Steps to Success in International Joint Ventures

International joint ventures are complex strategic partnerships that involve a myriad of legal questions coupled with cultural and relationship complexities. In this article, we explore some of the major considerations that joint venture partners should keep in mind when planning and establishing a joint venture, including partner selection, structure, governance, funding, investment value return, protection of goodwill, exit planning, and process management.

Partner Selection

A well-drafted legal agreement can protect parties against many issues, but it cannot prevent relationship breakdown and the irresolvable arguments that often result. To state the obvious, a successful joint venture is more than just a well-drafted legal agreement. It is a relationship of trust between the parties that can last on a handshake. Accordingly, choosing the correct partner—one that makes strategic business sense and with which there is a high level of trust—is fundamental. In many cases, this will involve undertaking appropriate due diligence on one’s proposed joint venture partner prior to establishing the joint venture. Once an appropriate partner is selected, the parties should understand and clearly document their respective legal rights and obligations.

Structure

Depending on the jurisdiction and the goals of the parties, the structure of a joint venture can take various forms. Broadly speaking, there are two primary approaches. One is an equity joint venture, which involves the formation of a separate legal entity to house the joint venture business in which each joint venture partner holds an equity stake. In the United States, a limited liability company (LLC) is often a preferred entity type due to its flexibility in terms of management and decision-making and the fact that it enjoys the benefit of pass-through taxation. The other is a contractual joint venture whereby the partners collaborate through contractual agreements without a separate legal entity intermediating. Which structure is most suitable will be fact-specific based on the commercial, legal, and tax issues, among others, at play in the relevant jurisdiction(s).

Governance

As with any business relationship, governance plays an important role in the organization and operation of a joint venture. Depending on the jurisdiction of formation of the joint venture, governance structures can differ, but some general considerations apply.

Voting standards are always important. They ensure how decisions are made and which party is in control of the decision-making. Clear drafting as to which matters are reserved to the management for determination and which require escalation to the joint venture partners for determination is imperative. Relatedly, where the joint venture is a separate legal entity, the parties must understand what statutory minority protections are available under local law in the relevant jurisdictions. This goes to the heart of control and management of the joint venture. A reasonable balance should be struck between partner control and management discretion, and any minority protections should reflect the ownership stake and agreed level of control of a minority partner.

The partners should also consider appropriate contractual provisions in the joint venture documentation to ensure that the joint venture (and its personnel) understands the requirements and business standards that are expected. Such provisions are likely to include representations and warranties; partner audit rights; and covenants to support the implementation of appropriate compliance systems, processes, and training (related to, for example, financial controls, antibribery, anticorruption, and ESG (environmental, social, and governance)).

Funding

Partner funding commitments usually align with the capital required to allow the joint venture to turn a profit in accordance with an agreed-upon business plan and budget model. The joint venture agreement should clearly outline each party’s initial contributions, whether in the form of cash (equity or debt) and/or assets, and establish appropriate mechanisms for determining when additional funding is required and how it will be contributed.

Depending on the nature of the business and the business plan, it is usually advisable to link partner funding commitments to the achievement of key performance indicators in the business plan on which management must deliver before a capital call can be made. This ensures goal-incentive alignment between management and the joint venture partners. It is crucial that any key performance indicators are well-drafted—sufficiently specific and measurable—to avoid any dispute about their achievement. It is also not unusual to allow the other partner(s) to make up the funding contribution of a partner that fails to meet its call, including by way of a loan/debt that can be converted into equity (assuming an equity joint venture structure) at a discounted value in a way that is dilutive to the nonperforming partner. However, such provisions require tactful negotiation to preserve the relationship between the joint venture partners.

Investment Value Return

Closely related to funding is how to structure and safeguard the investment return to the joint partners, whether that be by way of dividend, repayment of loan principal, or interest or royalty. This often involves a thorough understanding of the tax implications of the joint venture. There are likely to be tax implications for both the joint venture and the individual partners. Furthermore, depending on the jurisdiction, there may be specific tax advantages or disadvantages to particular mechanisms by which value is returned to the joint venture partners. Accordingly, specialist tax counsel, in conjunction with in-house tax/finance functions, will need to think through issues including the taxation of profits in the relevant jurisdiction(s); transfer pricing regulations; double tax treaties; withholding taxes on dividends, interest, and/or royalties; and any local tax incentives and exemptions before any decisions are made with respect to the appropriate mechanism to return value to the partners.

Protection of Goodwill

Carefully drafted restrictive covenants help protect the interests and goodwill of all parties involved in a joint venture. This includes not only traditional restrictive covenants such as noncompetes but also provisions regarding appropriate information barriers between the joint venture and the joint venture partners and nonsolicitation provisions to prevent the partners from poaching talented joint venture personnel.

Noncompete covenants can be particularly complicated, especially where the joint venture partners have operating businesses in sectors and geographies that may overlap with the joint venture, or have divisions within their companies that incubate new start-ups and projects that have the potential to compete with the joint venture.

Accordingly, the negotiation of these provisions requires close cooperation with the business team to identify areas of potential overlap, to assess the degree of competition, and to evaluate the potential impact of a covenant on the relevant business lines. From a drafting point of view, it is crucial to ensure that any covenants are narrowly tailored and account for existing and reasonably foreseeable business ventures of the partners, are of limited duration and geography, and include appropriate exclusions and exceptions.

Exit Considerations

While it may seem strange to think about exit before the joint venture is established, corporate counsel should always make sure that this is addressed early. Exit mechanisms are some of the most critical provisions in any joint venture agreement. They go to how parties ensure value realization and return on investment, as well as how to pick up the pieces if the joint venture becomes unviable or the relationship between the joint venturers breaks down. Planning for a potential exit allows the parties to be better prepared for any unforeseen changes in the joint venture, while also protecting their respective interests.

To ensure stability and to give the joint venture the chance to execute its business plan, it is typical in an equity joint venture for the joint venture partners to agree on a period of time during which the parties commit to not disposing of their equity interests. After this initial “lockup” period, there are multiple ways in which exit can be managed. This includes selling a partner’s interest in the joint venture to the other partner(s), buying out the other partner(s) to obtain full control, selling the joint venture company to a third party, going public, or dissolving the joint venture if it is no longer profitable or viable.

Common exit mechanisms to facilitate these options include drag- and/or tag-along rights in relation to share disposals, rights of first offer or refusal for existing shareholders, rights to initiate a third-party-led sale or listing process, and/or deadlock mechanisms. There is no one-size-fits-all approach. Much will depend on the nature of the relationship between the joint venture partners, the business established, whether the joint venture is on a majority/minority basis or an equal 50-50 basis, and whether value is seen as best maximized through public or private markets.

Exit provisions must be suitable in the broader context of the proposed joint venture. Drag-along rights can facilitate a smooth exit for a majority partner but may be regarded as unpalatable to a minority partner. Tag-along rights protect a minority partner but may make a sale more complex for the majority partner. Similarly, a right of first offer tends to advantage a partner that wishes to exit earlier, whereas a right of first refusal tends to favor a longer-term investor as it can be very difficult for a selling partner to persuade third parties to incur costs on negotiation and due diligence with respect to an offer where the third party could still lose the deal to the existing partner(s).

Some form of deadlock-resolution mechanism is also important to mitigate the negative impact of relationship breakdown. No deadlock mechanism is ideal, but, ultimately, its greatest value can lie in incentivizing resolution through good-faith negotiation, mediation, or arbitration given that the stakes of invoking the deadlock mechanism are so significant.

Process Management

Finally, it is worth noting that international joint ventures pose challenges on multiple nonlegal levels, such as language, cultural differences in approaching sensitive issues, risk tolerance, and underlying perceptions on doing business in various jurisdictions. As a result, complex legal matters coupled with such nonlegal challenges can be a recipe for protracted negotiations and the misalignment of expectations.

In-person negotiations can often help parties make progress. Parties can engage directly in discussions on key provisions with the benefit of their lawyers clarifying legal issues and documenting the final understanding in real time. Through debating and asking questions of one another, parties often come to a clearer and more thorough understanding of what their contract says, and pick up on issues that they had perhaps not previously considered. Given the benefits of such a high level of engagement by everyone involved, it is very often the most efficient way of negotiating successful international joint ventures.

Conclusion

International joint ventures involve a nuanced interplay of personal, cultural, commercial, and legal factors. Harmonizing these various factors is crucial to the success of any international joint venture. Corporate counsel’s role is, by definition, primarily legal in nature, but they play an important part in counseling their business teams on striking the appropriate balance among the personal, cultural, commercial, and legal dimensions at play. Issue spotting at an early stage helps the business team have a more holistic understanding of the proposed venture in a way that both better ensures commercial viability and success and builds rapport and trust with the joint venture partner.