EARLY RESULTS OF OUR recent study on how companies perform across different aspects of the JV dealmaking process has revealed fairly pedestrian performance all around, with critical gaps across key functions within core JV transaction workstreams. With respect to financial modeling, for example, we find that companies struggle to create a dynamic model of what we call “Total Venture Economics.” And since a complete picture of Total Venture Economics is needed to dynamically and deeply inform negotiations regarding partner contributions, JV valuation, service pricing, and other economically driven deal terms, it is no surprise that the dealmakers we surveyed also reported dissatisfaction with their ability to structure those terms – especially those related to partner contributions to the JV (see Exhibit 1).
The fact is, joint ventures are complex businesses to model. In many cases, this is largely due to the diverse financial flows occurring outside the venture P&L that can be hard to map, but are critical to understanding the business. For example, in a technology services JV transaction we advised on, the initial financial model developed by the deal team was focused on the JV’s P&L, and did not account for the counterparty’s “off-P&L” financial flows, including charge backs, and service and license fees for supporting the venture’s customers and systems. Once the model was expanded, it revealed that 85% of the total venture returns would be derived by the counterparty by Year 5, despite it only contributing 50% of the capital and assuming 50% of the risk.
To help companies address the unique challenges presented in JV dealmaking, including those related to financial modeling, we have developed a set of 20 best practices we call “JV Dealmaking Standards of Excellence.” Today’s post addresses challenges raised by financial modeling in joint venture deals, and illustrates one approach to modeling Total Venture Economics.
What the standard says. Our standard provides that, to achieve excellence in joint venture dealmaking, a company must develop a financial model of the proposed JV that includes an integrated picture of Total Venture Economics for the company and the counterparty.
Components within the standard. To fully meet the standard, this integrated picture of venture financials developed by a company should include:
- The forecasted P&L of the JV entity
- Each shareholder’s startup investments and other initial costs not included in JV P&L
- Shareholder margins (or subsidies) associated with their provision of services to the JV
- Shareholder technology, brand, or other license fees to or from the JV
- Financial benefits (e.g., below-market pricing) from the supply and offtake agreements with the JV
- Other off-P&L financial benefits and costs (e.g., cross-selling benefits, increased customer penetration and retention) that accrue to a shareholder
- Cumulative cash-out position for each shareholder over time
In addition, the financial model should includes sensitivities for all key assumptions (e.g., JV volumes, time to market, pricing, cost structure).
What it looks like in a company. To illustrate, consider a multi-billion dollar alternative energy venture between four partners, which was formed to develop and commercialize a radical new technology. We helped the deal team of one party identify the financial flows of each partner, estimate the costs and revenues associated with each of these flows, and evaluate how the integrated economics for each partner would play out over time (Exhibit 2). This allowed the deal team to forecast the cumulative free cash flow of each partner over 15 years – which showed that Partner 3 would likely fall into a severely negative cash flow position in Years 6 to 8. Because Partner 3 was the main technology supplier to the venture and did not have a strong balance sheet, this insight raised concerns about its willingness to remain in the venture over the long term – and the viability of the venture itself.
Understanding Total Venture Economics led our client to reset the proposed financial terms of the deal, including reducing future technology licensing and service fees paid to Partner 3, in exchange for co-funding of certain early-year technology development costs.
A distinguishing feature of joint ventures is that profits, revenues, and costs can flow in many different forms, and from many different directions – and this flexibility is both a blessing and a curse. It is a blessing because this flexibility allows value to be captured in unique and potentially more efficient ways, and a curse because it can obscure partner economics and drive misalignment. Creating a snapshot of Total Venture Economics can be an extremely helpful tool for avoiding the curse in favor of the blessing. With a clear view of various sources of venture value (and whether that value accrues to the JV or to one parent company), dealmakers can focus their attention on crafting and driving alignment on innovative deal terms to capture and protect value on an ongoing basis.