The Roadmap to Successful Ventures in the Middle East Series – No 7
Laying the Foundation Stones for Equity Joint Ventures
By Hugh Fraser, managing partner
Welcome to my weekly note with some personal views on what does/does not work when structuring business ventures in the Middle East region. My seventh theme is “Laying the Foundation Stones for Equity Joint Ventures”.
Equity Joint Ventures or EJVs are commonly used for Middle East ventures, even where 100% foreign ownership is permitted and, as discussed in my last note, localisation and in-country value programmes are driving these mechanisms at the expense of agency and distributorship trading. In definitional terms, an EJV structure applies where both the local and foreign partners are true investors and where their initial capital contributions and shares of cash calls, profits and losses are borne proportionately to their shareholdings. The relationship is much more integrated and involved than purely contractual co-operation arrangements.
Here are my top 5 golden rules on this theme:
- Defining and Valuing the Partners’ Roles and Inputs
An EJV is, by definition, a compromise away from the normal desire for 100% ownership and an acceptance that this is generally not commercially feasible in the region, even if legally permissible. Local inputs are typically capital, market knowledge and connectivity, national employees, local manufacturing, assembly, workshop or warehousing facilities, local procurement, business administration and logistics support and international contributions are typically technology, specialist personnel, equipment and capital. While the inputs are normally (relatively) easy to define their value or cost is a common friction point and so clear parameters are needed as to what pricing applies for transferred in assets, supply charges for personnel and leased equipment, interest on capital and royalties on intellectual property. These inputs may have a huge impact on the “profit (or loss)” for allocation according to the equity interests.
- Setting the Scope of Venture
The specific definition of the scope of the venture is fundamental and a clear focus on the products, services, territory, clients/markets is needed. Given that the relationship will inevitably be an exclusive one, this is critical in three dimensions: to align up with existing ventures in neighbouring territories, to avoid unintentional conflicts arising as to what can and cannot be done in future ventures with third parties and to set down any post-termination protective covenants to protect the ongoing interests of the parties.
- Moving through the Gateways
An EJV will normally involve substantial investment by the partners and so there are normally “gateways” to move through before the full investment contributions are injected in and the engines are throttled up. The key gateways are licensing and registration approvals, client authorised vendor approvals and minimum initial sales commitments (which may be tested via interim agency arrangements). In the event that any of the gates prove to be closed after all reasonable efforts and due diligence have been applied, then the parties should be free to terminate the process without further commitment or liability.
- Management, Decision-Making and Resolving Disputes
The EJV will typically have a discrete management team with the General Manager and Chief Financial Officer roles being appointed with mutual agreement and being tasked to be “neutral” even if transferred in from one of the parties. The best run EJVs allow the executive team to get on with it without over-management by shareholders, working to an annually updated and approved business plan and budget and reporting to a board which reflects the equity positions of the partners. In this context it is therefore important that the “reserved matters” are clearly defined and monitored, these being major decisions affecting the business over which both parties have a veto right including, typically, entering into contracts over a certain value or acquiring debt into the business. The management and decision-making clauses must go hand in hand with the dispute resolution mechanism and, regrettably, too little attention is given to framing DR and choice of law clauses which are effective and useful in the context of the region. In the event of unresolvable deadlocks then the EJV Agreement must move the spotlight on to orderly termination and exit arrangements.
- Duration and Exit Arrangements
Assuming the gateways referred to above are open and passed and given the level of investment will be substantially ahead of what is committed in purely contractual ventures, EJVs typically have an exit mechanism which involves a substantial notice period after a substantial initial commitment period. This may be subject to early break arrangements in the event of material breach of contract, insolvency, change of control, extended force majeure and unresolvable deadlock. The exit arrangements will typically involve a buy-out of one partner by the other according to a pre-agreed transfer price mechanism, failing which a sale to an independent third party, failing which the winding up of the venture. These are complex issues which need careful contract drafting workmanship and this is compounded in the case of the Middle East region by the inevitable need for regulatory approvals and legalised authorisations to complete the process.