Chapter 5: PARTIES TO THE JV: THE SELECTION

CHAPTER 5

Parties to the JV: The Selection

BEFORE ENTERING INTO A JV , the parties should engage in preliminary activities that can be of tremendous importance in properly structuring the deal and ensuring that their objectives will be incorporated into the JV documentation. Although the importance of each step depends on the transaction, consideration should always be given to the means by which reliable JV partners may be located and evaluated, and to the initial exchange of information between the parties to determine whether a basis for a relationship actually exists. An essential part of this process is the signing of a Confidentiality Agreement (see Chapter 7).

Locating Potential JV Partners

Much time and effort is generally spent in locating appropriate candidates for a JV. On the other hand, an existing relationship can be built with a current supplier, distributor, or customer. Information about potential candidates can be solicited from experts in the area of interest, such as trade associations, chambers of commerce, investment and commercial bankers, lawyers, accountants, and independent consultants. Firms with complimentary strengths and needs can be identified by reviewing information in published reports, such as the periodic reports that may be filed with the United States Securities and Exchange Commission (SEC) and with similar regulatory agencies in other countries. Government organizations in many countries (e.g., Ministry of Commerce, Ministry of Trade and Industry) often serve as catalysts for foreign investment and JV transactions.

Due Diligence Investigation

The preliminary exchange of information between potential JV partners is generally referred to as a due diligence investigation. It involves a review of each party’s business and affairs as a condition to consummation of the deal, and it is typically conducted by first obtaining publicly available information and next exchanging information made available by the potential parties.

REVIEW OF PUBLIC INFORMATION A preliminary investigation of information that is publicly available should reveal whether the potential JV partner is in good legal standing, has a good reputation among traders and consumers, has government or extended family connections, or has a long, stable, and profitable history. The public records that are available depend on the country’s regulatory laws and the organizational type of the potential partner’s entity. These records might include trade name and business registrations, trademark and patent registrations, credit reports, press releases, and tax, financial, and securities registrations. The usual practice is to employ an investigator, accountant, or law firm

Due Diligence Documentary Checklist

The items on this due diligence checklist are designed to provide the requesting party with a better idea of the proposed partner’s general business activities, organizational structure, and skills and experience in the specific functional areas that are most relevant to the particular JV. Certified copy of the charter documents of the prospective partner (e.g., articles of incorporation). Copies of any studies, reports, or business plans prepared by, or on behalf of, the prospective partner with respect to the proposed activities of the JV. All consents, filings, and correspondence with or to local regulatory agencies relating to the partner’s proposed activities on behalf of the JV. Description of the partner’s business activities within the geographic scope of the JV, and in other areas where the partner will be conducting activities similar to those to be performed for the JV. List of the partner’s major shareholders or other equity owners, and a description of any agreements among the owners with respect to management of the partner’s business. A list of key executives and managers of the partner, and biographical information for each listed person. A list of key personnel in the functional areas relevant to the partner’s activities for the JV. Financial information regarding the partner, including consolidated balance sheets and income statements for at least three years prior to the date of the proposed formation of the JV. A list of the partner’s key customers, suppliers, and financial partners. All material contracts, including deeds, leases, JVs, material supply, purchase, services, development, merchandise, equipment, license, marketing, and distribution contracts to which the partner is a party. Lists of all patents, trademarks, and copyrights held by or licensed to the partner. A list of pending, threatened, and historical litigation to which the partner is or has been subject, to the extent it is related to the activities of the partner for the JV.

within the country where the potential partner claims to exist. Such a local expert will be familiar with local official registers, banking and financial resources, industry networks, and the like. The investigation can be performed reasonably quickly at minimal cost, and it will indicate whether a company is worth approaching.

EXCHANGE OF PRIVATE INFORMATION Assuming that preliminary due diligence suggests the potential partner might be a worthy venturer, the next step is to approach the company and to determine its interest in a JV. The parties should then sign a Confidentiality Agreement (see

Chapter 7) and proceed with a more thorough due diligence check in which they voluntarily exchange relevant data about their own separate organizations. The type of information exchanged depends on the circumstances and the amount of preparation each party has made in advance. One party may have already conducted a substantial study of the proposed JV project, and may have developed some form of preliminary business plan to demonstrate the economic feasibility and attractiveness of the proposed JV. If so, the plan should identify the assets and resources that each party is expected to contribute to the JV, and these elements should be carefully analyzed during the due diligence investigation.

GOALS OF THE INVESTIGATION Much time and effort goes into a due diligence investigation, and therefore it is important to remember the purpose for the investigation. All concerns should be resolved with an eye toward accomplishing the following objectives: ■ Collect enough information about the other party to make a reasoned and informed decision about whether or not to proceed with the transaction. ■ Identify and, if possible, quantify the potential risks and liabilities associated with the proposed JV, with the intent of crafting a contract that resolves these concerns. ■ Confirm the accuracy and completeness of the other party’s representations and warranties that will be included in the documentation for the transaction.

■ Identify all the legal and regulatory hurdles that must be overcome to form and launch the JV, including governmental approvals and authorizations, and consents from other third parties.

UNIQUE PROBLEMS IN CROSS- BORDER DUE DILIGENCE Any cross-border transaction raises special due diligence challenges. Each party must be sensitive to, and become informed about, the cultural, geographic, and legal environment in which the other party operates. Consideration must be given to the problems associated with closing the particular transaction and participating in a long-term business relationship in a foreign jurisdiction located many miles and time zones away. Even what may seem to be the simplest things can be difficult in a foreign country. For example, weeks or months can pass before “public” documents are received because recrudescing and indexing procedures may be poor, or even nonexistent, in some countries. One party may need simply to rely on the accuracy of the other party’s representations and warranties to proceed with the transaction in a timely fashion. Be cautious, however, of taking short cuts merely to keep to a time schedule. Keep in mind that remedies for breach of a representation only kick in after the deal has been completed and cash and assets have been transferred to the JV. This means that a party may be left with having to litigate in a foreign jurisdiction because it was unable to perform the type of due diligence investigation that would have uncovered the problem at the preformation stage.

■ CULTURAL DIFFERENCES Successful due diligence for a new international JV requires attention to other unique factors, many of which follow from differences in language and custom. The first thing you need to do is to learn how the concept of due diligence is understood in the relevant country. If you already have experience with transactions in that particular country, then this can serve as your guide. If not, you will want to consult books or articles about the business culture and the general customs associated with doing business in the specific country.

Countries that follow the common law tradition tend to adopt or accept due diligence practices that are similar to those in the United States and Europe. Thus, one can expect that a fairly comprehensive investigation will be an accepted part of the pre-closing preparations and negotiations. But, in many countries in Asia and Latin America, due diligence may be viewed as a sign of mistrust or bad faith, and any attempt to conduct a full-blown review may destroy the relationship before it begins. To some extent, these differences reflect the fact that European and United States parties and attorneys tend to attach great importance to the documents associated with the transaction, while business people in other societies view the deal in terms of the relationship that exists between the parties. ■ REGULATORY COMPLIANCE When requesting information from a foreign party, consideration must be given to the need to comply with foreign country regulations relating to the export of sensitive information. In all but the smallest transactions, both parties will execute confidentiality agreements that include undertakings by both parties to maintain the secrecy of information received from the other party. Government restrictions, however, may prevent the foreign party from disclosing financial or technical information without first obtaining the approval of the appropriate administrative authorities. The need to comply with these regulations should be factored into the timetable for completing the due diligence review and the transaction as a whole. ■ RELIANCE ON FOREIGN COUNSEL Foreign counsel can often provide useful assistance in determining the acceptable scope of the due diligence transaction and in assisting the foreign party to understand the questions that are being asked.

In addition, legal opinions from local counsel may be used to supplement the representations and warranties of the foreign party. Don’t forget that the opinion will only be as good as the review made by the local counsel. Lawyers in many countries are not familiar with the rigorous back-up investigation undertaken by lawyers in the United States and Europe as a condition of rendering an opinion.

Also, lawyers in many countries are not accustomed to delivering opinions, and the foreign party may have a good deal of difficulty in explaining the elements usually included in a legal opinion.

Another thing to remember is that, although due diligence is usually conducted by attorneys in the United States, practices differ in other jurisdictions. In Japan and other parts of Asia, for example, lawyers are rarely used for due diligence investigations. Instead, the foreign party will be dealing with business people and accountants in the host country. In many cases, these persons have some form of legal training, but you should be prepared to describe fully the type of information that you are seeking. Language skills may be particularly important at this juncture, and you may need to rely heavily on local counsel to translate your requests and the means for compliance.

PROCEDURES FOR DUE DILIGENCE INVESTIGATION There is no standard set of procedures for conducting a due diligence investigation in the context of a proposed JV. The amount of effort will depend on the countries where the parties are operating, each particular company, the style of the company conducting the investigation and, to some extent, the size and importance of the proposed transaction in relation to the other activities of the investigating party. In most cases, the participants should sign a Confidentiality Agreement (see

Chapter 7) and agree on a formal investigation plan for the due diligence investigation. Each of the elements of the plan should be discussed during preliminary negotiations, so that the results can be available well in advance of the projected closing date. This will allow the participants to utilize the information to achieve the proper structure for the relationship and to establish communication about their questions and concerns over the resources that will be used in the actual JV. Also, a written investigation plan can expedite the transaction by setting deadlines for collecting the information.

ADDITIONAL DUE DILIGENCE PROCEDURES Document review should be supplemented with interviews of key officials of the proposed partner, the partner’s accountants, suppliers, and customers, and other persons who might have useful information relating to the partner. Also, special procedures should be followed in connection with functions and assets that are particularly important to the JV. For example, if one partner is to contribute patents or other intellectual property rights to the JV, the other partner will want to do a thorough technology review that covers the creation, ownership, and protection of those rights. Finally, the foreign partner should do its own analysis of the business, legal, and political environment in the host country, and in each country where the JV will be operating.

MANAGEMENT AND THE DUE DILIGENCE INVESTIGATION

Prospective JV partners can derive a number of significant sideline benefits from a due diligence investigation. For example, each party will have the opportunity to observe how the managers of the other party handle detailed inquiries into significant aspects of its prospective business plan. In many cases, parties can learn a good deal about the judgment and competence of the other party’s managers and analyze how they have organized and managed their existing operations. If the managers have clearly mismanaged or neglected important areas, this may raise concerns about whether they have the basic competence to carry out their part of the tasks for the JV.

Evaluating Potential JV Partners

Once the due diligence investigation is completed, a careful evaluation of the information gleaned is needed to decide whether a long-term JV relationship is feasible. Few subjects have been more extensively analyzed then the selection of potential JV partners. Clearly, a JV presents special problems because, by its very nature, it requires partial integration of the skills, attitudes, bias, and experiences of each party’s organization and the many persons within them. Accordingly, the

Building a Cultural Profile

When preparing to negotiate the terms of a new JV, take the time to build a cultural profile of your potential business partner. This important step will allow the negotiators to anticipate and understand cultural differences that might impact the negotiations and the actual operations of the JV. At a minimum, a cultural profile will improve your understanding of the other partner’s behavior. Profile questions should include: 1.Is behavior in the business culture influenced by a particular religious philosophy? 2.How important is nonverbal communication, such as body language and facial expressions, in the other party’s culture? 3.What is the role of humor in business negotiations? 4.Does the culture appreciate independent thinking and achievement, or is the status of the group more important? 5.What is the basis for authority in the culture (e.g., meritocracy, age, education)? 6.Are the social rules different for men and women, and are there any potential racial concerns?

7.Do businesspeople prefer detailed and precise communications or will general expressions of intent be sufficient? 8.How does the concept of time drive the decisions of businesspeople in the other culture? Will they stick to a schedule or use time simply as a rough framework?

9.What local manners and customs need to be recognized in the negotiation process (e.g., greetings, socialization, gifts)?

evaluation should focus not only on functional characteristics, but also on the likelihood of compatibility between the partners. A number of factors to consider are listed below. In addition, a party might refer to the discussion in Chapter 6 of some of the situations that create trouble for a JV. ■ COMPATIBILITY Each potential JV partner should be compatible in a number of areas, such as the level of commitment to the JV, the size and structure of the organization, and the underlying national and corporate cultures. Under the best of circumstances, the parties will have had some sort of prior relationship. If concerns about compatibility exist due to lack of information, some other form of business arrangement might be considered as a way to begin building trust. ■ FUNCTIONAL SKILLS AND RESOURCES The functional skills and resources of the potential partner should compliment those needed for the JV. For example, if a JV is primarily formed to take advantage of the local partner’s ability to access the market rapidly, the distribution skills of the prospective partner should be of greater importance than its ability to assist in developing new products.

■ MANAGERIAL RESOURCES The potential partner should have the managerial resources required to provide all necessary assistance to the JV, particularly in the areas where the partner is to have primary functional responsibility. This is often a difficult hurdle for JVs in emerging markets where the pool of qualified managers may not be as deep as in other countries. The foreign partner may want to consider whether to provide training to local managers and whether the JV will be able to retain the trainees after the know-how has been transferred. ■ FACILITIES AND SUPPORT A partner may provide facilities and administrative support for part of the JV’s activities. This contribution can reduce the overall capital investment associated with the JV. Careful review of the available facilities and support must be made, however, to ensure that they are reliable, efficient, and capable of meeting the needs of the JV.

■ GOVERNMENTAL AND REGULATORY ACUMEN In some situations, the skill and experience of a prospective JV partner in dealing with the government can be extremely important. Familiarity with government procedures and policies can be strategic when the venture involves products that are subject to government testing and approval. In a number of foreign countries, the government also exercises actual or de facto authority over local distribution, and the local JV partner’s experience and expertise could be essential to the JV’s success. ■ FINANCIAL RESOURCES The potential partner must have sufficient financial resources to support the JV and its functional activities for the JV. Failure to supply adequate capital is a major pitfall in any business. ■ REPUTATION A JV is perhaps the most visible form of business relationship. If possible, an effort should be made to find a partner with a solid reputation in the market, as well as in the functional skills and resources that the partner is being asked to provide to the JV. Although a JV is a separate entity and will build its own reputation, the JV parties bring to the table their own respective reputations as the foundation on which the JV will build.

A Few Final Questions

Much study is required before proceeding with even the most preliminary stages of a JV relationship. Managers on both sides of the potential transaction need to systematically review the potential trouble spots and, if possible, map out strategies that can be used in negotiations to minimize possible risks. The final essential step is for key personnel of both parties to consider a few fundamental questions before proceeding to full-scale negotiations: ■ Is the potential partner a direct or potential competitor and, if so, in what markets? ■ How important does the JV appear to be to the potential partner’s own long-term strategic and technical objectives? ■ What is the potential partner’s track record with respect to other collaborative relationships? ■ What measures can reasonably be taken, both from a legal and business perspective, to protect the value of the contributions made to the JV?