "joint venture" does not itself describe a specific type of legal entity. The owners may choose to organize their joint venture as:
The many considerations relevant to the choice of entity merit their own separate article. This article focuses on defining the scope of a joint venture, exclusivity arrangements and financing the venture.
Defining The Scope Of The Venture
Defining the scope of the venture is one of the most important, and often one of the most heavily negotiated, provisions in the joint venture agreement. Often the parties will have differing views of what the joint venture’s scope should be.
One party may be an operating company that will continue after the closing to conduct a business that is similar or related to the business that the joint venture will conduct – while another party may not intend to conduct any future business of its own that will be related to that of the joint venture. In such a case, the party with the future business similar or related to that of the joint venture will probably be interested in negotiating a circumscribed scope provision in the joint venture agreement, whereas the other party may argue for an expansive scope provision.
The outcome of the negotiation over this point will have important consequences. Many of the other provisions of the joint venture documentation – such as provisions restricting the owners’ ability to compete with the joint venture, investment restrictions and provisions relating to the joint venture’s permitted use of assets leased or technology licensed to the joint venture – will be keyed to the scope provision of the joint venture agreement. In addition, the definition of the joint venture’s scope may have implications for the range of activities that the owners are free to undertake without running afoul of common law doctrines, such as corporate opportunity and fiduciary duty.
The parties to a joint venture agreement may limit the venture’s scope many ways, such as by carefully defining:
In defining the scope of a joint venture, the parties should consider a number of factors, including:
Restrictions On Competition And Investment Restrictions
A well-drafted joint venture agreement will explicitly address two topics that are logically related to the defined scope of the joint venture (and to each other): The extent to which the joint venture owners are free to compete with the business of the venture, and the extent to which the owners are permitted to invest in other businesses that overlap with the scope of the joint venture.
Restrictions on the ability of joint venture owners to compete with the venture can be among the most heavily negotiated of all joint venture issues. This is especially likely when the potential joint venture owners have interests that conflict directly on this point.
If the proposed joint venture will be owned by two parties, one of which currently owns outright the business to be conducted by the venture and the other of which is contributing only cash to acquire an interest in that business, the parties may well view the competition differently. The party contributing cash will not wish to see the value of its investment eroded by competition between the joint venture and the other venturer (and, therefore, will likely want stringent restrictions on competition).
Conversely the owner of the business being contributed to the venture may wish to retain the option of continuing to conduct a business in which it feels it has proven competency. Antitrust issues overlay the commercial debate. If one party will own more than 50 percent of the equity of the joint venture, it will probably run less antitrust risk in agreeing to refrain from competition with the joint venture than will a minority owner.
Closely related is the issue of whether the joint venture agreement will include restrictions on the ability of the owners to invest in other entities, the businesses of which may compete with that of the joint venture. It would be a mistake to assume that if the joint venture agreement includes no explicit investment restrictions, then the owners are free to make investments on their own in other entities that are in the same line of business as, or in a line of business related to, the business of the joint venture.
Absent any restrictions on such activity in the joint venture agreement, a variety of common law rules, such as the "corporate opportunity" doctrine (applied in the partnership context and also extended to limit the activities not only of corporate directors and officers but also those of controlling stockholders) and various other incarnations of fiduciary duty, will occupy the field.
Unfortunately courts apply these doctrines in a manner that is difficult to predict, with the outcome of cases usually turning on fact-specific considerations. Thus, silence on this topic in a joint venture agreement can create ambiguity that renders the planning of future potential investment transactions very difficult.
Because many courts will respect negotiated contractual provisions that define the scope of the specific fiduciary duties that the parties owe each other, careful attention to the negotiation and drafting of artfully tailored investment restrictions will be effort well spent.
Financing The Venture
The relevant documents must address a number of issues relating to the financing of the joint venture. Typically, the owners of a joint venture will make contributions to the venture at the closing to finance the initial operation of the venture.
If the parties make these contributions in cash, the drafting issues are relatively straightforward, being limited to how much each party will invest and whether (and to what extent) there will be conditions precedent that must be satisfied before a party is obligated to make its cash contribution to the joint venture.
On the other hand, if one of the parties currently operates the business that the joint venture will conduct after the closing, that party will likely contribute that business to the venture. In such a case, the joint venture documentation must also deal with the question of valuation (the outcome of which will affect the relative ownership interests in the joint venture and may have implications with respect to other issues such as management and control); the representations that the venturer contributing assets will make about those assets; and the indemnification obligations that that venturer will undertake if the representations turn out to be inaccurate.
A joint venture may also finance its start-up activities by borrowing funds in addition to those contributed by the owners. One or more of the owners may be a lender to the venture, in which case the documents should address the amount to be loaned and the conditions precedent to the funding of the loan.
In addition counsel for a joint venture owner that is simultaneously a lender to the venture will seek to assure the inclusion of terms intended to minimize the risk of equitable subordination. Alternatively the parties may anticipate that the joint venture will seek funds from third party lenders.
If the parties contemplate this method of financing, the documents must address issues such as the extent to which the owners are willing to guarantee the repayment of loans made to the joint venture, and the consequences of a party’s being compelled by a lender to honor a guarantee in an amount that is disproportionate to that party’s relative ownership interest in the venture.
Unless the joint venture from the outset generates sufficient cash from its operations to meet its ongoing requirements, the venture will require additional funds after the initial closing. The joint venture documentation should address this possibility as well.
Each of the potential sources of funding mentioned above (i.e., additional equity investment from the owners, loans from the owners and loans from third parties), as well as equity from potential new investors, is theoretically a source of funds for a joint venture’s ongoing operations. If the owners themselves are willing to invest additional equity or make loans to the venture, the documents must address the timing of such fundings, the mechanics for making calls on the owners for additional funds, and whether such additional equity investments or loans are optional or mandatory on the part of the owners.
If additional equity investments or loans by the initial owners will be mandatory, the documents must also address the conditions under which such funding will be made available to the venture and the consequences of an owner’s default in its commitment to make a loan to or an equity investment in the venture.
On the other hand, if the joint venture will look to third parties as a source of funds, the initial owners may insist that their consent be required as a condition to a borrowing by the joint venture above some specified threshold or before a third party is permitted to make an equity investment in the venture (with resulting dilution of the ownership interests of the initial equity investors).
If the joint venture’s operations result in a positive cash flow, the venture could fund its post-closing requirements, in whole or in part, from the retention of earnings. A joint venture owner whose ownership position is insufficient to permit it to control the management of the joint venture will not be in a position to compel cash distributions by the venture absent some provision to the contrary in the joint venture agreement.
Therefore, the joint venture agreement should address the process by which the decision to retain or to distribute cash will be made during the term of the venture.
Joseph J. Basile, a partner in Bingham McCutchen’s corporate and finance areas, represents parties in complex domestic and cross-border transactions. He can be reached at [email protected] or (617) 951-8157. For more information on Bingham McCutcheon, visit www.bingham.com.
