In this update, we are looking at the preparation required before entering into a joint venture.
Tax changes possible for business sales
Before we launch on this however, a quick note on the recent request by the Chancellor to the Office of Tax Simplification (OTS) to report on how Capital Gains Tax (CGT) rates compare with other taxes, and how the present rules work. The government has attempted to downplay any expectations of major change, but from a business perspective, the OTS may look at reducing Business Asset Disposal Relief which at the moment means business owners and significant shareholders (over 5%) pay an effective CGT rate of just 10% on lifetime gains of up to £1M.
This will need careful monitoring for any business sales and purchases to include advance planning so that these are got over the line and completed before any reduction in the rate. Watch this space….
In the meantime, the rest of this update focusses instead on the start of a business relationship via the evergreen medium of joint ventures.
What is it?
Joint ventures are found in all sectors and industries in the UK. They allow two or more parties to collaborate; bringing their different experiences and ideas to the business. They also allow the parties involved to limit their exposure and costs associated with capital-intensive projects.
What is the issue with them?
Where there are two or more parties working together, disputes can unfortunately arise, so being aware of and understanding the plan of any joint venture will help to reduce the likelihood of any future dispute.
Without doubt, the best time to discuss and agree such things is at the outset of any joint venture. With this in mind, we have listed 5 things we would suggest agreeing before any joint venture commences.
Our key 5 areas to consider
- Structure
The most common factors driving the structure of a joint venture will be the parties’ preferred tax treatment and getting the right tax advice is important here.
The other key drivers of a joint venture’s structure will be:
- whether the parties wish to limit their liability exposure;
- the physical location of any assets to be held by the joint venture;
- the anticipated length of the joint venture;
- the preferred management structure;
- the degree of financial flexibility required by each party; and
- the ease of transferring, terminating or unwinding the joint venture.
There is no particular form of association prescribed by English law for the pursuit of an activity in joint venture. Joint ventures can then be implemented using the same structures as those available to any business, the most common being:
- a private company with liability limited by shares;
- a limited liability partnership (LLP);
- a general partnership;
- a limited partnership (LP); and
- an unincorporated contractual arrangement.
The key advantages of using a private limited company are limited liability, the company’s ability to own assets and to contract in its own right and a clear structure for accounting, governance and reporting purposes.
LLPs also offer limited liability along with the advantage of tax transparency, but they are not commonly used in commercial joint ventures.
Partnerships and LPs sit part way between corporate joint ventures and purely contractual joint ventures. A key advantage of using a partnership structure is that the individual partners are taxed directly on their profits.
Joint ventures can be conducted using companies or other corporate vehicles (such as LLPs), but it is also possible for each party to have a direct contractual relationship with each other.
- Operation of the Business
The roles and responsibilities of each party should be agreed at the outset of the joint venture.
For company based joint ventures, a shareholder with an interest of more than 50 per cent will be able, effectively, to control the joint venture, including through the power to appoint and remove directors as it sees fit and to pass majority votes of shareholders.
Therefore, in the absence of any agreement to the contrary, minority investors have relatively few rights by operation of law to exercise control over a joint venture entity’s decision-making. Usually then, minority investors seek additional, supplemental contractual rights, proportionate to the size of their investment in the joint venture, under the joint venture agreement, the constitutional documents or both. An example would be for the parties to specify the right to appoint directors to the board based on shareholdings in the joint venture entity (e.g., one director for every 10 per cent interest held) and to have the right to appoint a non-voting observer to the board. Minority investors are best protected if the investors agree that certain fundamental actions cannot be taken without the consent of all investors (or at least a supermajority (e.g. 90 per cent)). This will serve to protect the interests of any minority shareholders, but a note of caution – the longer the list, the higher the risk that a deadlock situation can arise, which is dealt with below.
- Ownership
The relationship between a joint venture entity and the joint venture parties will be governed by the terms of the agreements between the parties and, in respect of a joint venture that is a company or a partnership, the constitutional documents of the joint venture entity.
If the joint venture is to be driven via a company, an early consideration will be how many shares will be owned and what rights each share should have (voting, dividend or director appointment rights etc).
How shares are to be transferable will form a major part of this agreement as a rule. Commonly agreed provisions usually involve giving the remaining shareholders a right of first refusal before any transfer takes place or permitting individual shareholders to transfer shares to their spouse or children.
If the joint venture involves a minority shareholder, ‘drag-along’ and ‘tag-along’ rights are often included. Drag-along provisions ensure that a sale of the whole joint venture can be achieved. Tag-along provisions allow minority shareholders to participate if the majority shareholder is selling to a third party. Joint venture parties usually include a security power of attorney in the joint venture agreement granting the board of directors of the joint venture power to effect a transfer on behalf of the party, subject to the drag or tag.
Other common provisions involve requiring a joint venture party that decides to leave the business (or where other events occur in relation to them), to have to offer to sell their shares to the other shareholders under what are called default provisions and transfers.
For default transfers, it is important that the parties take advice when drafting the relevant provisions, as a provision that reduces the price paid for a defaulting party’s shares, discounts loan repayments on default, or reduces the level of bonus or incentive payments on default, could be found to be unenforceable.
- How to resolve an issue
If there is a fundamental disagreement about the business, joint venture can sometimes find themselves in a deadlock.
The courts have occasionally, in the absence of any explicit provisions in an agreement, been prepared to imply a duty of good faith in very specific circumstances. However, the default position remains that:
- There is no general doctrine of good faith in English law;
- The courts will only imply a duty to act in good faith into specific kinds of relational contract (such as employment contracts and contracts between parties with a fiduciary relationship) – and only where it satisfies the requirements for implied terms, set out above; and
- In any case, a term (including a duty to act in good faith) will only be implied into a contract to fill in gaps, where the contract would otherwise be commercially or practically incoherent.
It is therefore very important to have a mechanism in dealing with any conflict and the behaviour of the parties to the joint venture agreement during this time. This is particularly relevant to companies with equal shareholders as each shareholder could then block the other, preventing the joint venture the from operating properly. In determining the appropriate deadlock-resolution mechanism, joint venture parties will need to balance the need for a proportionate response with a suitable deterrent effect so that not every decision is subject to the deadlock-resolution mechanism. For example, if decisions are regularly referred to senior representatives or third parties, the decision-making process of the joint venture could become unworkable. Solutions can often involve one party buying the other out or even winding up the joint venture.
- Documentation
It is vital to make sure that a binding joint venture agreement is agreed at the start of any such business venture. A document of this nature will set out the blueprint for the business, will balance management control of the joint venture to ensure that the joint venture operates smoothly on a day-to-day basis but that key decisions that could affect the value and liabilities of the joint venture are reserved for the shareholders/owners and will provide certainty to each party.
The process of negotiating the agreement will also prompt discussions (and hopefully solutions) on any points of disagreement at an early stage – hopefully providing a more stable foundation for the business to be built upon.
Conclusions
To sum up, preparing early and well is vital to the chances of success for a joint venture in terms of getting it up and running. There is no ‘off the shelf’ joint venture agreement and therefore checking the legal and practical rights and constraints in each agreement is essential.
We can assist with a number of different types of joint venture review with different pricing and complexity models to help you get both reassurance and assurance on the above. We also have specialists on hand to both advise and support you in assessing any business opportunity.
Please drop me an e mail or call if you need any further details and stay safe and well.
Roger
