Due Diligence for Joint Ventures

Joint Ventures can be a great way for a business to enter a new market or line of business.  There are quite a few items to consider.  Often the best partner for a Joint Venture is a competitor.  It will be important to define what will be shared, who will run the operations, who will own any intellectual property created, and the process to sell interests in the Joint Venture entity, among several factors.

What is a Joint Venture?

Joint ventures are partnerships between two or more independent parties (JV parties). The parties enter into these arraignments for commercial, strategic, or financial reasons. A joint venture (JV) can be formed to develop a narrowly defined project or technology, or to own and operate a business. Some JVs are conducted through contractual relationships between the JV parties, while others involve the creation of a separate entity to carry out the JV.

The scope and nature of legal due diligence on JV transactions varies. This blog post considers due diligence specific to JVs and factors to consider in determining the scope of diligence for a JV project or transaction. It does not cover business or financial due diligence.  Future blog posts will consider due diligence specific to services to be provided to the JV, antitrust issues, the agreements required to form the JV, and due diligence related to intellectual property in the JV context.

Anticompetitive Concerns
If the JV parties or their affiliates are competitors, the parties may need to impose restrictions on the exchange of information and due diligence. Competitors are prohibited by law from sharing some information (like pricing). Sometimes the parties can redact sensitive information or develop a procedure to limit access to those materials. Antitrust counsel should be consulted as early as possible on these matters. For example, your company should not make any agreements with the joint venture partner that limits your company’s freedom to act on any matters outside the scope of the joint venture, such as limiting your company’s ability to compete with the joint venture, without appropriate legal review with your attorney.

Define Internal Stakeholders
It is important to identify internally any actions that are necessary for a JV party to itself proceed. For example, are any third party consents or approvals required under your existing contracts? Other items to identify include:

• Stakeholder, lender, or other consents or approvals needed to enter into the JV
• Liensor encumbrances on assets to be contributed to the JV.
• Existing restrictive covenants, such as a non-compete, that may prohibit entering into the JV or an agreement with the other JV party.
• Required antitrust or other regulatory actions, notices, or filings.
• Required announcements of the transaction, particularly if a JV party is a public company.
• Any internal reorganization or restructuring that might be required to enter into the JV.

While JV transactions vary widely in their scope, purpose, and structure, typically due diligence should focus on:

• The other party’s good standing, outstanding litigation, and financial stability
• Issues relating to the JV and its purpose or business.
• Contributions to the JV from the other JV parties, including any non-cash assets, services, or support to be provided.
• Ancillary agreements to which the JV will be a party.
• The ability of the JV, the other JV parties to perform their obligations.

As part of its due diligence, a JV party should:

• Review the JV's business plan and related risks and liabilities.
• Assess the long-term value of the JV and potential synergies with a JV party's primary or other businesses.
• Evaluate the ability of the other JV parties to perform future obligations and commitments.
• Evaluate any non-cash assets and any services or other support to be contributed or provided to the JV by the other JV parties and any related liabilities.
• Identify services or support that will be needed by the JV, whether from the JV parties or others, including any services or support that may not have been considered in the JV's initial business plan or financial models.
• Evaluate the terms of agreements that the JV will be a party to, including any IP license or other ancillary agreements.
• Identify any third party consents, regulatory filings, or other actions necessary to form and operate the JV.
• Consider the cultural fit between the JV parties.
• Identify issues that should be discussed between the JV parties before entering into the JV, or contractual protections that should be included in the JV documents.

Joint Venture Purpose or Business

You should analyze relevant laws, compliance, and specialty areas that will apply to the business of the JV. Specialists should review their respective areas of expertise.  If the JV involves competitors, you must consider and comply with applicable antitrust laws. We will discuss this further in a separate blog post. Depending on the JV business, you may need to consider corruption risk.

Contributed Assets

If non-cash assets are being contributed to the JV, the due diligence investigation should consider these assets and be used when valuing the assets. The review may also include a confirmatory review of assets that your company would be contributing to the JV (such confirming that the assets you intend to contribute are free and clear of liens).

You should consider the following questions as part of due diligence on contributed assets:

• Are the descriptions of assets to be contributed to the JV sufficient and comprehensive?
• Are there any asset sharing arrangements (or other rights to use assets of the transferor JV party or its affiliates not being contributed), transition or other services or support that the JV will be need to allow it to make full use of any contributed assets or to otherwise obtain the full benefit? Does the transferor JV party or any of its affiliates intend to retain any rights in any contributed assets, such as a right of use? If so, what limitations or restrictions, if any, is the retention subject to?
• What liabilities are associated with the contributed assets? Is the JV assuming any of these liabilities, or if not, how will they be discharged? Are there any potential undisclosed or understated liabilities, including any risk of successor liabilityfor liabilities not intended to be assumed by the JV?
• Should or will the JV assume any related contracts, or become subject to any related contractual rights or obligations? Are there any undischarged contractual obligations that do not provide a future benefit to the JV? Depending on the type of assets, are there any warranties or indemnification rights that should be assigned to the JV?
• Are there any contractual or other restrictions on the ability of the transferor JV party to transfer, or the ability of the JV to use, the contributed assets?
• Are any third party or regulatory consents or approvals required for the contribution?
• Are there specific types of representations and warranties, indemnification that the transferring JV party should provide, either to the JV, the other JV parties, regarding the contributed assets?
• Is there a different method of transfer (other than a contribution of assets in exchange for JV equity) that should be used to transfer the assets (such as a license of the asset to the JV or a sale of the asset to the JV under an asset purchase agreement)? Are there tax advantages to structuring the transfer as an asset purchase rather than a contribution?

While they vary considerably based on the nature of the contributed assets, steps that may be helpful in completing this due diligence include:

• Review financial statements and identify relevant liabilities.
• Conduct UCC, tax, and judgment lien searches to identify any liens on the contributed assets, including, in the case of any contribution of stock or other equity interests, any assets of the entities being contributed.
• Review all licenses, approvals, or permits required in connection with the contributed assets, and any relevant current or past enforcement actions, notices of violation, complaints, or other relevant matters or correspondence.
• Consider whether any relevant licenses, approvals, or permits can be assigned or otherwise transferred to the JV, or whether the JV will have to apply for new ones.
• Review all related contracts, including any warranties, purchase agreements, service contracts, and customer or supplier contracts or arrangements. Confirm whether relevant contracts or rights in the contracts can be assigned or otherwise transferred to the JV and, if so, any necessary consents or approvals to do so.
• Obtain and reviewing information regarding any relevant threatened or pending claims, lawsuits, or administrative proceedings.
• Review any prior insurance or warranty claim history, maintenance logs, or records.
• Consider future maintenance obligations and costs and any capital expenditures made over the previous three years (or other relevant time period), including any variance from budget.
• Consider whether any third-party review or appraisal is appropriate. Review copies of any valuation or other reports that might contain relevant due diligence information.

Any entities contributing stock or other equity interests, the assets, rights, and liabilities should also be included in the due diligence review.

Use the Information Uncovered in Due Diligence
It may be better to form a separate entity to carry out the JV rather than relying on a direct contractual arrangement between the JV parties if there is any potential for future liability related to the business of the JV. If the due diligence raises questions about the financial condition of another JV party, a creditworthy parent company or other affiliate should provide a guaranty or other support for its obligations.

JV parties should discuss and resolve issues of concern in the early stages before entering into the JV documents, rather than down the road when issues are likely to become more complicated to deal with. Even if it is not possible to resolve an issue during the negotiating phase, a discussion can raise the awareness of the other JV party to the concern.  This also helps determine if the JV parties are a good fit culturally. In other cases, it may be possible to add a protection into the JV structure or documents to mitigate the concern.

Impact of Due Diligence

Proper due diligence can impact a JV in several ways:

• Valuation of JV assets and ownership.If the value of assets a JV partner is not accurate or does not take into account liabilities or other issues, this could result in an unfair allocation of the percentage ownership between the JV parties. Due diligence can identify issues that should be taken into account in valuing the contributed assets.
• Effective operational planning.The JV parties can devise solutions to problems in the initial planning stages before they begin operations, and factor these costs into financial models if the JV parties identify operational issues early.  This may include any services or other support required to operate the JV and carry out its business plan.
• Modification of business plan.The JV parties may identify impediments to their original plans (for example, a required third party or governmental consent) and find ways to adjust their plans rather than abandon the JV.
• Contractual protections.The JV parties may require each other to make certain representations and warranties in the JV agreement, set conditions that must be met before the JV can commence, or covenants that a JV party must fulfill. These provisions can provide assurances or other undertakings regarding contributed assets and also provide recourse if issues arise later. However, the parties should keep in mind that contractual protections and remedies in a JV may not be as helpful as in an acquisition agreement. Because the JV parties will have an ongoing relationship, launching a claim or suit for breach of contract or indemnification claim may sour the relationship between the JV parties and therefore not be a realistic remedy.
• Abandonment of venture.In extreme situations, the JV parties may decide to abandon the JV or pursue an alternative structure, such as an acquisition, because they can no longer achieve the projected value or a JV party is no longer comfortable with certain risks or liabilities.

Please reach out to the Goosmann Law Firm if you considering a joint venture.  We are happy to help you consider all of the legal and business risk factors, and with all associated documents.  We are committed to customer service and will consider alternative fee arrangements.

Angela Madathil is a Real Estate, M&A, and Deal Attorney and provides legal assistance to buyers and sellers of businesses, as well as business brokers in Kansas, Missouri, and Nebraska.   This can involve contract review and negotiation, due diligence assistance, and post-sale integration.  The Goosmann Law Firm team advises to buyers and sellers of businesses, as well as business brokers throughout the Midwest and has attorneys licensed in Iowa, Kansas, Minnesota, Missouri, Nebraska, South Dakota, and other states.