What Is a Joint Venture?

By Janel Vaughan

I. Introduction

As business projects get larger, technology more expensive, and the costs of failure too large to be borne alone, businesses feel the need to work with joint ventures. In general, a joint venture ("JV") is an association of two or more entities (whether corporate, government, individual or otherwise) combining property and expertise to carry out a single business enterprise and having a joint proprietary interest, a joint right to control and a sharing of profits and losses. Regardless of the scope of the undertaking, the nature of the JV or the respective degrees of equity or management involvement, a JV must: (1) be a separately identifiable entity; (2) have an ownership interest in such entity by each joint venture partner ("JVP"); and (3) have an active management involvement or deliberate rejection of the right to such involvement by each JVP.

In increasing numbers, businesses have been reaching beyond national boundaries in an effort to locate new opportunities for growth, new markets, and new venture capital. Each foreign market offers unique opportunities and risks, and many firms naturally look to JVs with one or more partners for assistance in entering new markets. JVs have become a major feature of the international business landscape due to increased global competitiveness and technological innovation.

JVs are common and successful in several industries. For example, in the land development and construction industries, JVs are often used to obtain sufficient financing to acquire large land tracts or to undertake major building projects. JVs are also common in the manufacturing, mining, and service industries. A JV may be formed to conduct research and development work on a new product or technical application, to manufacture or produce various products, to market and distribute products and services in a specified geographic area, or to perform a combination of these functions. The function of the JV will be linked to the overall objectives of the parties and will dictate to a large extent the substantive terms of the JV arrangement.

The formation of a JV can be a complex process. After a compatible JVP is selected, the specific goals of the enterprise must be defined, the structure of the JV must be negotiated, numerous legal issues must be recognized and resolved, and potential areas of conflict between the JVPs must be identified and reconciled. If the JV is formed under the laws of a country other than the United States, the JVPs must take the time to understand the requirements of the foreign country's corporate law.

II. Reasons for Forming a Joint Venture

There are many motivations that lead to the formation of a JV. They include:

• Risk Sharing – Risk sharing is a common reason to form a JV, particularly, in highly capital intensive industries and in industries where the high costs of product development equal a high likelihood of failure of any particular product.

• Economies of Scale – If an industry has high fixed costs, a JV with a larger company can provide the economies of scale necessary to compete globally and can be an effective way by which two companies can pool resources and achieve critical mass.

• Market Access – For companies that lack a basic understanding of customers and the relationship/infrastructure to distribute their products to customers, forming a JV with the right partner can provide instant access to established, efficient and effective distribution channels and receptive customer bases. This is important to a company because creating new distribution channels and identifying new customer bases can be extremely difficult, time consuming and expensive activities.

• Geographical Constraints – When there is an attractive business opportunity in a foreign market, partnering with a local company is attractive to a foreign company because penetrating a foreign market can be difficult both because of a lack of experience in such market and local barriers to

foreign-owned or foreign-controlled companies.

• Funding Constraints – When a company is confronted with high up-front development costs, finding the right JVP can provide necessary financing and credibility with third parties.

• Acquisition Barriers; Prelude to Acquisition – When a company wants to acquire another but cannot due to cost, size, or geographical restrictions or legal barriers, teaming up with a JVP is an attractive option. The JV is substantially less costly and thus less risky than complete acquisitions, and is sometimes used as a first step to a complete acquisition with the JVP. Such an arrangement allows the purchaser the flexibility to cut its losses if the investment proves less fruitful than anticipated or to acquire the remainder of the company under certain circumstances.

III. Basic Elements of a Joint Venture

• Contractual Agreement. JVs are established by express contracts that consist of one or more agreements involving two or more individuals or organizations and that are entered into for a specific business purpose.

• Specific Limited Purpose and Duration. JVs are formed for a specific business objective and can have a limited life span or be long-term. JVs are frequently established for a limited duration.

• Joint Property Interest. Each JV participant contributes property, cash, or other assets and organizational capital for the pursuit of a common and specific business purpose. Thus, a JV is not merely a contractual relationship, but rather the contributions are made to a newly-formed business enterprise, usually a corporation, limited liability company, or partnership. As such, the participants acquire a joint property interest in the assets and subject matter of the JV.

• Common Financial and Intangible Goals and Objectives. The JV participants share a common expectation regarding the nature and amount of the expected financial and intangible goals and objectives of the JV. The goals and objectives of a JV tend to be narrowly focused, recognizing that the assets deployed by each participant represent only a portion of the overall resource base.

• Shared Profits, Losses, Management, and Control. The JV participants share in the specific and identifiable financial and intangible profits and losses, as well as in certain elements of the management and control of the JV.

IV. Structuring the Joint Venture

Structuring any JV may pose a challenge. This is especially true where parties are from different jurisdictions and various cultural backgrounds are involved. After parties have decided on fundamental issues such as the commercial nature, scope and mutual objectives of the joint venture, the JVPs must determine the geographic location of the venture and what form or legal structure the joint venture will take.

Generally, the structure chosen will be between different types of partnerships, corporations, or some form of a limited liability company, depending on the tax liability each JVP wants to be exposed to. The precise tax and legal features of vehicles of the same general type will vary from one country to another.

V. Managing the Joint Venture

Some JVs are dominant parent enterprises – projects are managed by one parent like wholly owned subsidiaries. The dominant parent selects all the functional managers for the enterprise. The board of directors, although made up of executives from each parent, plays a largely ceremonial role as the dominant parent executives make all the venture's operating and strategic decisions. Having managers from only one parent can lead to frustrations for the managers as well as parent company executives.

A dominant parent enterprise is appropriate where a JVP is chosen for reasons other than managerial input – i.e., financial backing, access to resources, patents, or because it consumes a large amount of the product to be made. Dominant parent joint ventures are also appropriate when a company takes on a partner solely in response to pressures from a host government. In such situations, a foreign company often prefers to find a passive local company that (1) has no knowledge of the product, (2) is willing to be a passive investor, and (3) is neither a government agency nor controlled by the government. The passive partner, who may be supplying technology or money, must trust the competence and honesty of the dominant parent. If the local partner never learns the business of the JV, the dominant parent's bargaining position with the host government will remain strong.

Other JVs are shared management ventures, where both parents manage the enterprise. Each parent supplies both functional managers and executives to serve on the board of directors. Here, the board of directors has a real decision-making function.

One type of shared management venture is the 50:50 JV. This type of JV is characterized by 50:50 participation in which each partner contributes 50 percent of the equity in return for 50 percent participating control. Under such participation, each JVP is equally at risk, and is not subservient to the other JVP as would be the case where majority control is vested in one party. This sharing of interest and control also raises the possibility of deadlock during disputes and early termination of the JV.

It is important to note that not all shared management ventures own equal shares. JVs are flexible so that they can be structured in such as way that one JVP has more than a co-equal role in the JV (e.g., 40/60).

Shared management is critical in ventures where both JVPs are needed for managerial input, as in manufacturing situations where one parent is supplying technology and the other knowledge of the local market. However, deteriorating performance in a shared management venture obliges each parent to become more involved in the operation of the venture. Unless either parent is willing to defer to the other's knowledge or expertise, the decision-making process can become slow can confused and trigger a series of events that can lead to the destruction of the venture.

Because the amount and type of help needed from a partner may change over time, some companies opt to begin their venture under a shared management that they can later convert to a dominant venture. However, once both parents have become accustomed to operating the venture, such transitions become difficult to make.

The high failure rate of shared management ventures suggests that dominant ventures outperform shared management ventures. Since shared management ventures are not consistently used for riskier business tasks, their high failure rate is a strong indication that they are more difficult to operate than dominant parent ventures. Parents of the venture may, and often do, disagree over strategic and organizational decisions. Differences in the parent venture's priorities, direction, and perhaps values result in confusion, frustration, and slowness in the decision-making process and may place a joint venture at a distinct competitive disadvantage. As a result, if a partner is chosen for reasons other than managerial input a dominant parent structure will usually be best.

Majority ownership and dominance of a joint venture do not always go hand in hand. A parent holding only 24% of one venture's shares may be its exclusive manager. Similarly, one parent may dominate a venture, despite the fact that it is a 50-50 deal.

VI. International Joint Ventures

International JVs are those in which one of more or the parties is located outside the host country or those in which the operations of the JV take place, or are directed toward, territories abroad. About three-quarters of all JVs are international. Many countries have created a wide range of economic incentives for using a JV structure for foreign investment. Because such arrangements necessarily involve two or more sovereign jurisdictions, international JVs present special problems. The international JV must consider the host country's

investment laws and regulations and often obtain the host country's governmental approval.

International JVs frequently involve a local and foreign company. In some cases, economic incentives that the host country provides may be the deciding factor in a foreign party's determination of whether the rewards of the proposed venture outweigh the risks associated with entering an unfamiliar market. Of course, the value of the incentives depends on the ability and willingness of the local government to deliver on its promises, as well as the diplomatic skills of local managers in dealing with regulators.

In countries where foreign inward investment is restricted for a variety of reasons, a JV with a local firm may be the most preferred, or even the only, entry route for the foreign investor. Egypt generally requires foreign investment to take the form of JVs, but will make exceptions in appropriate cases. In Egypt, foreign equity in the JV is generally limited to 49 percent, however a 100 percent foreign-owned company may be approved to operate in the free zones, in the oil industry, or to complete specific contracts.

JV laws in developing countries tend to vary in the manner they apply to different sectors of the economy. In India, the government has identified 37 high priority areas covering most of the industrial sector that are vital to India's national interests or able to bring in new, needed technology. JVs in these areas involving up to 74 percent foreign equity receive automatic government approval within two weeks. Greater than 74 percent and areas outside the high priority list are open to investment but governmental approval is required and it is not automatic. In Nigeria, the maximum allowable amount of foreign equity depends on the economic sector involved. These restrictions often force technology transfers and/or managerial control to the domestic partner.

JVs in developing countries are considered less stable than those in developed countries. Although the opportunity to obtain local management is sometimes regarded as a major advantage of joint venturing, the need to work with local management can sometimes be a major problem in developing countries. For example, local management styles and expectations may lead to clashes with foreign partners. Potential conflicts among the management team are material and often result in early termination of the JV. Also, the advantage of having local managers who know how to deal with government officials may evaporate if a change in leadership occurs.

Managers of international JVs may not only have communication problems because of language barriers, they may also have different attitudes toward time, the importance of job performance, material wealth, and desirability of change. Such differences can delay the creation of an effective, cohesive management team. JVPs in developing countries may have an imbalance in levels of expertise and management styles resulting in poor integration and cooperation.

VII. Termination of Joint Ventures

Any number of events may lead to the termination of a JV. Many termination events are anticipated and provided for in the joint venture agreement. For example, a breach of the joint venture agreement may trigger termination, as will other events, such as failure to meet research and development deadlines. A JV may terminate upon achieving its objectives. Alternatively, a JV may terminate upon failing to meet its objectives. The agreement could provide that one JVP buy the other out or sell its shares, or vice versa.

Excessive costs, failure to achieve projected income, or unforeseen capital requirements may make the continuation of a JV unattractive. In addition, a change in the JV's objectives or those of a shareholder may also lead to the early termination of the JV. Changes in objectives may result from a JVP's internal strategic redirection, competitive advances, or market changes beyond the control of the JV or its shareholders. Disagreement by JVPs on fundamental management issues may also lead to termination.

An obvious disadvantage of sharing capital obligations is the need to share profits generated from the actual operation of the JV. Issues can arise in this area not so much because of the cash contributed, but because of the fact that the parties will also be contributing intangible assets to the business, such as intellectual property rights and technical expertise. Technology and management sharing can potentially create significant problems

among the parties. In particular, one party's mastery of the other's technology can lead to improvements on that technology beyond the intended services of the JV, a factor that tends to discourage companies from disclosing their technologies for fear of losing the competitive edge to their JVP.

Many commentators argue that JVs offer a structure for reducing the "free riding" of the local JV partner because both partners contribute to the costs associated with the exploitation of the technology in proportion to their expected benefits. The theory is that a JV partner will have an incentive to focus on protecting the results of the JV activities rather than trying to replicate independently the results for its own account.

VIII. Examples of Recent Joint VenturesParty to Joint Venture Percent Participation Value Subject