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Testing the Waters: Structuring JV Transactions in Times of COVID-19

posted 12 months ago

Why contractual JVs can be an effective alternative to the traditional equity JV model in these uncertain times.

‘Uncertainty’ – if there was one umbrella term to describe the overarching sentiment in the global economic landscape due to the COVID-19 pandemic, perhaps this would be it.

This uncertainty has caused the strategic players to adopt a cautionary approach while contemplating inorganic growth through joint ventures (JVs). Potential JV partners are now wary of committing to infuse capital without any guarantee of the JV’s success. Moreover, JVs typically have a complex structure and often require a detailed governance structure, defined rights and obligations of the parties and entails significant compliance and administrative costs.

How can strategic players minimise risks while structuring their JV? One alternative could be to opt for a contractual JV model instead of a traditional equity JV model.

What are Contractual JVs?

Contractual JVs/alliances are business ventures which are implemented and governed by a set of agreements agreed between the JV partners. They have distinct advantages such as lesser formality, ease of formation, administration as well as liquidation. It is also a flexible model and can be adapted to the requirements of the partners as required.

The parties are not required to spend time and energy in the initial phase of JV to set up a formal entity and create a proper governance mechanism. The parties can instead focus on fulfilling the commercial objective of the partnership. This model can be particularly beneficial if the parties intend to make market entry in a quick and time bound manner or if the parties wish to develop a prototype and demonstrate proof of concept.

In a contractual JV, the parties are required to perform their respective obligations while they retain complete control and oversight over their resources and employees. The parties are only required to agree on the milestones and broad parameters to achieve such milestones. There is no requirement to micromanage each party’s actions or joint decision making on operational matters which ensures lesser chances of deadlock or differences in the decision making.

Given the nimble and agile nature of a contractual JV, potential JV partners may consider adopting a flexible approach in the formative phase of the JV. This will surely give a good head start to the parties and may prove critical in the commercial success of the JV.

Choosing between an equity JV and contractual JV

Although, adopting contractual JVs may have their own advantages, there may be certain commercial as well as legal reasons where a contractual JV model may not be suitable for the parties. Therefore, before deciding on a JV structure, it is imperative that the parties clearly identify their goals and objectives from the business partnership. Some of the following parameters may help the parties in deciding which model is best suited for them:

Innovation and time criticality: If the JV is technology driven and has been created for the purpose of developing innovative products which are required to be quickly launched in the market, it may be better to adopt a contractual JV which can quickly adapt to the business requirements. The parties may not even require an independent asset or employee base for such a business. The parties will, however, be required to define clear ownership rights for intellectual property developed by the JV.

Uncertainty of success: If the parties are entering into a new line of business or entering a new market, there is bound to be unpredictability. In such a case, the parties are likely to be circumspect before committing too much capital or getting into a formal arrangement which is onerous to unwind. A contractual JV will perhaps be better and depending on the success of the initial phase of the JV, the parties can gradually migrate to an equity JV model.

Size of operations and capital outlay: If the JV will require constant capital infusion and is intended to have large size of operations, an equity JV model is preferable. Due to complexity of the business operations, it may be preferable if the ownership of assets and employees is then transferred and housed in a separate JV entity. An organization structure with a dedicated management team may also be required to ensure success of operations.

Regulatory regime: If the intended business of the JV is in a sector which is heavily regulated and requires separate licenses and approvals to operate the business, an equity JV model may be more suitable as the JV company can obtain requisite licenses. Also, there may be restrictions on a foreign company from directly entering into certain business sectors or owning certain types of assets. In such cases, the parties will be required to explore an equity JV model.

Liability risk: If the business has potential liability risk, the parties should consider insulating themselves by creating a separate JV entity. In such a case, the JV company will ordinarily be liable for the business liabilities. It is only in rare instances that corporate veil of a company is lifted, and the JV partners may be exposed to liability.

A useful tool in uncertain times

The need for adopting elastic and amendable structures have assumed greater significance now as businesses are struggling with mitigating the disruptive effects of the COVID-19 pandemic and there is little clarity on the future success of businesses. Therefore, in this environment, contractual alliances can help bridge the gap if potential JV partners are unable to definitively come to the decision whether to enter into a classic equity JV partnership.

There are a lot of benefits that can be derived by the JV partners by entering into a contractual JV during the preliminary phase of a JV partnership.

Therefore, unless there are any commercial or regulatory reasons for adopting an equity JV model, the parties may consider entering into a contractual JV.

After due assessment of the performance of the JV, the parties can then take the leap towards an equity partnership model for the longer term.

About the Author: Prasenjit Chakravarti is a partner and Nitish Goel is principal associate at Khaitan & Co.

Disclaimer: The views expressed are solely of the authors and ETCFO.com does not necessarily subscribe to it. ETCFO.com shall not be responsible for any damage caused to any person/organisation directly or indirectly.

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