Establishing Strategic Alliances and Joint Ventures

by Robert M. Fogler & E. Lee Reichert

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Strategic alliances and joint ventures are becoming increasingly common as businesses attempt to achieve corporate objectives through new and different types of legal arrangements. The tightening of the equity markets, along with a simultaneous slowdown in merger and acquisition activity, has undoubtedly fueled this recent interest. While the terms "strategic alliance" and "joint venture" have many different meanings, the most common definition of either relationship is a business venture that involves two or more entities working together to achieve mutually agreed upon business objectives. To the extent companies desire to structure their relationship as a separate legal entity, that entity typically is referred to as a "joint venture." In contrast, a more classic strategic alliance exists as a contractual arrangement or series of interrelated agreements without a separate stand-alone entity.

Companies that desire to enter into strategic alliances or joint ventures typically are in similar or complimentary industries and often use strategic alliances and joint ventures to achieve strategic synergies with other companies. While businesses in virtually every industry employ these devices, emerging growth and high technology companies routinely enter into such agreements, particularly telecommunications, internet, and software businesses. This article provides an overview of the legal issues associated with entering into and negotiating strategic alliances and joint ventures agreements.

Initial Steps in Evaluating a Possible Strategic Alliance or Joint Venture.

Prior to beginning discussions on the definitive documents that will embody a strategic alliance or joint venture, there are a number of issues that attorneys must consider in providing advice to their clients.

Confidentiality and Nondisclosure Agreements

Before entering into external discussions that may culminate in a strategic alliance or joint venture, companies should make sure that they enter into a legally sufficient confidentiality and nondisclosure agreement. Key issues to consider in negotiating confidentiality and nondisclosure agreements include the following:

• whether the restrictions should be mutual;
• the term of the confidentiality and/or nondisclosure restrictions;
• the definition of "confidential information";
• the treatment of information disclosed orally;
• exclusions from definition of confidential information;
• permitted use of any confidential information;
• the degree of care to be used with regard to such confidential information;
• parties to whom disclosure is permitted (e.g., only employees on a need-to-know basis, consultants, affiliates);
• the return of confidential information;
• disclaimers of accuracy;
• nonsolicitation provisions;
• publicity restrictions;
• forum/venue provisions;
• provisions regarding the binding effect on non-signatories (e.g., affiliates, employees, consultants);
• indemnification obligations; and
• equitable remedies.

Oftentimes, the respective parties provide an imbalanced amount of information, and their interests therefore may differ when negotiating a confidentiality agreement. The party who will be disclosing more information will want to (i) broaden the definition of confidential information, (ii) lengthen the term during which the confidential information must be kept secret, (iii) limit the people within each party's organization given access to the confidential information, and (iv) limit the ways in which the confidential information may be used. Conversely, the party receiving most of the information will want to do the opposite.

Choice of Legal Structure.

Because there are many ways to structure a strategic alliance or joint venture, parties should choose the legal structure carefully to match the business objectives of the relationship. One of the major advantages - and disadvantages - of entering into a strategic alliance or joint venture is the variety of ways in which it may be legally structured. Especially where the parties are competitors or potential competitors, attorneys and their clients should consider closely whether the proposed strategic alliance or joint venture will raise antitrust concerns. Some of the possible ways to structure strategic alliances and joint ventures are as follows.

Network of Contracts. Parties structure many strategic alliances simply as one or more contractual agreements to provide certain services, products or resources to each other. These arrangements work well either: (i) when each party's contribution is easy to define and is unlikely to change as the relationship evolves, or (ii) when the parties want to be able to "divorce" without much trouble. Examples of common types of strategic alliances include licensing agreements, supply agreements and distribution agreements. While these arrangements give each party control over its obligations, the governing agreements typically do not allow for much flexibility if the nature of the business relationship changes.

Equity Investment. Strategic alliances often are structured as equity investments, particularly in the high-tech industry where emerging growth companies seek to partner with larger companies with greater access to capital. To the extent that any entity issues shares of stock (or warrants) as consideration for entering into a strategic alliance or joint venture, attorneys must be cognizant of the relevant federal and state securities laws.

In exchange for an equity investment, an investing company often receives (i) representation on the recipient company's board of directors, (ii) an option to increase its investment in the smaller company in later rounds of financing, and/or (iii) priority on the purchase or distribution rights on the product or service being developed. The smaller company benefits primarily by receiving funding to grow its business, as well as by the credibility gained by its association with the larger company. The principal benefit to the larger company often is access to a new technology or product without expending the resources necessary to develop the technology or product internally. With the dramatic decline in institutional venture capital investments over the past year, many businesses have looked to strategic alliances to provide the necessary capital infusions to continue to operate their businesses.

Joint Venture Entity. Counsel and clients structure many business ventures as classic "joint ventures" by forming a separate entity in which each party has an equity stake. The new entity can take the form of a corporation, partnership, or limited liability company. The choice of entity will depend primarily on limited liability and tax considerations, as well as the likely exit strategy for the joint venture. In contrast to other forms of strategic alliances, classic joint ventures often give the parties greater flexibility to change the nature of the strategic alliance as it evolves. Because the parties' relationship primarily is based on their mutual financial interests in making the joint venture successful - rather than specific contractual obligations - the parties can more easily change the direction or nature of the joint venture to accord with changing market conditions.

Term Sheets & Letters of Intent.

Parties to a strategic alliance or joint venture typically begin their discussions by developing a term sheet or letter of intent that sets forth the basic business terms of the relationship. Just as in the merger and acquisition context, it is important for attorneys to be mindful of the issues associated with drafting and executing a term sheet or letter of intent, so as to ensure that the term sheet or letter of intent is not unintentionally determined to be a binding agreement. A term sheet normally will cover only the most significant business terms, such as the purpose of the strategic alliance or joint venture, each party's contributions to the venture, mechanisms for management and control of the venture, and if applicable, buyout provisions.

Common Strategic Alliance and Joint Venture Agreement Provisions.

While the specific terms of any strategic alliance or joint venture will vary depending on the business relationship, attorneys commonly face the following issues in drafting and negotiating the governing documents for such relationships.

Contribution of Assets.

Because strategic alliances and joint ventures typically are motivated by each company's desire to obtain access to another party's asset or resource, it is important to agree on the assets or resources that each party will contribute. In cases where the parties agree to contribute cash or tangible assets, drafting is usually easy. In other cases, one company may agree to contribute intellectual property, human capital, or other assets or ideas that are not easily identifiable or quantifiable. In these cases, the parties should consider what remedies will be available if the contributing company fails to meet its obligation(s) to provide these assets. The parties also must agree on the valuation or establish a valuation method for these in-kind assets.

Intellectual Property & Confidential Information.

The parties to a strategic alliance or joint venture should consider carefully how to allocate, control and protect confidential information and other intellectual property that is contributed to, or developed in, their business relationship. Many of the considerations identified above with regard to confidentiality and nondisclosure agreements also must be addressed in the governing documents. In addition, the parties may want to provide that all employees and consultants with access to confidential information must execute a separate stand-alone confidentiality and nondisclosure agreement.

A party may license intellectual property to either the newly formed joint venture entity or to the other party, with the license typically expiring upon termination of the business relationship. The license may be either for a fee or on a royalty-free basis. Where a license is contemplated, the parties may place limits on how the other company or the joint venture entity may use the licensed intellectual property so as not to dilute its value or harm the reputation of the licensor.

The parties also should consider how to allocate new intellectual property that is developed in the course of the business relationship. In a classic joint venture where the new intellectual property becomes the property of the new entity, the parties should consider who will own the new intellectual property if the entity subsequently is dissolved. In such cases, attorneys should consider requiring all independent contractors and employees of the new entity to execute agreements assigning new intellectual property and inventions to the joint venture.

Financing Rights & Obligations.

Parties to a strategic alliance or joint venture often contemplate ongoing financing. The terms of the investments may include a priority return - either in the form of preferred stock or a promissory note - as well as rights of first refusal or even veto rights, in cases where the venture seeks additional financing from an outside source. In some cases, a company that initially contributes cash will receive priority rights to purchase more equity in the venture. These rights may take the form of an option or warrant, or as a pro rata participation right in future financings. Alternatively, one or both of the parties in the relationship may have obligations to provide future financing, which obligations often are conditioned on the achievement of specified goals or milestones. In these cases, it is important to draft the milestones to be clear and objectively measurable. Another option is to provide for alternative milestones, whereby if only the lower milestones are achieved, the party investing funds purchases the equity at a discount.

Profits.

Where companies structure the business venture as a classic joint venture or as an equity investment by one party in the other party, the parties often share profits pro rata according to their respective equity interests. In cases where one company contributes more cash, however, that company may receive priority on the distribution of profits. Conversely, where a strategic alliance is structured through contractual arrangements, allocation of profits and/or revenues can take many forms, such as royalty or license payments or sales commissions payable from one party to the other.

Control & Management.

The mechanisms parties choose to allocate control over a strategic alliance or joint venture often depend on the legal structure of the relationship. In the case of a new entity or where an equity investment is involved, it is typical to address representation on the joint venture's or the other party's board of directors or similar governing body. Sometimes the governing documents will provide that the entity may not take certain actions - such as financing activities, changes to the products or services being developed, capital expenditures above a designated amount, or the sale of the entity - without approval from both of the parties in the relationship. Where the relationship is structured simply as a contractual agreement to provide certain products, services or other resources, the parties typically have less ability to control or manage each other's business. Instead, the documents simply may provide for mutual approval for changes in the way that the joint product or service is developed, marketed, sold or distributed.

Exclusivity & Restrictions on Competition.

Parties that enter into a strategic alliance or joint venture often desire to tie up the strategic partner, either through an exclusivity provision or through restrictions on competition. These provisions may be unenforceable under governing state law and also can raise antitrust concerns. In lieu of such provisions, strategic alliance and joint venture agreements sometimes provide for "most-favored nations" clauses, whereby one party agrees to treat its business partner at least as well as any third parties with respect to certain commercial or business terms. In addition, in any strategic alliance there is an increased risk that once a company's employees start to work closely with the other partner, the company's employees will be recruited directly or indirectly to join such partner. For this reason, the governing agreements often contain a mutual non-solicitation provision restricting each party's ability to recruit the other's employees.

Reporting Obligations.

Most strategic alliance and joint ventures provide for reporting obligations. In the case of a classic joint venture or an investment by one party in the other party, the reporting obligations might require that full financial statements be provided on a regular basis to each investing party. In other cases, where a strategic alliance is limited to a portion of each party's business, such as the licensing or distribution of a particular product, reporting obligations may be limited to an accounting of sales of the product.

Defaults & Remedies.

By their nature, strategic alliances and joint ventures agreements require flexibility in their contractual provisions. As a result, many obligations involve necessarily ambiguous commitments or "agreements to agree" on the future direction of, or commitments to, the business relationship. It can therefore become easy for one party to shirk its responsibility to support the venture without technically breaching the provisions of the operative documents. While often there are extra-contractual reasons for a party to act in good faith - such as maintaining its reputation within its industry - parties nevertheless should try to draft contractual provisions that will provide proper incentives for each party to support the venture. One solution is to bundle together reciprocal commitments, so that a party's commitment to perform a particular obligation is conditioned upon the other party's performance of a prior obligation. Another solution is to provide for reciprocal penalties - such as liquidated damages - so that the parties find each other in a "mutual hostage" situation if the relationship deteriorates. Even if these penalties are difficult to enforce in a court of law, their threat can motivate parties to sit down together to work out their differences. Conversely, the parties can link reciprocal rewards under the relevant agreements to the achievement of important goals or milestones, such as extending a product license if the licensee achieves specified sales goals.

Deadlock & Dispute Resolution Mechanisms.

Deadlock can arise either where a decision specifically requires joint agreement or where the parties' relationship becomes strained and one or both parties stop cooperating on the business venture. There are three common mechanisms for attempting to resolve deadlock. First, the parties can agree that "high-level" executives, sometimes identified by name or position, will meet and attempt to resolve any disputes or deadlocked issues. While this mechanism can be relatively inexpensive and quick, there is no guarantee it will resolve the deadlock. Second, the parties can agree to mediation or arbitration by a third party, although this process can be slow, expensive and occasionally confrontational. Third, in cases where the relationship is structured as a classic joint venture or where there is an equity investment involved, the parties can include an option whereby one party may buy out the other party in the event of deadlock.

Term & Termination.

Strategic alliances and joint ventures typically are not intended to last forever. The parties often provide a termination date, at which time contractual arrangements will terminate or one party will buy the other's equity stake. Buyout provisions can be difficult to negotiate in advance because the parties may not be able to accurately predict the value of the strategic alliance or joint venture at the time of the buyout. One solution is to provide that the valuation will be based on revenues or profits at the time of the buyout, or that a third-party appraiser will determine the valuation. Alternatively, the parties can adopt a "shotgun" or "auction" provision, whereby one party initiates the process by proposing to buyout the other party at a specified valuation, and the other party must agree to buy or sell at that price, or begin an auction by proposing to buy at an increased valuation. When a strategic alliance or joint venture terminates, the parties should consider which rights or obligations will survive the termination and should provide for the division of shared assets, if any. Provisions that survive termination often include confidentiality obligations, nonsolicitation provisions, and indemnification provisions for losses caused by the other party's actions or products.

Other Miscellaneous Provisions.

Attorneys drafting strategic alliance and joint venture agreements should review standard legal provisions (e.g., indemnification provisions, boilerplate language) in the context of the business objectives of their clients. Some of these miscellaneous provisions that often are addressed in the governing documents are briefly described below.

Assignability. Due to the unique nature of the relationship that has led the parties to enter into a strategic alliance or joint venture in the first place, it is common for the governing documents to prohibit either party from transferring or assigning its interests under the relevant agreements without the prior consent of the other party.

Representations and Warranties. As a condition to entering into a strategic alliance or joint venture, one company often requires the other party to make certain representations and warranties about the assets it will contribute or about its business.

Publicity. Most agreements prohibit the issuance of any press releases or other types of publicity without the prior approval of both companies.

Regulatory Provisions. Depending on the type of parties involved and the nature of their business operations (e.g., telecommunications companies and financial institutions), a strategic alliance may implicate regulatory issues that must be specifically addressed in the governing documents.

Conclusion.

Empirical evidence suggests that the failure rate of strategic alliances and joint ventures may be as high as seventy percent. Therefore, it is likely that the parties to such business relationships at some point will disagree about the direction, purpose, or division of the assets involved in the strategic alliance or joint venture. As a result, attorneys preparing and negotiating the governing documents should consider carefully the issues that are most likely to lead to disagreement and should attempt to address those issues in the underlying agreements. In order to increase the possibility of the business venture succeeding, the governing agreements must carefully balance the flexibility required to allow the relationship to evolve and achieve the desired corporate objectives while still clearly specifying each party's rights and obligations.

About the Authors:

This month's article was written by Robert M. Fogler and E. Lee Reichert, both of whom are partners in the corporate department of the Denver law firm Kamlet Shepherd & Reichert, LLP, (303) 825-4200.

This article originally appeared in the May 2002 edition of The Colorado Lawyer, volume 31, number 5, and is reprinted with permission.