““Crafting an alliance often brings lawyers Crafting an alliance often brings lawyers and executives into a big struggle”and executives into a big struggle”

ExecutivesExecutives - tend to be more concerned with - tend to be more concerned with building successful businesses. They are building successful businesses. They are more focused on growth and often argue for more focused on growth and often argue for broad-based alliances with running room for broad-based alliances with running room for scope expansion.scope expansion.

LawyersLawyers - want to limit risks and create - want to limit risks and create future options for the corporate parent. They future options for the corporate parent. They tend to favor alliances that are narrow in tend to favor alliances that are narrow in scope and long on contractual detail.scope and long on contractual detail.

For example, lawyers often shun For example, lawyers often shun 50-5050-50 joint ventures because of the risk of joint ventures because of the risk of deadlocks in decision making, executive often deadlocks in decision making, executive often see them as ideal for encouraging trust and see them as ideal for encouraging trust and independence. independence.

The best firm should combine legal The best firm should combine legal and business best practice when and business best practice when structuring alliances.structuring alliances.

We will be focusing on five essential We will be focusing on five essential deal terms in order to see how deal terms in order to see how combination between lawyers and combination between lawyers and executives will work: executives will work: ownership, ownership, scope, structure, valuation, and exit.scope, structure, valuation, and exit.

Companies entering alliances are often Companies entering alliances are often concerned about their share of economic concerned about their share of economic ownership in a venture due to maximize ownership in a venture due to maximize of financial rewards and also influence of financial rewards and also influence over critical venture decisions.over critical venture decisions.

For example, McKinsey study shown For example, McKinsey study shown that 50-50 alliances have a substantially that 50-50 alliances have a substantially higher success rate than those with higher success rate than those with uneven ownership which is 60 percent of uneven ownership which is 60 percent of the time.the time.

Lawyers typically advise against 50-50 Lawyers typically advise against 50-50 joint ventures, recommending that the client joint ventures, recommending that the client take a majority position and management take a majority position and management control while also protecting the parent’s control while also protecting the parent’s interests (our interest). interests (our interest).

But companies do not always heed the But companies do not always heed the lawyer’s counsel against 50-50 joint venture lawyer’s counsel against 50-50 joint venture because neither partner is willing to turn because neither partner is willing to turn over control to the other side. When over control to the other side. When ownership is split 50-50, lawyers will ownership is split 50-50, lawyers will attempt to protect parent interests by attempt to protect parent interests by drafting a detailed joint venture contract drafting a detailed joint venture contract specifying that both partners will have equal specifying that both partners will have equal seats on a governance board. seats on a governance board.

Some executives approach is just like the Some executives approach is just like the lawyers that try for the majority lawyers that try for the majority ownership, but others look beyond the ownership, but others look beyond the matter of economic ownership and focus matter of economic ownership and focus on decision-making control, for instance, on decision-making control, for instance, by executives will identifying a few key by executives will identifying a few key issues before the agreement is signed.issues before the agreement is signed.

Consider a U.S. firm and a Latin Consider a U.S. firm and a Latin American firm that was negotiating a American firm that was negotiating a joint venture to manufacture and sell the joint venture to manufacture and sell the U.S. firm’s product in Latin America. U.S. firm’s product in Latin America.

Decision making lies at the heart of Decision making lies at the heart of successful alliances, the ideal approach successful alliances, the ideal approach contemplates using five mechanisms.contemplates using five mechanisms.

1.1. Separate Economic Control from Decision-Separate Economic Control from Decision-Making ControlMaking Control

2.2. Seek the Casting Vote or Veto Power on Seek the Casting Vote or Veto Power on Certain DecisionsCertain Decisions

3.3. Agree in Advance on Ten to Fifteen Key Agree in Advance on Ten to Fifteen Key DecisionsDecisions

4.4. Develop a Decision-Making MapDevelop a Decision-Making Map5.5. Create Conflict Resolution MechanismsCreate Conflict Resolution Mechanisms

For example, a joint venture in the For example, a joint venture in the office equipment business was 50-50 office equipment business was 50-50 in economic control, but one partner in economic control, but one partner operated the alliance and controlled operated the alliance and controlled all major decisions.all major decisions.

Example, one leading Example, one leading international oil company signed a international oil company signed a 50-50 joint venture in the Indian 50-50 joint venture in the Indian market after concluding that a market after concluding that a casting vote on capital expenditures casting vote on capital expenditures was enough to protect its interests. was enough to protect its interests.

For example, firms may want to For example, firms may want to agree in advance on transfer pricing, agree in advance on transfer pricing, venture staffing, and dividend venture staffing, and dividend policies. In deciding on certain policies. In deciding on certain decisions, partners will uncover decisions, partners will uncover potential areas of conflict and speed potential areas of conflict and speed decision making once the alliance is decision making once the alliance is operational.operational.

The alliance should has a clear understanding of roles in different decisions. The partners should consider developing a decision-making protocol, a road map of the most important decisions that the alliance will face.

For example, the JV agreement For example, the JV agreement might allow one partner to fund might allow one partner to fund investments while diluting the investments while diluting the other’s ownership stake. To avoid other’s ownership stake. To avoid conflict in the future, the alliance conflict in the future, the alliance might be allowed to buy crucial might be allowed to buy crucial inputs or sell its output on the open inputs or sell its output on the open market if the parents fail to reach market if the parents fail to reach the agreement.the agreement.

What sort of legal structure will hold What sort of legal structure will hold them together ? them together ?

- between joint venture and non-- between joint venture and non-equity (contractual) alliance.equity (contractual) alliance.

Structure for joint venture:Structure for joint venture:

Corporation, General Partnership, Corporation, General Partnership, Limited partnership, Limited Limited partnership, Limited Liability.Liability.

1) Liability Not primary: 1) Liability Not primary: For For example, if partners choose general example, if partners choose general partnership they can establish new partnership they can establish new subsidiary corporate subsidiaries subsidiary corporate subsidiaries that will be the partners in the that will be the partners in the venture.venture.

2) Neither Is governance: 2) Neither Is governance: If the If the partner of 50-50 contractual alliance partner of 50-50 contractual alliance wants four member board of director wants four member board of director so each partner can bring two so each partner can bring two representative for the committee.representative for the committee.

3) Taxation and Accounting Treatment3) Taxation and Accounting Treatment

Will the firm be taxed as corporation or Will the firm be taxed as corporation or partnership?partnership?

Corporation – Taxed TWICE !!Corporation – Taxed TWICE !!

Payment from venture to venture parent will Payment from venture to venture parent will also be different depending on structure. also be different depending on structure.

4) Regulation4) Regulation Non equity alliance or joint Non equity alliance or joint venture which is under general partnership, venture which is under general partnership, limited partnership or limited liability. limited partnership or limited liability.

‘‘DOESN’T NEED A REPORTABLE DOESN’T NEED A REPORTABLE TRANSACTIONTRANSACTION

corporate joint venture NEEDS REPORTABLE corporate joint venture NEEDS REPORTABLE TRANSACTION’(if they reach certain size)TRANSACTION’(if they reach certain size)

Executive should focus on business Executive should focus on business issues that will affect the choice of issues that will affect the choice of structure. structure.

Key questions:Key questions: Do partners plan to make additional capital Do partners plan to make additional capital

investments?investments? If successful, will the alliance last for three If successful, will the alliance last for three

or more years?or more years? Is one partner likely to sell its interest to the Is one partner likely to sell its interest to the

other partner or a third party, or will the other partner or a third party, or will the venture be spun off to public investors?venture be spun off to public investors?

““The answers will help decide whether to The answers will help decide whether to establish venture or contractual alliance”establish venture or contractual alliance”

Steps to focus on:Steps to focus on: 1)What concern about the structure 1)What concern about the structure

that should be address?that should be address? 2) Lawyer should be asked to identify 2) Lawyer should be asked to identify

and look of the benefit of Governance, and look of the benefit of Governance, tax regulatory and liability concerns. tax regulatory and liability concerns.

3) Work together to generate answer.3) Work together to generate answer.

Defining scope requires the partners Defining scope requires the partners to establish boundaries of geography, to establish boundaries of geography, product categories, customer product categories, customer segments, brands, technologies, and segments, brands, technologies, and fixed assets between the alliance and fixed assets between the alliance and the parents. the parents.

Lawyer’s PerspectiveLawyer’s Perspective

Define the scope of an alliance narrowly Define the scope of an alliance narrowly and reserve rights for the parent to and reserve rights for the parent to expand into related area in the future expand into related area in the future with or without partner.with or without partner.

Reasons: Reasons: To REDUCE risk.To REDUCE risk.

A more narrow scope approach would be A more narrow scope approach would be limiting the scope to a specific country, limiting the scope to a specific country, signing a nonexclusive agreement, signing a nonexclusive agreement, building in minimum performance building in minimum performance requirements would have been a better requirements would have been a better strategy. strategy.

Lawyer’s Perspective Lawyer’s Perspective

Drawbacks of Narrow Scope:Drawbacks of Narrow Scope: Can interfere with ongoing venture Can interfere with ongoing venture

development, especially if technology development, especially if technology licenses from the parents are too restrictive.licenses from the parents are too restrictive.

Narrow scope means that the alliance will Narrow scope means that the alliance will depend on the parents for resources, which depend on the parents for resources, which might leads to potential conflict. might leads to potential conflict.

Narrow scope limits the alliance’s ability to Narrow scope limits the alliance’s ability to respond to change to adapt to new market respond to change to adapt to new market condition.condition.

Executive’s PerspectiveExecutive’s Perspective

Often want to have a broad venture that Often want to have a broad venture that allows room for growth.allows room for growth.

Statistic shown from Statistic shown from 150 multinational 150 multinational companies surveyed, companies surveyed, 65% experienced 65% experienced major conflict in the first year of their major conflict in the first year of their alliance. alliance. Where as the successful alliance Where as the successful alliance studied were substantially expanded in studied were substantially expanded in scope. scope.

A solution would be to narrow the scope at A solution would be to narrow the scope at the initial stage and then allow expansion the initial stage and then allow expansion in the appropriate time.in the appropriate time.

The Best of Both WorldThe Best of Both World

Create Room for Growth.Create Room for Growth. Select Partners that are Not Select Partners that are Not

Competitors: This will reduce Competitors: This will reduce disputes over the activities and disputes over the activities and ensure commitment of the alliance. ensure commitment of the alliance.

Establish Exclusive Arrangement Establish Exclusive Arrangement Only When Necessary.Only When Necessary.

The Best of Both World The Best of Both World

Anticipate and Negotiate Changes in Scope in Anticipate and Negotiate Changes in Scope in Advance: Advance:

E.g. European vehicle company alliance with a E.g. European vehicle company alliance with a Korean company aiming to distribute through out Asia. Korean company aiming to distribute through out Asia. Its initial geographical scope is to distribute its product Its initial geographical scope is to distribute its product a single country; however, plan to expand to other a single country; however, plan to expand to other country after Korean sales were established. country after Korean sales were established.

Defines how Parents will use Technology Defines how Parents will use Technology Created by the Alliance: Created by the Alliance:

E.g. two chemical manufacturers might E.g. two chemical manufacturers might collaborate to develop a new type of plastic, with one collaborate to develop a new type of plastic, with one of the firm having the right to sell to automotive of the firm having the right to sell to automotive segments, and another have the right for all other segments, and another have the right for all other customers. customers.

How much each partner’s How much each partner’s contribution worth?contribution worth?

What economic interest in the What economic interest in the venture the partners will receive in venture the partners will receive in the return for these contributions?the return for these contributions?

How the partners will value the How the partners will value the output of the alliance?output of the alliance?

The Lawyer’s PerspectiveThe Lawyer’s Perspective

Approach to valuation is from the Approach to valuation is from the perspective of their clientperspective of their client

Tend to negotiate aggressively to Tend to negotiate aggressively to minimize clients resources devoted to minimize clients resources devoted to the alliance and maximize its share of the alliance and maximize its share of the future profit or other outputsthe future profit or other outputs

Result: Result: it often time ends up as a win it often time ends up as a win lose situation, may then interfere lose situation, may then interfere with the creation of a strong with the creation of a strong businessbusiness

The Executive’s PerspectiveThe Executive’s Perspective

More likely to advocate valuation that More likely to advocate valuation that creates a strong alliancecreates a strong alliance

E.g. executives maybe willing to E.g. executives maybe willing to value assets on favorable terms for value assets on favorable terms for the alliance to improve the chance of the alliance to improve the chance of future success.future success.

A strong alliance will make sense only A strong alliance will make sense only if the result is meeting the goals of if the result is meeting the goals of the company (e.g. maximize the company (e.g. maximize shareholder value). shareholder value).

The Best of Both WorldThe Best of Both World

By establishing By establishing three deal termsthree deal terms::

A group of executives and lawyers A group of executives and lawyers assigned to protect parent interests and assigned to protect parent interests and analyze the alliance from parent’s analyze the alliance from parent’s perspective.perspective.

A third team would consist of A third team would consist of executives from both sides. Its role is to executives from both sides. Its role is to protect the interests of the alliance. The protect the interests of the alliance. The purpose is to develop a business plan purpose is to develop a business plan and determine how the alliance can and determine how the alliance can maximize synergies and resources. maximize synergies and resources.

An alliance is rarely a permanent An alliance is rarely a permanent management. management.

McKinsey’s analysis shows that the McKinsey’s analysis shows that the average life span of joint venture is average life span of joint venture is about seven years, with more than 75 about seven years, with more than 75 percent of terminated joint ventures percent of terminated joint ventures acquired by one of the partners. acquired by one of the partners. With With the above statistics, it is very important the above statistics, it is very important to consider the exit provisions in an to consider the exit provisions in an alliance to protect their interestsalliance to protect their interests

Lawyers recognize the need to negotiate exist Lawyers recognize the need to negotiate exist clauses and will almost always insist that these clauses and will almost always insist that these clauses be included in the alliance agreement.clauses be included in the alliance agreement.

Lawyers must ask their clients to identify the Lawyers must ask their clients to identify the events that will trigger a right to exit. For events that will trigger a right to exit. For example:example:

1.1. Change in control of one of the parents.Change in control of one of the parents.2.2. The inability to agree on a key issueThe inability to agree on a key issue3.3. The failure to achieve an important business The failure to achieve an important business

milestonemilestone4.4. The breach of contractThe breach of contract5.5. A sunset date after which either partner can A sunset date after which either partner can

terminate the alliance upon notice to the other.terminate the alliance upon notice to the other.

Lawyers must also asked their clients to discuss Lawyers must also asked their clients to discuss how the exit should be made once an exit right is how the exit should be made once an exit right is triggered. For example, in joint venture, it is triggered. For example, in joint venture, it is common to propose “put” provisions, under which common to propose “put” provisions, under which one partner has the right to require the other to one partner has the right to require the other to purchase its interest.purchase its interest.

Lawyers may also suggest that partners be given Lawyers may also suggest that partners be given the right to sell their interests to third parties once the right to sell their interests to third parties once exit rights are triggered.exit rights are triggered.

Lawyers may recommend that this transfer right Lawyers may recommend that this transfer right be subject to a right of first refusal, under which be subject to a right of first refusal, under which the non-selling partner would have an option to the non-selling partner would have an option to acquire the interests of the selling partner before acquire the interests of the selling partner before the selling partner may transfer its interest to a the selling partner may transfer its interest to a third partythird party

Lawyers may suggest that the exit be affected Lawyers may suggest that the exit be affected by selling the alliance in its entirety or by selling the alliance in its entirety or conducting an initial public offering.conducting an initial public offering.

Finally, good lawyers will ask their clients to Finally, good lawyers will ask their clients to focus on termination-related valuation issues. focus on termination-related valuation issues.

For example, if the partner is going to sell For example, if the partner is going to sell its interest to the alliance or other partners, its interest to the alliance or other partners, what price should be paid? Lawyers may what price should be paid? Lawyers may suggest the use of an outside appraisal like suggest the use of an outside appraisal like investment banks or advisers to set a “fair investment banks or advisers to set a “fair price”price”

Executives tend to approach exit provisions Executives tend to approach exit provisions differently. Many want to defer detailed differently. Many want to defer detailed discussion on the grounds that such discussions discussion on the grounds that such discussions can reduce trust. can reduce trust.

The vary act of suggesting exit provisions can The vary act of suggesting exit provisions can seem like a proof of bad faith. seem like a proof of bad faith.

Executives may want to avoid discussion of exit Executives may want to avoid discussion of exit provision for a second reason: it forces an provision for a second reason: it forces an uncomfortably blunt assessment of whether the uncomfortably blunt assessment of whether the parent is the natural buyer or seller of the assets. parent is the natural buyer or seller of the assets. If the partner is the natural seller- say, because If the partner is the natural seller- say, because the business really does not fit the company the business really does not fit the company portfolio but cannot be sold for an attractive price portfolio but cannot be sold for an attractive price today-this can be embarrassing for the managers today-this can be embarrassing for the managers running the business.running the business.

As with most other elements of alliance As with most other elements of alliance negotiations, both lawyers and negotiations, both lawyers and executives have perspectives that executives have perspectives that should be combined in the integrated should be combined in the integrated negotiation plan.negotiation plan.

1.1. Address Exit Up FrontAddress Exit Up Front. .

This is very important in terms of This is very important in terms of determining the terminal value of the determining the terminal value of the alliance, the partners should consider alliance, the partners should consider them in detail in the negotiationsthem in detail in the negotiations

2. 2. Be Careful with “Buy-Sell” ProvisionsBe Careful with “Buy-Sell” Provisions.. This is most common device to set alliance This is most common device to set alliance value upon termination but it is appropriate value upon termination but it is appropriate only when each partner is just as likely to be only when each partner is just as likely to be the buyer or the seller.the buyer or the seller.

3. 3. Assess Who Is Likely to Be Buyer or SellerAssess Who Is Likely to Be Buyer or Seller. . It is often possible to anticipate which It is often possible to anticipate which partner will be the acquirer by looking at partner will be the acquirer by looking at how closely the alliance’s business is how closely the alliance’s business is connected to each partner’s core activity connected to each partner’s core activity and at the ability of each partner to invest.and at the ability of each partner to invest.

Both lawyers and executives have much to Both lawyers and executives have much to offer in crafting alliance agreement. Best offer in crafting alliance agreement. Best business practices suggest that some of the business practices suggest that some of the typical lawyers’ concerns- the desire to typical lawyers’ concerns- the desire to define scope precisely and the reaction define scope precisely and the reaction against against 50-5050-50 joint ventures- are overblown. joint ventures- are overblown.

Similarly, the lawyers’ views on such issues Similarly, the lawyers’ views on such issues as exit mechanisms and structure can as exit mechanisms and structure can provide significant help to the executives. A provide significant help to the executives. A good working relationship between the two good working relationship between the two parts of the negotiating team should increase parts of the negotiating team should increase the likelihood that the resulting alliance will the likelihood that the resulting alliance will be well designed and successful.be well designed and successful.