The concept of two or more persons combining their resources to collaborate on a joint venture is as old as time. The sophistication these joint venturers bring to the table, however, is perhaps higher now than ever before. With this sophistication comes complexity that cannot be handled through boilerplate documentation.
The following is a list of considerations you should review before forming a joint venture. That means before the first day of investment and/or business to ensure each party understands their duties, roles and redress should the venture not go as plan or a change in circumstances dictates an exit or reorganization.
- Whether the joint venture should be operating out of an entity. Some ventures may not necessitate the use of a multi-member/partner/shareholder entity, e.g., an expense sharing arrangement, although a single member/shareholder entity may be prudent.
- Whether multiple entities should be considered to control different aspects of the relationship, through either a holding company structure or separately siloed entities.
- Whether entities should be taxed as partnerships or corporations for U.S. federal income tax purposes. This list is focused mainly on tax partnerships given their flexibility, although we are deeply versed in corporate entities and corporate governance.
- Whether entities should be formed in a local jurisdiction or formed in Delaware (and potentially registered to do business in the local jurisdiction). Many times, the decision is driven by state law considerations and variations of fiduciary duty.
- Whether the name is available in the jurisdiction of choice, and whether business will be operated under this name or whether a trade name will be used. It is advisable to research the name both locally and federally in case there are any infringement issues.
- For administrative purposes, you will need to obtain full names and addresses of the members. You will also need to determine a principal place of business and a mailing address if different.
- Whether the members should hold their interests as individuals or through entities for liability protection and partnership dispute purposes (a decision for the owners).
- Whether the members will be contributing cash, property or services in exchange for their equity interest. It is extremely important for the members to be clear about the value of their contributions if capital will be infused by means other than cash. There could also be unintended tax implications for contributing services or appreciated property to an entity that will be taxed as a partnership, e.g., members contributing appreciated property may be specially allocated income before members contributing cash, and members contributing services may wish to make an election to accelerate ordinary income so that future appreciation (in the interest) is taxed at capital gains rates.
- Whether one, all or a percentage of the members may require a capital call from the members. Depending on the venture itself, the methods, manner and amounts can be of great import. There is also potential flexibility and dilution or loan provisions available for members should one of the members not make a required capital call. For example, some partners may desire to have any shortfall be considered capital/equity whereby non-contributing members’ interests are diluted, whereas others may desire to have any shortfall contributions be considered a loan between the members at a pre-arranged term and interest rate.
Distributions & Allocations
- Whether distributions are going to be in accordance with ownership percentages or by some other formula, the members need to mutually agree to a waterfall.
- Whether allocations of income are going to be in accordance with ownership percentages or by some other formula that has substantial economic effect. If distributions are in accordance with ownership percentages, we would generally recommend income allocations to follow. If distribution provisions are by some other formula, target allocations may best match income to cash so that members are not allocated “phantom” income without cash.
- We generally perform and recommend that the distributions and allocations be modeled at the outset using a number of scenarios to ensure the cash and tax implications are aligned with their intentions.
- The liquidation distribution and allocation provisions should also be agreed to out the outset, and we generally recommend they correlate to those in place during the life of the venture.
Management & Member Decisions
- Whether the entity should be member-managed or manager-managed. Generally speaking, we recommend a manager-managed structure as it provides additional flexibility in the decision-making process and streamlines how actions may be taken.
- Using a manager-managed structure, you have the ability to restrict and limit the powers of the managers such that certain actions require the approval of all or a percentage of the members or other managers. If you would like there to be multiple managers, a board structure is also available such that some or all decisions must run through the board of managers and/or members.
- Deadlock provisions can be extremely valuable where current or potential (death, resignation, incapacity, etc.) managerial or membership percentages could result in a stalemate when it comes to the decision-making process. These provisions generally work through the progression of workouts from good faith efforts to mediation to arbitration, etc.
- Whether veto powers make sense for major acts based on dollar limit or potential to change the core venture, e.g., incurring debt, selling substantially all of the assets, an act putting the venture into bankruptcy, etc.
- There remains a plethora of situations where a member either desires or is required to transfer some or all of their membership interest to a different party. Each potential situation should be contemplated and addressed in the joint venture agreement.
- Voluntary membership interest transfers are generally restricted to particular classes, whether that is other members, family of members or defined affiliates of members. There may also be restrictions on decision making authority of transferees in this situation, such that their interest is only economic in nature (i.e. with no right to vote). Joint venturers may want certain voluntary transfers to go to a vote of the members and/or managers.
- Involuntary transfers at death, disability or incapacity may also be restricted to similar classes, but should also include a personal representative, executor or other third parties that may be put in charge of an entity member during an interim period.
- Buy sell provisions should also be contemplated at the outset. Such provisions may include drag-along/tag along requirements, puts or calls or firsts rights of refusals to the other members before transferring an interest in the venture.
- Is there a business plan or budget that should be incorporated with standards for modification and updating?
- It is prudent to clearly document any related party agreements or fees to be approved by the parties in advance to avoid issues with conflicts of interest.
- Carefully draft for confidentiality and other restrictive covenants including covenants not to complete if applicable.
- The new partnership audit rules should be addressed in any organizational document governing an entity that is taxed as a partnership for income tax purposes. Along with this is the appointment of an individual that will serve in this capacity.