Planning Exit Strategies for Joint Ventures

Introduction

One of the most common phrases that negotiating parties often use when they are unable to agree but are willing to move forward on other issues in their agreement is “Let’s agree to disagree”. In context of a Joint Venture (‘JV’), however, a lack of agreement can have much higher stakes as such disagreements can quickly turn into deadlock for the business, impacting its ability to operate and creating problems for business value if one party is not willing to move forward beyond their point of disagreement.

Despite the fact that JVs are collaborative business relationship, they are rarely intended to last indefinitely. Both parties may have different business strategies in the long run, or their business goals may differ. However, in a JV agreement, exit strategies are usually a secondary issue in negotiations, where both parties are focused on launching the business / collaboration. It is considered off-beat to discuss / touch upon the exit eventualities. Resultantly, parties fail to anticipate how rights and obligations will play out when one partner seeks to exit. Thus, from a structuring point of view, parties entering into a JV should think beyond the initial alignment of interests and carefully design exit mechanisms from the outset.

Need for incorporating exit strategies while structuring JVs

The assumption underlying a JV is that all parties concerned will work together in an attempt to achieve a common business objective.  However, in reality, different risk appetites and capital allocation strategies can cause tension between parties. Deadlocks in governance issues, for instance, in terms of growth strategies, capital infusion, and appointment of key management personnel, are among the most common issues that can cause a JV to terminate. Without proper mechanisms in place for orderly transfer of shares and exits, parties to a JV may feel locked in an untenable partnership. In this context, proper exit strategies have two key functions. They provide commercial certainty in terms of how a partner can exit a JV.  Secondly, proper exit strategies can act as a form of discipline in managing JVs.

Put and Call Options

Put and call options are popular tools in JVs, providing exit and control flexibility, especially for foreign investors. A put option allows the holder to require the counterparty to buy their shares on occurrence of certain specified events such as breach, deadlocks, non-achievement of financial milestones, and the passing of time. On the other hand, a call option allows the holder to buy the stake of another party.

In the case of foreign investors, put options provide a risk management tool that allows them to exit the joint venture in cases where the joint venture is not performing well and where there is a breakdown in strategic synergies. While call options allow the investors to increase their stakes in a JV over time, usually where the initial stake is limited in nature.

 Drag along rights: Majority led exits

Drag-along rights are one of the important exit strategies in a JV that allow a majority-led exit, especially in situations where a strategic investor seeks a controlling exit. These are essentially the rights that allow the majority shareholder in a JV to force minority shareholder to sell its shares in the JV company to an outside buyer on the same terms and conditions. This is important because it allows the buyer to purchase a clean stake in the company without any fragmentation of ownership.

From a structural point of view, such provisions are important in situations where a foreign investor seeks an exit in the form of a strategic sale and the drag-along right serves an important tool that facilitates an exit without any hinderance from the minority shareholder that may renegotiate the underlying commercial arrangements at the time of exit.

ROFR: Controlling ownership transitions

Rights of first refusal (‘ROFR’) is often used in JVs to regulate changes in shareholding and maintain balance between partners. ROFR binds a JV partner planning to sell its shares to offer these shares to existing partners at an equivalent rate prior to selling these shares to a third party.

ROFR is used as a significant tool for maintaining a balance of ownership and restricting unwanted shareholders’ participation in a JV. From a practical standpoint, this right should be structured in a manner that it functions as a commercial filter rather than a permanent barrier to exit and details as to timeline, valuation requirements and consequences of non-exercising these rights should also be clearly specified in the JV agreement.

Deadlock in governance: Russian roulette and Texas shoot-out

Governance deadlocks and exit rights often go hand in hand, particularly when both JV partners hold near-equal stakes in a JV. In such JVs, the exit rights are also linked to the governance provisions of the agreement, including the composition of the board of directors, quorum requirements, reserved matters, voting requirements, and other such factors. In many cases of governance deadlock, the exit mechanisms may be the only option available to the partners in the JV to resolve the disputes that may arise in the future. To overcome such governance deadlocks, exit mechanisms such as Russian roulette and Texas shoot-out clauses allow for exit or takeover of the business by one of the JV partners.

In Russian roulette, one party either sells its own shares or purchase shares of the other party at an agreed price. On the other hand, in Texas shoot-out, both parties bid for shares of each other through sealed bids, and the party with the highest bid takes over shares of the other party. The idea is to establish a self-correcting pricing mechanism that results in fair valuation of shares through the threat of being on either side of the deal.

While drafting such clauses, it is pertinent to note that the transfers between residents and non-residents must be in line with the pricing guidelines and sectoral restrictions in effect. This is because, a transfer initiated due to a deadlock, which results in foreign shareholding exceeding permissible sectoral limit, might require restructuring or regulatory approvals.

For foreign investors, these tools are useful in achieving a structured resolution in the event of a deadlock in a JV, depending on how these are drafted, balancing commercial reality with regulatory requirements.

Conclusion

Exit planning has moved from being a peripheral issue to become an integral part of Indian joint venture agreements. As joint ventures become increasingly complex and priorities evolve, the ability to disengage has become as important as the ability to cooperate.

Effective exit strategies, supported by drag-along, put and call options, and ROFR provisions integrated with existing structures, facilitate effective management of strategic divergence without compromising business stability. For foreign investors and Indian partners alike, an effective exit strategy has become one of the key value-safeguarding measures in JVs.