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In times when full acquisition of a company through classic M&A may still hold significant economic uncertainties – either due to negative consequences of the COVID pandemic for the target company or, on the contrary, because it is too expensive due to existing market conditions and the related opportunities – partial acquisition in the form of a joint venture may be an alternative option worth considering. But also entering into such strategic partnership involves particular challenges. Some of these issues are discussed below.
As part of a transaction the buyer usually acquires full control over the target company. He is able to implement his concept of further business development without having to take into consideration any third-party opinions. A joint venture, on the other hand, is always a mutual undertaking of several parties involved in the target company who have to come to an agreement at least on key issues. Also in a situation where one of the partners acquires the majority of shares, the minority shareholder will not renounce all of his rights that enable him to exercise influence.
In this sense, in a transaction where the buyer acquires only part of the shares, the document on which negotiations will often focus is the articles of association (and a shareholder agreement, if additionally concluded) and not the SPA. This is because regulating the issue of corporate governance is of decisive significance in a joint venture. Although a “partnership-based” collaboration where shares are allocated evenly on a 50/50 basis is regarded as balanced and, thus, fair, it is exactly this parity of votes that carries significant risk of failure of the joint venture where partners have different visions as to the further course of the business. Therefore, clear stipulations on how to resolve such deadlock situations are a central element of every joint venture agreement. A solution can be the incorporation into a joint venture agreement of regulations on conducting a mediation process as soon as a conflict arises or on allocation of the final decision-making power to one of the partners (coupled with an exit right of the other partner, if necessary). It is essential to avoid a situation where the company is "paralyzed" over a longer period of time.
Similar rules also apply, however, if shares are allocated on non-equal terms because also a minority shareholder will want to reserve veto rights in order to prevent abuse of the majority rights by the partner.
When forming a joint venture, the partners focus on appropriate valuation of the assets to be contributed to the new company by both of them. Here, in particular when valuing the assets and liabilities to be contributed – often in the form of a (line of) business – it is essential that the same valuation principles and assumptions are used so as to ensure comparability. This applies, on the one hand, to assumptions made in business planning, such as growth rates in sales revenues and/or cost items, and, on the other hand, to assumptions made when determining the discount factor.
Although in the case of establishing a joint venture in the due course of a M&A deal the transaction aspect is of significantly greater importance because part of the shares in the target company are acquired, the issues that arise are similar: This is because a buyer of course wants the target company (and thus his own shareholding) to benefit from his financial investment whereas the seller is also interested in being remunerated for his previous engagement in the target company in the form of a purchase price.
Only in exceptional cases will it be possible to avoid this conflict of objectives. Should the target company be in economic difficulties, a seller could agree that the buyer not only pays a small purchase price, but also significantly contributes to the restructuring of the target company because after such recovery the seller will be able to achieve a more attractive purchase price when finally exiting the target company.
There are also merely practical issues that accompany such partial acquisition by forming a joint venture that should not be underestimated.
For example, work and corporate cultures of both business partners are fully compatible only in exceptional cases and yet each partner will expect that the one known to him will be applied in the target company.
If the target company was part of a larger group it can be expected that also the group-wide IT and accounting systems have been integrated into the seller’s landscape. On this basis, when a joint venture is formed, the joining partner / majority shareholder may factually receive access to business areas that are actually not the subject of the joint venture.
If, in a M&A transaction, the buyer decides to initially acquire part of the target company, his intention is normally to minimise existing uncertainties regarding the acquisition of the entire enterprise and to fully eliminate them over a certain period of time. In this respect, joint venture solutions are not of permanent nature, as a rule. This means that already the purchase agreement or at least the shareholder agreement has to anticipate and regulate the termination of collaboration, or the “exit”. In order to maintain – on the part of the buyer – a certain degree of flexibility necessary for verifying and eliminating uncertainties and risks, the buyer may request the seller as the fellow shareholder to transfer the remaining share portion to the buyer, thus rendering him the sole shareholder (“call option”). At the same time, exercising the call option is subject to the fulfilment of certain agreed-upon general conditions, including the core elements and calculation of the purchase price yet to be paid. Should the buyer not exercise the call option within a fixed period of time, the seller usually holds an equivalent put option that enables him to sell the minority share (possibly being unattractive to third parties). Apart from that, it is common to agree on sale prohibitions or rights of first refusal to secure the parties' positions.
Those regulations which address the transfer of shares between the parties of the original share purchase deal are supplemented with agreements regulating the transfer of the shares to third parties during the lifetime of the joint venture. In this context, the majority shareholder is usually granted the right to force the minority shareholder to sell the remaining shares still held by that shareholder if a third party is interested in buying the share for a certain minimum price so that the third party can acquire 100% of the shares in the target company (“drag-along right”). Also in this case, there is an equivalent regulation to protect the interests of the minority shareholder. If the third party would be satisfied also with purchasing the majority share, the minority shareholder may join in the purchase process between the majority shareholder and the third party in such a way that he may request the third party also to acquire a respective part of the shares held by the minority shareholder. As a result, there would be three shareholders remaining in the company, since the previous majority shareholder as well as the minority shareholder would each sell a proportionate portion of their shares to the third party (“tag-along right”).
Since the partnership is not of permanent nature, also the exit scenario should be clearly and unambiguously regulated right from the start. Basically, the exit price should reflect an appropriate purchase price that would be agreed between independent third parties, i.e. at arm's length. This means that the entire amount of the increase in hidden reserves achieved over the time of holding the shares together should be proportionately reflected in the increase in the price. The parties should therefore agree on the Discounted Cash Flow method (according to IDW S 1) to apply. This method is, however, also largely based on assumptions, both regarding the underlying planning for the next three to five years and regarding the determination of a risk-adequate interest rate. Here, in particular the determination of an appropriate peer group of comparable companies plays a key role. Therefore, clear stipulations should be incorporated into either the joint venture agreement or the shareholder agreement from the outset in order to avoid any disputes. It is also possible to determine at the beginning by whom and how this peer group should be determined. Moreover, certain surcharges and discounts on the market value of the shares determined in this way may be made, depending on the reasons for the exit of a given partner. If he acted to the detriment of the joint venture, the other party should have the possibility of purchasing his portion of the shares at an appropriate discount. If e.g. the parties agree that a certain period of time must lapse, the market value should be paid as compensation at the end of that period.
As far as the parties are aware of the challenges inherent in “collaboration” (even if entered into only for a limited time), forming such a joint venture may be an interesting alternative to the acquisition of all shares through classic M&A. In this context, attention should be paid just as much to actual issues relating to the formation of such a joint venture as to the manifold legal and economic issues of joint control, decision-making and termination of the joint venture.
Hans-Ulrich Theobald
Partner
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Transaction advisory | Mergers & Acquisitions
