Bar News - July 21, 2006
Business Law: Practical Tips for Equity Joint Venture Agreements
By: Julia Schappals
The Equity Joint Venture (or EJV) is a deceptively simple concept: two or more legal persons, known as the Joint Venture Parties (JVPs), pool capital to establish a separate corporation in which each JVP is a shareholder. Despite high failure rates (most do not survive five years); successful EJVs can reap very substantial benefits. A key feature of successful EJVs is careful planning and drafting of the pre-incorporation agreements. This article will examine some of the significant, but less obvious issues to be addressed in those agreements.
The Confidentiality Agreement
This should be the first document executed between the prospective joint venturers and allows each party an opportunity to evaluate whether the other’s technology or proprietary capital would be feasible for meeting the joint venture goals. Frequently, the confidentiality agreement remains in effect through the negotiation of the MOU (memorandum of understanding) and until execution of the “joint venture contract.” It should detail proprietary information transferred and restrict use and dissemination to specific evaluation and negotiation activity.
If a joint venture contract is not executed by a designated time, the transferred data should be returned or destroyed with appropriate survivorship of the use restrictions and confidentiality obligations. It should be separate from the MOU but typically is incorporated into the executed joint venture contract. Note that the JVPs may need to execute additional confidentiality agreements with the joint venture entity itself.
The MOU or Term Sheet
This is arguably the most critical document of the EJV in that it encapsulates the fundamental terms, flushes out commitment to the goals of the enterprise and forces the parties to think through the skeletal framework of the deal. A major hassle negotiating the MOU is an ill omen and signals the need for a re-evaluation of the parties and the project.
There are three important points to include in the MOU: (1) a statement to the effect that neither party is obligated to execute a joint venture contract, but if one does ensue, it will contain (inter alia) the terms described in the MOU; thus, extinguishing the MOU, (2) if a joint venture contract is not executed by a certain deadline, the whole deal is off and the only surviving obligation is to return and protect proprietary information per the confidentiality agreement; and (3) until the deadline, neither party will pursue any alternative joint venture partner.
At this point, a non-binding draft budget of the costs anticipated with each major task, phase or milestone as described in the MOU should be prepared but should not be a part of the MOU. This budget should be matched against the business or feasibility plan for a reality check. Because the MOU is usually the first time the parties have actually engaged in the give-and-take of putting the deal together, there is usually a tendency to focus on negotiating the structural details and not on the cost. If the negotiated MOU reflects substantial changes from the original business plan, a review of tax implications is necessary, particularly in international EJVs.
The Joint Venture Contract
This document is both a “fleshed out” version of the MOU, and the contract to establish the “joint venture company.” In addition to containing the usual legal requirements of all business agreements, the following issues should be considered:
Scope of the joint venture: If there is a possibility that the joint venture company could compete with your client in the future, it would be wise to limit its scope in the joint venture contract, as well as the “joint venture articles.” If an expansion of the scope becomes desirable later, it is usually an easy matter to make appropriate document modifications, but it may be very difficult to negotiate an acceptable scope limitation later.
Capital contributions: A carefully drafted description of any in-kind capital contribution (e.g. technology) and its valuation formula is critical and should dovetail with the “definitions” provisions. Vaguely describing this type of capital contribution invites a major dispute and a claim of material breach of the joint venture contract. In international EJVs, note that some countries, (e.g. People’s Republic of China) impose substantial restrictions on use of in-kind capital contribution.
Additional monetary capital calls can result in dilution of your client’s interest in the EJV and should first be considered on a pro rata basis, based on each party’s original capital contributions. The documents often state that the JVPs will make capital contributions at certain intervals, per a formula or on the occurrence of specified events. Unless the JVPs are fairly sophisticated, use of preferred stock should be avoided. Keep in mind that the role of the joint venture corporation’s directors in determining and pursuing capital requirements may vary by jurisdiction.
Board of directors and management: Essentially, the JVPs exercise control over the JV entity through their selection of the entity’s directors. To prevent impasse, the Board should consist of an odd number of directors, unless an alternate impasse-breaking structure is devised (e.g. an appointed swing vote). In 50-50 EJVs it is common for the JVPs to agree on the selection of the odd-numbered director.
Breach and dispute resolution: Arbitration and/or mediation is the most acceptable method of major dispute resolution since this is the best vehicle for assuring EJV survival. However, these avenues are complex and expensive and should be reserved for the most serious disputes or those whose value exceeds a specific threshold. Since some types of conflicts will be foreseeable, the parties might allocate responsibility for deciding disputes in such areas to the JVP most experienced in that issue. Alternatively, a rotating schedule among the JVPs for ultimate conflict resolution authority may be considered.
Choice of law: The agreement should specify that the joint venture contract will be governed by, and disputes determined in accordance with, the substantive and procedural laws of the jurisdiction of one of the JVPs, preferably the same jurisdiction used in the confidentiality agreement and MOU. Many agreements specify that in the event of disputes, the law of a “neutral jurisdiction” will apply. Unless a JVP is located in a jurisdiction notorious for vague laws or uncertain enforcement (e.g. Sudan) this approach should not be used because it lends substantial uncertainty to the drafting, interpretation and enforcement of the transactions.
Escape plans and termination mechanisms: A distinction should be made between those foreseeable, non-breach situations resulting in termination of one of the JVPs interests and those resulting in a termination (“wind-up”) of the EJV entity. In the former, the triggering event is often a change of control of one of the parties and the remaining JVP should have a right to purchase the other’s shares, usually in accordance with a specific formula or through reimbursement of the other’s capital contributions.
The joint venture contract should address the obligations of the terminating JVP to continue performing (if feasible) ancillary agreements with the EJV (e.g. licenses, supply agreements) to enable the EJV to continue operations with minimal interruption. It is also common to seek covenants of noncompetition, nonsolicitation and nondisparagement from the departing JVP but the validity and enforcement or such provisions may vary with local law.
Triggering events for wind-up include expiration of the EJV term or, more typically, major changes in regulatory or business climate make continuation of the EJV impractical. In these situations, the rights of each JVP to entity assets are usually in proportion to their respective capital contributions. In addition to the customary corporate wind-up considerations, the documents should cover the rights of each JVP to use transferred technology as well as improvements or new technology developed by the EJV, return of proprietary and other property, and survival of confidentiality obligations.
There are, of course, many other considerations involved in establishing a successful equity joint venture beyond the documents themselves. Like a marriage with children, the EJV requires commitment to the long term, endurance through setbacks, fidelity and a willingness to ante up money should the need arise.
Julia Schappals has drafted and negotiated many complex transactions, including joint ventures, in the United States, Europe, Australia and Asia. In 2003, she was recipient of the Woman of Distinction in the Business Law Community Award by the Women Lawyers Association of Los Angeles. An active member of the California Bar, she relocated to New Hampshire and was admitted to the New Hampshire Bar in 2005. She may be reached at: firstname.lastname@example.org or by calling 603-472-3365.