Executing Successful Joint Ventures (Part 3): Frequently Asked Questions
How do the joint venture partners get compensated?
Joint venture partners may realize compensation from a variety of contracts, such as: allocations of profits/losses under a joint venture agreement; royalties from license agreements; fees under management and technical assistance agreements; salaries under executive compensation agreements; or sales proceeds under distribution, supply and manufacturing agreements. It is important to understand the elements of the venture being contributed by each party, and how those contributions drive value for the venture, before allocating value under the various agreements.
It therefore is important to have the business plan and financial models (without sensitivity analysis) completed before negotiating these agreements. Care should be taken at this stage not to divulge trade secrets. There is a tendency to share information in order to foster an atmosphere of trust. Although well-intended, it often leads to bad outcomes, with your counterparty deciding it no longer needs a complicated business relationship when it now is well-positioned to execute the business plan on its own.
It is also important to create the proper incentives for value creation. For example, allocations of profits/losses are bottom-line oriented, and therefore are appropriate where the joint venture partner has responsibility over operations. Under other arrangements, the contracting partner gets paid regardless of the level of profits of the venture, e.g. commissions, license fees and earnings under supply agreements. In the case of a supply agreement, the parties may use volume discounts in order to allocate more value to the joint venture as its account becomes more valuable to the supplying partner.
A useful tool in allocating the profits/losses of some joint ventures is to borrow the “carried interest” or “profits interest” from the private equity model, wherein a partner who contributes capital is entitled to a full return of its capital and often an agreed return on capital, before a managing partner who has not contributed capital (or who has contributed a relatively modest amount of capital in order to demonstrate “skin in the game”) shares in a percentage of the profits.
Who should control the joint venture?
Of course, each partner would prefer to control the management of the business. But it is often the case that the priorities of activities that each party seeks to control are different. Using a combination of affirmative control rights and negative control rights often can give control rights to one party without diluting the control sought by either party. For example, where one party provides the bulk of capital to the venture and the other party provides local management and know-how, an integrative compromise frequently is to grant board level control to the financial partner but give the host country operating partner both the affirmative right to nominate the chief executive officer and chief operating officer, subject to veto rights of the financial partner, and the veto right to approve any changes to a business plan that is approved during the original negotiations. Depending upon the nature of the joint venture, other decisions where negative control rights should be considered include changing product lines, incurring expenses over a stated level, initiating law suits, selecting accountants and lawyers, mergers and acquisitions, and making distributions.
To accommodate the interests of the more passive partner, the joint venture agreement typically
assigns clear financial and operating reporting obligations on the managing partner. In some countries, local law requires a defined percentage of local ownership. Creative negotiation and documentation frequently can effectively accommodate the interests of the parties by shifting economic incentives.
What should you do to avoid conflicts over management styles?
As part of the initial discussions, the parties should identify labor and management approaches, and authority for personnel decisions should be agreed upon. Advice of local counsel on local labor and employment law relating to termination and other workers’ rights also should be identified. The expatriate partner should be cautious about getting “dead wood” staff from the local partner and the time and cost relating to termination. Similarly, proper controls should be put in place to avoid the siphoning off of know-how.
Costs of staffing may also raise issues. For the expatriate partner, placing personnel into the venture comes with a significant burden, as it disrupts domestic operations and typically requires compensation for housing and potentially private education for the children of the expatriate personnel. The host country partner may be reluctant to have the venture pay the full cost of expatriate personnel. The host country partner may not have a full understanding of these costs, making it imperative to address them up front. In addition, there often is a disparity in compensation levels between the expatriate staff and the host country staff. Proper attention to this issue in early stages of negotiation can avoid potential conflict and unplanned costs when untrained host country employees demand higher compensation.