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Pursuing a Joint Venture-is it a Good Idea?

A joint venture (“JV”) for a new sale initiative is generally better than an individual venture for a new sale initiative because the liabilities, costs, and risks are more limited and spread out amongst the parties involved. JVs allow for the relatively easy sharing of assets, critical expertise, and experience to better ensure the success of the new business.  JVs generally take one of four forms: (1) contractual JVs, (2) JV partnerships, (3) corporate JVs, or (4) JV LLCs. A JV for the sale of bacon oil that takes the form of a separate LLC entity can be advantageous to both companies. It combines the protections of an LLC with some of the positive attributes of partnerships and corporations, avoiding some of their downsides and offering members maximum flexibility in creating an entity and structuring the JV and its operations in a way that works best for them.

Benefits of JV Initiatives

Tax and Accounting Implications

Members of a JV LLC can choose to either: (1) assume the tax obligations of the JV or (2) have the JV treated as a corporation and assume the obligation to pay taxes on profits. If choosing the former, the LLC will be treated as a partnership for tax purposes and the profits and losses pass through the financial statements of the JV to the members on a pro rata basis at each member’s effective tax rate, eliminating double taxation. When selecting what tax treatment to apply, the JV LLC members also have significant flexibility in determining whether or not the profits and losses of the JV impact the income statements of individual JV members, allowing losses to flow through to members that can be used to offset income from the members’ other operations.

If the JV is designed with the possibility of a sale or IPO in mind, a JV LLC generates greater after-tax proceeds of a sale or IPO. Sale proceeds are greater because a buyer will pay more for assets and accompanying amortization tax shield than it will for corporate stock. If the exit is an IPO, JV members will increase their tax basis in the ultimate public company stock by undistributed operating earnings during the time the JV was an LLC. If the JV is unsuccessful, the JV LLC can often be unwound by splitting up the business, while a tax-free split-up is difficult or impossible for a JV corporation.  Also, ultimate losses on disposition or shutdown of a JV corporation are capital losses that can be effectively unusable, while losses in a JV LLC are normally ordinary.

When the members contribute business assets, including intangibles, to a JV LLC, the depreciation allocation method is a material deal term that should be negotiated at the term sheet stage. Transfers of LLC interests to affiliates are customary, but the JV LLC agreement should require the non-transferring partner’s consent or provide for an adjustment to compensate the non-transferring partner because transfers can restart and delay depreciation for both partners.  Provisions to resolve disagreements relating to tax filing positions or handling of tax audits should be negotiated at the outset.  Transactions between the members and the JV LLC are subject to arm’s length transfer price standards, as are the provisions for allocation of JV LLC profits between the members.

Liability

Unless the contract agreement provides otherwise, the liability of JV LLC members is typically limited to their percentage ownership interests in the company and avoids joint and several liability. Members can also contractually limit their liabilities and obligations amongst themselves. In Delaware and some other jurisdictions, members may also limit their liability under the terms of the contract for breaches of fiduciary duties that would otherwise apply if the parties did not specifically opt out of them. Section 18-1101 of theDelaware LLC Act expressly allows LLC members to insert a provision in their operating agreement that allows for a waiver of fiduciary duties. A JV LLC can also be a good choice for ventures involving multiple investors that intend to create new products or services that will be jointly owned.

 

Loss of Corporate Opportunities

Participants in a JV LLC can lose the ability to pursue certain corporate opportunities on an individual basis. In order to ensure the JV LLC’s success, members should address any areas of potential conflicts of interest between their respective businesses as well as the business of the JV at the outset. Exclusivity and non-compete provisions should also be placed in the JV agreement to help alleviate issues with any potential conflicts.

In addition, common law doctrines often provide that officers, directors, and controlling shareholders have a fiduciary duty to pursue all opportunities available and relevant to the JV exclusively through the JV entity. Such common law does not specifically apply to JVs but to the corporate and non-corporate forms that JVs may take. In Feeley v. NHAOGC, LLC (62 A.3d. 649 (2012), the Court ruled that fiduciary duties may be explicitly waived but that customary fiduciary duties of officers, directors, and controlling equity holders will apply in LLCs in the absence of such waivers. This case is still good law with respect JV LLCs.

A JV LLC agreement may waive the application of fiduciary duties altogether or expressly waive certain duties or elements of the fiduciary duties. A JV LLC, can waive the applicability of the corporate opportunity doctrine (part of the fiduciary duty of loyalty) in its governing documents. However, to be effective, the waiver must clearly describe the specific business to be conducted or specific areas of business in which opportunities are being waived and the specific opportunities the members or managers will be able to pursue without directly presenting them to the JV. I can provide additional research on the applicable regulations and case law surrounding corporate opportunity doctrines in the jurisdictions in which the JV would be governed upon your request.

Breach of Contract and Fiduciary Duties

                When dealing with third parties through the JV’s ordinary course of business, exposure to liability for breach of contract can increase unless a separate entity to limit liability is formed, and all potential contract parties are notified of the distinct and separate nature of the JV. If JV LLC members provide goods or services directly to the JV, they should only do so under negotiated contractual arrangements. Furthermore, managing members of the JV LLC or their designees on the board or governing body of the JV LLC should delegate responsibility for the direction of the JV’s contractual relations to the JV management team.

As mentioned, each member and its designee may also be at risk of liability for potential breaches of fiduciary duties owed to the JV entity and its fellow JV parties. The directors, managers, and majority owners of JVs established through LLCs, as well as other stand-alone entities, may be subject to applicable fiduciary duties of care, loyalty, and good faith under applicable state law unless any such applicable duties are waived in their governing documents.

-Ean Harris