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Most of our posts focus on issues related to Texas private companies such as LLCs or corporations, but the real estate joint venture (JV) is another distinct but common way for two or more private parties to form a legal entity. These JVs are often used for the purpose of buying, developing, leasing, operating, managing, and ultimately selling for a profit, real estate assets.  JVs are typically governed by a written JV agreement that establishes the duties, obligations, responsibilities, and expectations for the parties to the agreement. Entering into a JV agreement should be done with care, however, because it is not uncommon for conflicts to arise between the partners during the development or operation of the project, exiting from a JV can be an experience that is not for the faint-hearted. This post reviews a number of issues that commonly arise between partners in forming, operating, and exiting the JV.

What Is a Real Estate JV and Who Are the Players?

A JV is commonly defined as a combination of two or more parties (people or entities) that is formed to acquire or develop and own, lease, manage and sell one or more real estate assets. The JV typically has two categories of partners: the “operating partner” and one or more “capital partners.” JVs are frequently used by experienced real estate developers to obtain the capital they need for their projects.

The capital partner is typically a passive investor (again a person or an entity) who provides the bulk of the equity capital that the JV needs. In most cases, the capital partner is not involved in the JV’s day-to-day management or operations, although the capital partner is likely to insist on having approval or control rights over “major decisions.” The JV will typically raise about 20% to 50% of the total amount of the equity capital needed for the project and then obtain debt financing from a bank or other lender for the remaining capital needs.

As discussed below, the JV agreement details the specific initial financial contributions that each partner is required to provide. Further, the JV agreement should specify what happens when additional contributions are required and, in that regard, if the additional contributions are not made, how the ownership interests of the various participants will become diluted.

Management of the JV

Management and voting rights of each of the JV partners and formal meeting requirements should be addressed in the JV agreement. The operating partner will typically serve as the “managing member” or “manager” with the authority to bind the JV to contracts with third parties, but these decisions may be subject to specific approval rights granted to the capital partner. The major decisions that the capital partner has the right to veto generally include all loans or financing arrangements, the acquisition of additional real property, the sale of JV assets, property management agreements, major leases, deals with affiliates, oversight of lawsuits, filing for bankruptcy, granting liens on JV assets, mergers, and spending the JV’s funds above certain approved limits, and granting of easements.  In some cases, the capital partner can force the major decision to happen (i.e.,operating partner cannot block it), and in other cases, the capital partner has only veto or blocking rights. Voting rights should clearly establish a decision-making hierarchy and clarify who holds decision making authority over the JV.

The major decisions provision of the JV agreement is not a boilerplate term and is subject to negotiation. From the perspective of the operating partner, the right of control may be the difference between success or failure of the JV, i.e., the capital partner may be in position to veto action that the operating partner considers essential for the JV’s success. Therefore, the operating partner should be firm in securing enough autonomy in the JV agreement to ensure that the capital partner cannot derail the most important decisions that the operating partner needs to be make for the JV to achieve and maintain success.  

Comparing/Contrasting the Goals of the Partners

The goals of the two different JV partners are definitely aligned, but they are different because of their distinct roles. The capital partner joined the JV to obtain a robust return on its capital investment. To obtain this desired economic outcome, the capital partner will require approval rights over major decisions by the operating partner, which the capital partner views as placing its investment at undue risk. These control rights will therefore include, as noted, the right to veto (i) requests for additional capital, (ii) large increases in the JV’s debt, (iii) the terms for sale of the JV assets, and (iv) the manner for winding down or selling the JV.

By contrast, while the operating partner is also seeking a strong financial return from the JV, the operating partner wants to achieve this result by minimizing its capital investment. More specifically, the operating partner wants to secure a disproportionate share of the profits from the JV through what is commonly referred to as “carried interest.” The operating partner will have the day-to-day control of the JV, and it will want to limit the approval (veto) rights that are granted to the capital partner, block the capital partner from removing the operating partner from its position, and generate fees for providing services to the JV, which include property management, leasing, development, acquisition, and disposition services.

Thus, the JV partners share the goal of securing favorable financial returns from the business, but the operating partner wants to preserve the freedom to make decisions regarding the manner in which the business will be run to meet those goals. By contrast, the capital partner wants to protect its investment and will therefore be unwilling to completely turn over the reins in running the business to the operating partner. The checks and balances at issue should be hammered out at the beginning so that each partner understands the motivation of the other partner, and so that they have a clear understanding of their respective roles, rights, and obligations.  

The Role of Capital Contributions

The JV agreement sets forth the amount each partner is required to contribute to the JV as the “initial capital contribution.” Some or all of this initial capital contribution is often mandatory, and remedies will apply if there is a failure to fund, often including being suit to suit for failure to fund or forfeiting the interest in the JV. Usually there is a “cap” on the amount of initial capital contributions and a date after which these contributions cannot be drawn.

A JV agreement also will include provisions for additional capital contributions requested by the operating partner that may be used for discretionary expenses, as well as to fund additional acquisitions, development costs or unanticipated costs or operating expenses. These additional capital contributions may also be for “necessary” expenses, which if not paid will cause material loss to the JV (i.e., property taxes, debt service, insurance, expenses necessary to prevent immediate threat to health, safety, welfare of public). The JV agreement will set forth whether the additional capital contribution is mandatory or not, and if not, the remedies for failure to fund are less severe than for initial capital contribution and would not include a lawsuit for non-payment or forfeiture of the partner’s interest in the JV.

Payday – Distributions to Partners via the “Waterfall”

The terms of the JV agreement that dictate the manner in which distributions are allocated among the JV partners are known as the waterfall provisions. Contrary to what may be expected, it is common for distributions to vary from the amount of capital invested. For example, JV agreements used in real estate ventures and by private equity funds often provide incentives to operating partners that allow them to contribute a smaller share of the initial capital contributions, while providing them returns that far exceed their equity investment.

In a financially successful JV, the order of payment will be as follows: first, the JV will pay all debt and operating expenses that are owed to lenders and other third parties; second, the JV will then repay the additional capital contributions and the initial capital contributions that the JV received from partners; and third, the distributable cash proceeds arising from operations or from the sale of the underlying asset will then be paid through distributions to partners in accordance with the waterfall distribution provision in the JV agreement. The operating partner usually determines the amount of cash available for distribution after deducting expenses to be paid and making deposits to reserve accounts for future liabilities.

A common JV agreement scenario may include up to four tiers in the distribution structure, although this can be customized by the parties. The tiers will dictate what steps each dollar will take before becoming fully disbursed, with the four common components being (1) a return of the capital contribution; (2) a return of preferred capital contributions (i.e., commonly called a preferred return, the “pref” or the “hurdle rate”); (3) the catch-up provision; and (4) the carried interest. In the first tier – the return of the capital contribution – all proceeds have to first repay the investors’ full capital investment amounts. Then, the preferred return must be met. Typically, this is an amount in the range of 6% to 8% of the investment, but this rate increases in higher interest rate environments. Next is a catch-up provision, which usually serves the interests of the operating partner and allows the operating partner to collect a substantial portion of the JV’s profits. Last, the remaining profits are shared among the JV partners on a pro-rata basis. A carried interest usually qualifies for capital gain tax treatment that makes it more favorable than payment in the form of a fee that would be taxable at ordinary income tax rates. 

The waterfall distribution provision of the JV agreement addresses who gets paid and in what amount, so the interpretation and implementation of this provision is a common source of dispute.  Thus, operating and capital partners should pay close attention in negotiating this provision, and make sure to fully understand how it will operate in practice. To illustrate, “return of capital” can be defined as (i) the total amount of capital contributed just for investment; (ii) the capital contributed to those investments that are realized; or (iii) the total amount of capital contributed for investments, as well as for investment expenses, and for operational expenses. Each of these different definitions will have a substantial impact on the amount that is distributed, as well as the timetable for distribution.    

Time to Go – Exit Considerations

A critical component of a JV agreement are the exit provisions, which set forth the terms under which the capital partner is permitted to leave the JV. These terms therefore set forth when, how and for what amount a capital partner is permitted to depart. Some of the most common exit terms utilized by capital partners in JV agreements are listed below:

  • A “forced sale” provision that permits the capital partner to sell its interest in the JV asset without obtaining the consent of the operating partner;
  • A “permitted transfer” provision allowing the capital partner the right to transfer its interest after making its full contribution of capital to the JV;
  • A “buy-sell” provision, which allows either of the JV parties to send a notice to the other partner specifying a cash purchase price at which the offeror partner would be willing to purchase all the assets of the JV entity. After this offer is submitted, the receiving partner must elect to buy or sell its interest at this price;  
  • A right of first offer, which is a first right to buy the property or a JV interest before the triggering party offers it for sale to a third party;
  • A right of first refusal to buy the property or the JV interest after the triggering party has first located a buyer who is willing to purchase it on the same terms as the third-party offer;
  • A drag along clause, which gives the majority partner the authority to force

a minority partner to join in the sale of a JV;

  • A tag along clause, which enables a minority partner to force a majority partner to join in the sale of a JV;
  • A put/call option clause that enables one partner to require the other partner to purchase its interest (a “put”) or to purchase the other partner’s interest in the JV (a “call”) at an agreed value or at an appraised value;
  • A redemption clause that allows a JV partner to redeem the interest of another JV member’s interest at fair market value; and
  • A dissolution clause that provides for the occurrence of events that cause the JV to dissolve in the future. These “exit” clauses are often included in JV agreements to avoid future disputes between the partners. 

One or more of these exit provisions should be included within a JV agreement. Well-drafted exit provisions reduce or prevent disputes between JV partners by setting forth when, how and for what amount a capital partner is permitted to depart the JV. 

Conclusion

JVs provide a flexible, established way to develop, maintain and govern substantial real estate projects. But JV agreements are not “cookie cutter” types of documents, and both capital partners and operating partners need to focus closely when negotiating and adopting the key terms of these agreements. In particular, they should carefully negotiate the provisions in the JV agreement that concern (i) major decisions, (ii) capital contributions (both initial and additional) (iii) distributions of cash according to the “waterfall,” and (iv) exiting the JV agreement. The allocation of profits and losses between the partners and exit from the JV agreement can lead to protracted and expensive conflicts if the terms are not spelled out in careful detail so there is no misunderstanding between the parties.

As a final note, we suggest using specific examples that include actual amounts in the drafting of JV agreements. Providing specific examples in the JV agreement of how distributions are determined by the operating partner and what amounts will be issued at various levels of distributable cash is a good way to head off at least some of the disputes that might otherwise take place between the partners. Finally, the partners may also want to consider having disputes about distributions be subject to a fast-track arbitration that will allow a prompt resolution of conflicts of this nature rather than allowing these claims to become embroiled in years of litigation. 

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Oliver Cone is a co-author of this post, and is a Senior Vice President at Bulkley Capital.  Bulkley is  an M&A advisory firm based in Dallas that manages tailored sales processes for privately held companies across the U.S. with values of $15 million or  more.

The reasons for selling your private company are highly individualized. You may have taken your company quite far and are now ready for your next challenge; it may now be time to retire and convert the substantial value you have created in the business into cash that you can put in the bank; or perhaps the strong relationship you once had with your business partner has run its course. Whatever the reason, once you have reached the decision to sell your business, the question is what comes next?

Most private company owners go through a sales transaction just once, but it will be the most consequential business deal of their lives. It is therefore critical for the majority owner to be ready, and this post provides guidance for those considering this path.

Preparing for the Sale

Before beginning to consider selling a private company, it is important for the business owner to understand the nature of the sales process, the timetable that is likely to be involved, and the preparation required for the ultimate result to be successful.

  • Selling a business is an elaborate process, not an event. From starting the process to closing on a sale generally takes six to eight months, including preparation, but it could be longer depending on a number of factors. This timetable may be extended if a potential buyer does not emerge promptly, if there are several suitors creating a bidding process, if due diligence becomes more extensive, or if there are issues that require more extensive negotiation, such as contracts for key employees, transition of IP rights, or dealing with special indemnity issues such as environmental concerns.
  • Nothing substitutes for comprehensive preparation. A business is not a loaf of bread, and it is more much than its financial statements. As a result, there are significant rewards to be obtained if the owner will spend the time and money to develop a compelling story that will be attractive to sophisticated buyers. This includes compiling the data that buyers will want to review, validating financial results with a quality of earnings report (QoE) and presenting the company’s potential in the best possible light.
  • Buyers are paying for the future. Following up on the previous point, in order to maximize value, the owner needs to present to potential buyers a clear path for future growth of the company and that the company has what it takes to get there. The owner knows best about what opportunities exist for the company if it had enough time and investment capital to realize them.

The Owner’s Role in the Sales Process

While it may seem logical for the owner to be front and center as the one who is driving the sales process, that is not the best approach in most instances.

  • The owner should remain in the background. If the owner appears indispensable to the ongoing business, that will be interpreted as a risk by the buyer who knows that the owner will be leaving at some point after the transaction closes. The owner will therefore want to point to current and future leaders of the business to show they are more than capable of helping the business to grow and thrive when he or she departs. Further, the owner should not wait until the transaction is on the verge of closing before handing responsibility over to key members of the management team.
  • Master the critical details. The sales process will include an exhaustive analysis of things that the owner knows intuitively, but which may be rarely tracked and documented by the business. The owner should not expect the buyer to simply take the owner’s word for these things, and they should be documented. Examples include: (i) the margin profile of the company’s products or lines of business, (ii) employee tenure and turnover rates, (iii) the nature and length of top customer relationships, and (iv) the terms of key agreements, e.g., leases, customers, and vendor contracts.
  • Engage with more than one potential buyer. Involving more than one buyer in the process is likely to enhance the perceived value of the business, and therefore, the owner is advised not to deal with just one suitor. A horse race among several viable buyers provides the owner with negotiating leverage and ultimately yields the best price.
  • Arbitrary actions can do real harm. The process should be targeted, using a rifle-shot – rather than shotgun – to locate only the most viable/attractive buyers. That is the best way to ensure confidentiality of important information, to protect key customer and vendor relationships, and to avoid fear and anxiety among the employees.

Make the Process a Team Effort

There are many different facets of the sales process, and the owner will experience great stress and likely drop some balls if he or she attempts to do this without help.

  • You need help from your team. The owner has built a viable, thriving business and there are too many questions for just one person alone to answer. The owner should bring trusted employees into the sale process and communicate clearly with them why the transaction will be good for the company and its teammembers. Putting in place financial retention mechanisms can ease employee concerns about life after the transaction.
  • Engage experienced professionals. Finally, the optimal result is more likely to be obtained when the owner retains professional M&A advisors who understand the industry, who are able to source the best potential buyers to purchase the business, and who can present the company in the most favorable light to these buyers.

Conclusion

Selling a business is a big deal, and it should be approached in a strategic, coordinated fashion with the understanding that it will require a tremendous amount of effort. Gathering all the necessary information will have the owner burning the candle at both ends. And navigating through unfamiliar waters when the stakes are so high produces a high level of stress. The good news is that there is a proven path to success and experienced professionals available who can help along the way. The end goal will be worth it if the sales process is handled in a manner that allows the owner to realize a substantial financial reward for years of effort and sacrifice.

*Oliver Cone is not an attorney and the views and opinions expressed in this article do not reflect those of the firm.

Private growth companies have ups and downs – only rocket ships tend to go straight up.  Therefore, it can be difficult for an investor holding a minority stake in a private company to know whether a challenging time for the business represents only a temporary rough patch, or  whether the company’s road to long-term success has become much steeper. This post reviews various problems that arise in business to help minority investors evaluate the impact the company is facing. In most cases, the best approach when a problem arises is for the investor to wait and see if the company mounts an effective response to address the situation. But if the company’s response seems to be digging a deeper hole, seeking a prompt exit from the business may be the investor’s wisest path.

Initial Question – Does the Potential Exist for a Partner Exit?

The first step for a minority investor in evaluating whether it is time to seek an exit from a business is to determine whether this exit right exists in the company’s governance documents or in any agreements that the investor entered into with the other owners of the business. If a minority investor does not have a buy-sell agreement in place that requires either the majority owner or the company to repurchase the investor’s ownership interest in the business, the investor may simply lack the ability to exit the business when desired. We have posted before about the importance of securing a buy-sell agreement or other partner exit plan at the time the investment is made. When an investor has reached the decision to exit the business, the existence of the buy-sell agreement is essential to secure a timely departure on reasonable financial terms.  

For those minority investors who have the right to trigger an exit from the business, the remaining portion of this post reviews a number of problems that can arise during the growth phase of the business, which may cause the investor to decide to exercise that right.

Departure of One or More Company Founders

It is not uncommon for one or more company founders to depart during the company’s growth phase. Some entrepreneurs are simply much better at conceiving of a new, profitable idea than executing on it in a business setting. The peaceful departure of a founder who is not equipped to facilitate the growth of the business could be a positive for the company. This is particularly true when the departing founder retains a stake in the business and remains fully supportive of the business and the remaining or new management team.

In a more dysfunctional scenario, however, a company founder may be ousted due to financial struggles, removed by larger investors, or remain a negative external influence. In this situation, it may seem like the best course is to abandon ship when the founder is removed. But caution is advised, because the larger investor will not want to see its investment in the company squandered. As a result, this large investor may bring in a more experienced management group, oversee a better growth plan for the business, and turn the company around. Thus, before seeking an immediate exit when one of the company’s founders departs under hostile circumstances, the investor may want to allow the dust to settle a bit to see whether the company’s next phase is more promising after new leadership has been installed. 

Entry of New, Larger Competitor in the Marketplace

The early success of the company may attract other competitors to the marketplace, and if so, and some of them may be larger and better funded. Taking on an established competitor can be a very daunting task for a growth company. But once again, jettisoning the investment in the company at the first sign of more seasoned competition entering the marketplace is not advised.  The growth company is smaller and likely to be more nimble, more connected to the customers and vendors, and may be preferred over the larger company. This is another situation where patience is required to see whether the company can withstand and continue to succeed in response to the challenges that are posed by the larger competitor. 

It is not unusual for the larger competitor to realize at some point that it is better to join forces with the growth company than to continue to divide the market. If this happens, and the larger company seeks to purchase its smaller competitor, this would be regarded as a strategic acquisition. This transaction would bring top dollar for the private company and provide the investors with handsome returns. Of course, this will only happen if the growth company is able to continue thriving in response to the competition posed by the larger competitor. 

Government Delays in Issuing Certifications, Approvals or Patents

For companies doing business in regulated industries or that rely on patents to protect their intellectual property, delays by the government in permitting new drug trials, giving FDA approvals or issuing patents can be harmful, if not devastating to the business. But liquidating a private company investment once the news of the delay is received is likely not the best option.  At that point, the company’s value will be at a low point, and an exit at this stage is destined to result in a significant loss. Thus, the investor must decide whether to exit at this low point or to stay the course in hopes that the company can survive the delay, secure a belated approval from the government or await the issuance of a new patent to boost the company’s value.

Assessing Litigation Risk

Another frequent business risk is litigation that embroils the company, and lawsuits can threaten the company both internally and from third parties. By way of example, the founders of the company can become involved in fights over control, the company could be hit with lawsuits by competitors, or the company could become subject to some type of cyberattack resulting in litigation by customers. Each of these lawsuits presents different types of problems to assess, which may be difficult because the investor likely will not have access to all of the facts that are necessary to thoroughly evaluate the risk that the litigation poses to the company. 

In this situation, some important questions for the investor to consider before seeking to exit the business are: (1) Is the litigation an existential threat, i.e., are the claims severe enough that they threaten to bring about the company’s demise or does it present a challenge that can likely be managed by the company’s leaders; (2) does the company have insurance that applies to the claim and the legal defense costs (claims that are covered by insurance pose far less risk for the company); and (3) is the company functioning on a business as usual basis while the litigation is ongoing, or is the litigation such a large distraction that is having a direct, negative impact on the company’s performance? Securing the answers to these questions will help the investor to decide whether the company can ride out the storm of the litigation or whether getting out before the litigation concludes is the right option, which would be before things become even more dire for the business.

Conclusion

Growth companies are successful not because they have no problems, but because they have learned to overcome their challenges. Investors in these companies also need to decide whether their company and its management team are built to last, or whether the company lacks the resources or the leadership skills necessary to survive over the long haul. If the company is responding effectively to the types of problems discussed in this post, it may be best to stay the course, but if the company is struggling to overcome them, the investor may need to exit and find a better opportunity in which to invest. Many investors refer to the “eye test,” as in don’t deny what your eyes are seeing when the bloom has come off the rose.