Value for the partners associated with a Joint Venture (JV) can be approached in four ways:
- Value related to resources used by the JV
- Value related to the JV’s operational efficiency
- Value related to the what the JV produces (including the profits it makes)
- Value inherent in the JV assets (accessible at partner exit or JV termination/liquidation)
To assess and control the value it derives from a JV the partner needs to have access to good quality information about these four areas. Audit rights are important to provide the partner with assurance that the value assessment is correct. JV reporting systems should be designed to provide the partner with an automated flow of key value information.
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JV Resource Value
Sometimes the main purpose of a JV’s existence is to obtain and add value to resources (e.g. a mining or an oil exploration JV). In such cases the value of the resource as it enters the JV and the distribution of this value between the JV partners will be a key componant of the JV formation agreements. However there are other, sometimes more subtle, ways in which partners can derive resource value from a JV.
An important decision to be addressed at JV formation is how the JV will procure the resources it needs (here resources are considered in the broadest terms to include physical resources like raw materials, energy resources, technological resources like know-how, human resources, financing etc.). Sometimes it would be unnecessarily expensive for a JV to set up its own procurement department and purchasing systems when one of the partners has an efficient system with spare capacity to handle additional JV transactions.
If, however, a JV procurement service is to be provided by one of the partners the other partner(s) should get assurance that they are not disadvantaged by this approach. For example, by combining procurement for the JV with its own procurement needs the purchasing partner may be able to extract volume discounts from its suppliers. An appropriate proportion of any such discount should be passed back to the JV and not simply be kept by the purchasing partner. Likewise any rebates relating to JV procurement must be carefully controlled. Audit rights for the non-purchasing partners to check the procurement services the JV uses can provide assurance that the system is operating in a fair manner.
If the JV is part of a complex which includes operations of one or more or its partners it may obtain some of its resources (e.g. energy or raw materials) ‘over-the-wall’ from the partner company. Here the conditions under which the resource is sold should be transparent and agreeable to all partners. One way of ensuring fairness in such negotiations is to benchmark the price the JV pays with that paid by other companies on the same complex (especially ones owned by the supplying partner). When I negotiated a JV resource agreement as part of such a partner owned complex I tied the JV price to the price applicable to all other users in the complex.
JV Operations Value
The value available through cheap raw materials and healthy end-product sales prices can be seriously eroded if the JV does not operate efficiently. Often JVs are set up in developing regions and a certain degree of inefficiency may be inherent in the locality. For example in some regions higher manpower numbers are required – but this can be more than compensated for by lower unit labour costs. It is important, however, not to assume a JV has to be less efficient just because it is in a developing area – local managers in such locations can be very ambitious! When I was president of a chemicals JV in the Far East we had the lowest cash fixed costs per tonne of product of the whole of my group – easily beating costs in the UK, USA and other parts of Asia.
The operational efficiency of a JV is dependant upon making sure the equipment, technology and processes are well designed and then running them efficiently. For both areas expertise from the partners is indispensible. This expertise can be provided either through qualified secondees from the partner companies or bought-in experts, for example from technology licensees. If these approaches, hardware/software and people, are used to good effect the next important factor is to ensure the JV provides the partner with regular good quality information about its operations. This is needed to allow operational efficiency to be monitored and appropriate corrective actions to be recommended.
All of the items in the above paragraph should be addressed in the JV formation agreements (see the governance section). In addition I have found that peer reviews, benchmarking and operational audits, where partners support the JV in maximising its efficiency can help tremendously. This is where partners can add considerable value to a JV by sharing their own experience – and of course this value eventually returns back to the partners though JV profits or asset value growth. If the provision of such expertise comes only from one partner it may be necessary to have a technology transfer agreement in which the JV provides an appropriate remuneration for the support received. It is important to agree the terms of such transfers prior to formation of the JV to minimise disputes between partners later.
Value from JV Products and Services
The purpose of most JV’s is to produce something and by selling this ‘something’ the JV will obtain revenue from which it should be able to derive a profit. This profit eventually flows back to the JV partners in accordance with the rules laid down in the JV formation agreements (a profit distribution clause – see governance section). However there are other ways in which partners can derive value from the products or services supplied by the JV.
Sometimes one of the partners may sell the products or services on behalf of the JV. If the JV pays the partner a commission on the sales this is one way that this partner can derive additional value from the JV. The selling partner may also derive ‘marketing’ value because by selling the JV’s output with its own similar products/services the partner will appear to have a larger market share. Such situations may require careful consideration with regard to competition/antitrust laws – particularly if the market share of the partner becomes too great (see compliance section).
If the partner takes the products from the JV for its own use, for example as a raw material, the transfer price used will need to be carefully scrutinised by the other partner(s) to ensure a fair ‘arms length’ price is used (in other words one that an independent purchaser of the same products would be expected to pay). This approach should also apply to services or know-how (e.g. technology) supplied by the JV to a partner company. It is important to lay down some general rules and principles for such transfers in the JV formation agreements even if at the time of formation the exact nature of the transfer is not known. I have worked in one JV which over a period of about 10 years had advanced the original technology supplied by one of the partners to such an extent that the JV was able to transfer the improvements back to the partner company (for a suitable fee of course).
Value in JV Assets
Most JV’s are not static. Like any successful business venture they can be expected to grow their business and expand their production facilities over time. Significant growth projects will normally require the agreement of the partners in the JV – how this works should be laid down in the JV’s formation agreements (see the governance section). When these agreements require the JV to redistribute all of its annual profit back to the partners a special permission will need to be granted if some of this profit is to be kept in the JV to fund its expansion. Similarly if an expansion is to be externally funded (e.g. through a bank loan) this should also require partner permission.
Such expansions will normally be expected to increase the value of the JV’s assets. Some of the increase will be in the physical asset value, for example more machines and greater stocks of raw materials and end products. A successful business will also generate increased value through non-physical assets like customer/client goodwill and brand recognition. The JV may also increase its value through developing its intellectual property like know how and technological developments and enhancements.
It is important that the partners ensure these improvements in the asset value are correctly recognised in the asset register, balance sheet and accounts of the JV. This is not just good business practice, it is probably required by law (see compliance section) and will be very important if there is ever a change in the shareholding or owner participation of the JV. Therefore it is important that when partners carry out audits of the JV they carefully assess the accuracy of the values shown in the asset registers.
When a JV is formed the potential for a change in shareholder or owner participation should be carefully considered. Very few, if any, JVs survive for ever with their original partner structure. The value contained within a JV’s assets will be very important when assessing how much a partner’s share in the venture is worth. If a JV is being broken up/liquidated all partners will probably want to ensure they receive maximum value from the assets. However if one exiting partner is selling their share to the remaining partner(s) the ‘seller’ will try to maximise the value whereas the ‘acquirer(s)’ will be interested in the value of the shareholding/participation being minimised.
To reduce disputes arising from such differences the formation agreements for the JV should try to lay down how shareholdings will be valued if one or more partners decide to exit. They should also specify whether the remaining partners have pre-emption rights to acquire the shareholding of a departing partner (in other words they have the first right to buy the share before it is sold to a third party). The rights of remaining partners to veto the sale of the share to what they might consider to be an unacceptable or ‘hostile’ new partner should also be made clear.
The JointVentureRisk.com website and its author, Chris Duggleby, are not qualified to provide legal advice and therefore any questions in relation to the legal liability of a joint venture or its partners should be addressed to suitably qualified, competent legal advisers.
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