VENTURE FORTH

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By Richard E. Clark

In the past few months you have been discussing various options with a large, U.S.-owned biotech firm that is prepared to enter into a joint venture (JV) with you to develop and exploit your proprietary technology. You believe that your intellectual property, when allied with the U.S. company’s access to development capital and proven production and marketing experience, will result in a successful outcome for both parties. Your business objectives are clear. In addition, you wish to maintain at least a 40 per cent interest in the JV and have some concerns about locking yourself in for a long period, as ideas and markets in the biotech sector develop quickly. You have indicated that although you share mutual interests now, things may change in the next few years: your collaborative partner today may become your competitor tomorrow.

Negotiating a JV:
It is imperative that you enter into a very clear confidentiality agreement at the beginning of negotiations. This will ensure, at least, contractual protection for the confidential information that you disclose, including details of your valuable intellectual property. As with other material transactions, you may enter into a precontractual letter of intent (LOI) or memorandum of understanding (MOU) to record the basic terms of the business arrangement respecting the JV. For example, your LOI can record the basic intentions of the parties and avoid future misunderstanding, set out additional conditions such as regulatory approvals and provide a convenient way of notifying third parties (such as financial institutions) of the proposed formation of the JV. As there is a growing body of case law indicating that the actions or conduct of parties may turn an LOI into a binding obligation, you might consider splitting the LOI into two, with the non-binding provisions forming one distinct portion and the binding provisions the other. The non-binding provisions should clearly indicate that fact and also provide that any binding relationship with respect to the deal itself is subject to and conditional upon the execution and delivery of definitive agreements.

Forms of JV Vehicles:
You have decided to use the most common type of JV, a corporate JV. In Canada, a JV normally takes the form of a corporation, general partnership, limited partnership or co-ownership JV. Each form has its own advantages and disadvantages and the choice of vehicle for the JV often depends on the tax implications for the parties. A corporation is taxed in its own right and provides limited liability to you as a shareholder, unlike some other vehicles including general and limited partnerships — both of which are flow-through vehicles for tax purposes and the general partners of which have joint liability for the obligations of the partnership. There are other forms of JV vehicles, including the Nova Scotia unlimited liability company, which is treated as a corporation for Canadian tax purposes but a partnership (tax flow-through) for U.S. tax purposes. However, the unlimited liability aspect for shareholders would have to be addressed.

Other Regulatory Factors:
There may be other regulatory factors to consider at the outset. The formation of most JVs would be considered “mergers” within the meaning of the Competition Act, and if the Competition Tribunal determines that a merger (or a proposed merger) would prevent or substantially lessen competition in a relevant market, it can seek injunctive relief or orders for divestiture of assets or shares. There are, however, partial exemptions for JVs under that act and your JV could be structured to take advantage of these exemptions. The formation of your JV is not large enough to trigger the pre-merger notification requirements under the Competition Act, nor to be reviewable under the Investment Canada Act as an acquisition of control of a Canadian business by a non-Canadian (even through a Canadian subsidiary).

Documentation:
The documentation relating to the formation and operation of your JV will most likely include:

A master JV agreement (it actually looks like an agreement of purchase and sale of a business) describing the formation of the JV and containing representations and warranties, pre-closing covenants, conditions of closing, indemnities, etc.
The continuing JV document. In your case, this will be in the form of a shareholders’ agreement, and when people talk about the JV document this is usually what they are referring to.
Other documents, such as licences or asset transfer, marketing, R&D or technical assistance agreements. There may even be formal employment agreements for you and your colleagues.
Governance:
One of the critical issues involved in the shareholders’ agreement will be the governance arrangements. As your JV takes the form of a corporation, the management and control arrangements will be relatively straightforward and, in your circumstances, the following are recommended:

A supermajority (such as 75 per cent) or unanimity for major decisions (such as changing the nature of the business, amending the articles or approval of the business plan).
A board of directors to manage the corporation, possibly with a specific list of items that must go before the board. You will undoubtedly want representation on such board, to at least have a say in business decisions.
Day-to-day decisions to be made by officers of the corporation. Perhaps you can obtain the right to name specific officers or, better still, have the CEO role alternate, say, every two years.
Although a grocery list of items can be included as “veto items” for the shareholders, control over the annual business plan/budget of the proposed JV will generally subsume many of the items that would otherwise go on the list (such as financing, acquisitions and divestitures, etc.). Thus, control over the business plan is the key management tool, and this may effectively mean control over the JV — which is one of your main concerns.

Since this shareholders’ agreement will be a “unanimous shareholders’ agreement,” it is also possible to “neutralize” the board of directors and have the shareholders themselves assume all of the rights — and obligations — of the directors.

Financing:
Funding (both initial and ongoing) is one of the most difficult matters to deal with under the shareholders’ agreement. You will invariably deal with the initial capital in great detail, specifying the amount of the investment, timing, interest rates, terms, etc. The problem arises with ongoing funding, as you do not wish to be committed to funding an unlimited amount over an unlimited period of time.

Shareholders’ agreements often provide that additional financing will be borrowed from third parties to the greatest extent possible, with or without guarantees. However, if you are not prepared to lend and/or provide a guarantee, and the other shareholder is not prepared to put up the funds, there may be a deadlock at the very time additional capital is required. You may then find yourself in a situation of having to inject additional funds in order to save your investment. As one of several partial solutions to the problem, you may consider an annual business plan or budget whereby funds are irrevocably committed for a period of time — usually one year — with projections for subsequent periods of time. It is possible to stipulate in the shareholders’ agreement that if an annual business plan cannot be agreed to, the approved operating and/or capital expenditures from the most recently completed fiscal year would be “required” funding over the following one-year period.

Exit Strategies:
As you are (quite rightly) concerned with the long-term future of your JV, it is absolutely essential to provide some form of exit strategy. Among the more commonly used arrangements are:

Right of First Refusal (ROFR): You must have a binding written offer from a third party, and then are obligated to offer your shares to the other shareholder at the same price per share and otherwise on the same terms and conditions as the third-party offer. If the ROFR is not exercised, you are free to sell to the third party, for a specified period of time, on terms that are no more favourable than offered to your other shareholder. This exit right is quite restrictive and offers little liquidity.
Right of First Offer (ROFO): This is similar to a ROFR but does not require a third-party offer and is generally more flexible. It merely requires you to offer your shares to the other shareholder on specified terms; if not accepted, you may sell to a third party for a specified period of time, on terms that are no more favourable than first offered. This may be coupled with a “drag-along” (in the present circumstances if the majority shareholder wishes to sell, it can “drag” you along in a sale to a third party) or “piggyback” (in the same circumstances as a drag-along, you can piggyback on the majority shareholder’s sale).
“Puts” or “calls”: You could negotiate an option to sell (a “put”) your shares to the other shareholder at predetermined time(s) and price (or “fair market value”). Alternatively, the majority shareholder may want an option to acquire your shares (a “call”) at predetermined time(s) and price (or formula).
“Shotgun”: A “shotgun” buy/sell is an arrangement whereby you (or the majority shareholder) can force a purchase or sale by giving notice and naming the per-share price. The recipient of the notice has the choice of buying or selling at that price. Shotguns are usually considered draconian and qualifications are often inserted on their use.
Registration Rights: A possible feature of shareholders’ agreements, which are of particular interest in technology JVs, are so-called registration (a U.S. term and concept) or prospectus rights, whereby one of the shareholders may force the corporation to go public on specified circumstances after a given period of time.
Dispute Resolution:
Because shareholders’ agreements subsist over a period of time, it is important that you build an effective dispute-settlement procedure into your agreement. These procedures could include:

informal arrangements, such as simple statements that you both will use “best efforts” or “reasonable commercial efforts” to resolve disputes through co-operation and consultation;
escalation within both organizations to avoid self-serving or intransigent decisions of particular representatives;
arbitration and/or litigation — to be used if the disputes are serious enough and you are unable to reach a solution.
Arbitration has its advantages (including confidentiality, enforceability of the arbitral award, the ability to avoid jury trials and possibly a reduction in time and costs). Litigation provides a judicially determined solution with the rigour of legal proceedings (well-established rules of evidence, rights of appeal, etc.).

Non-compete:
You’ll also wish to insert provisions that ensure that the majority shareholder (as well as yourself) does not compete with the JV during the continuance of the JV. This will undoubtedly require that the “business” of the JV be defined in the shareholders’ agreement and that the majority shareholder agrees to not only run all of its “business” activities through the JV but to also forward any opportunities to the JV. You should also request that such shareholder extend the non-compete for a transitional period of time — say, one year — following the termination of the JV. Finally, for the sake of fairness, you should ensure that confidential information about the JV or either shareholder should remain with the owner of such confidential information.

Conclusion:
There are several key factors you should bear in mind when considering your joint venture or strategic alliance:

lyour objectives should always be clear before entering into the JV;
during the continuance of the JV, governance as well as dispute resolution are critical factors;
control of the business plan essentially means control of the business;
restrict the other shareholder from competing with the JV;
unfortunately, since most JVs do not survive very long, your exit strategy is probably the single most critical factor.
Richard E. Clark, B.Sc. (chemical eng.), B. Comm., MBA, LLB is a senior partner at Stikeman Elliott LLP, Barristers & Solicitors, in Toronto, Ont. He may be contacted at rclark@stikeman.com for more detailed advice and suggested documentation.