HAVE AN ESCAPE HATCH: EXIT STRATEGIES FOR UNWINDING JOINT VENTURES

HAVE AN ESCAPE HATCH: EXIT STRATEGIES FOR UNWINDING JOINT VENTURES

Starting a joint venture is often exhilarating.  The parties have grand plans for the future, and the decision to launch is most often the result of thorough analysis with a vision for the future and the conclusion that the whole will be significantly greater than the sum of the parts.  The participants are eager to move forward and begin realizing the success of the venture.  Because the venture partners are, at this point, necessarily optimists, they are likely to have discussed and perhaps even agree on parameters for sale strategies – when will we cash in and get rich – but though those are important considerations, of equal importance is the consideration of how to unwind the venture if things don’t work out.  By some estimates, between 40-70% of all joint ventures ultimately fail.  The separate businesses can suffer setbacks, and personal relationships may be damaged if exit strategies and alternatives are not considered and agreed on at the outset.  This is a summary of the most frequently used exit alternatives.

Joint ventures usually take the form of limited liability companies or corporations.  Overall, LLCs provide more flexibility and do not require as extensive recordkeeping as corporations.  This may be a good thing or a bad thing.  Keeping complete minutes of board or governing member actions can force better decision making by causing the parties to document considerations that went into the deliberative process.  This can also aid the considerations in determining how an exit will work.

Parties may also resist considering exit provisions because they think that inclusion of specific provisions may make it too easy to get out if the going gets rough.  It is easy to say that good business partners will work out their differences, but that may or may not be the best solution given the circumstances.

Governance provisions, including exit rights, are usually found in the Operating Agreement of an LLC or in the Shareholders’ Agreement of a corporation.  The most frequently used exit strategies are:

  • Buy-sell provision
  • Parallel exit rights (tag-along and drag-along rights) in the event that the joint venture partners do not have equal ownership or management rights
  • Fixed termination date
  • Optional termination if agreed-upon performance metrics are not met

In addition to those provisions, we also recommend considering an optional termination after a period of time – take stock of how things are going after a year or two, and give either party the ability to terminate at that time with no hard feelings.

The buy-sell option is probably the most frequently used provision.  It generally gives one party the right to buy out the other for a price that is either predetermined or, more likely, subject to a formula.  In some cases there is also an option where one party can name the price at which it is willing to either buy or sell its interest.  This also can have the effect of forcing the parties to come to mutual agreement if the price is not an accurate reflection of the value.  Buy-sell provisions can also be structured to provide for buyout at a discounted price if one party breaches the joint venture agreement or does not meet performance goals or milestones.

Parallel exit rights can also be effective.  These allow an interested seller of the venture to “drag along” the other joint venture partner upon the same terms and conditions as the interested seller has negotiated and also prevent one seller from freezing out the other by allowing the other party to “tag along” in the proposed sale also upon the same terms and conditions as the proposed seller.  These are often used if the parties do not have equal interests in the venture as they serve to protect both the majority and minority interest holders.

Fixed and optional termination dates offer another alternative.  In all cases, the parties’ expectations are great at the outset of the venture but operating the venture and the passage of time can result in the venture not meeting one or both party’s expectations for a variety of reasons, none of which may be the fault of either party.  In this circumstance, the parties now have the ability to unwind or modify the agreement to address concerns that have arisen.  Termination options have the practical effect of hitting a reset button; the venture will terminate unless the parties mutually agree to go forward either under the current structure or with modifications.

Ring Fencing.  If the parties include a termination date and the operations of the venture allow different components of the business to be operated separately, consider “ring fencing” or segregating a portion of the venture’s assets or profits to make accounting and operational challenges more manageable in the event of termination.  For example, if one party has contributed a specific line of assets to the venture, keeping them segregated can make unwinding the venture much easier.  It can also serve to maintain or improve credit ratings to the extent ownership (and, accordingly, security interests of creditors or lenders) is kept separate.

All of these exit options are almost certainly better than resolving disputes in court.  The business drivers and operational structures of joint ventures are necessarily complex, and trial courts often do not have the sophisticated business experience necessary to thoroughly analyze the situation and deliver a fair and just outcome.  Careful planning and the inclusion of an escape hatch for each party can avoid significant obstacles in the event the venture doesn’t work out.