SCROLL TO THE Capital Contributions and Funding section of a joint venture agreement, and you likely will find three standard terms establishing the funding structure: First, the owner companies will make an initial capital contribution to fund the venture. Second, if the venture requires additional funds, the owners have the right, but not the obligation, to contribute additional capital in proportion to their equity interests. Typically, additional capital calls require supermajority or unanimous owner approval. And third, the venture can seek external funding, with the approval of the owners.
Sounds reasonable, right? Unfortunately, this baseline funding structure is couched in subtext that may seriously disadvantage more capital intensive JVs likely to require funding beyond 12 months. Unmanaged, it can leave the future JV CEO tin-cupping for capital, forced into a constant quest to secure agreement and monies from multiple owner companies, who themselves may face diverging investment appetites and financial situations. This structure leaves management over-focused on fund-raising rather than developing the business. It elevates employment uncertainty among current and potential venture staff. And it imposes added risk to the owners, whose initial investment is held hostage to the future funding agreement of their partners.
There is a better way.
We have recently been working with a variety of companies – in high-tech, alternative energy, healthcare, and other sectors – that are forming ventures where the timing to profitability is uncertain or lies beyond one year. Rather than defaulting to standard financial arrangements, these companies have been looking for alternative funding structures. Their hope: avoid a situation where their JVs are left over-dependent on the future agreement and financial kindness of all the owners, who themselves are showered with demands during their own annual budgeting cycle.
ALTERNATIVE FUNDING STRUCTURES AND EXAMPLESHow might companies circumvent this annual tyranny of owner funding? Our experience and review of dozens of venture agreements point to eight common multi-year funding structures (Exhibit 1):
- Basic multi-year funding commitment
- Basic multi-year funding commitment, with added credit facility
- Annually renewed multi-year funding plan
- Multi-year “burn rate” funding commitment
- Activity-specific multi-year funding commitment
- Negative cash flow funding commitment
- Multi-year funding of all reasonable amounts
- Commitment to fund full development plan
- Bertelsmann-Lycos: Basic multi-year funding commitment, with added credit facility. In 1997, Media companies Bertelsmann and Lycos established a JV, Lycos Europe, to launch the Lycos search engine in a number of European countries. Back then, web portal services were barely gaining traction as a viable business concept in Europe, and the venture’s success hinged on localizing the Lycos portal in core European markets – for which it required capital to seed and grow local venture entities.
Given Lycos’ status as a cash-strapped Internet start-up, the venture agreement provided for both partners to capitalize each local venture entity with just the minimum legally mandated amount in proportion to their equity interests. But it imposed an additional funding obligation on Bertelsmann. Under the agreement, Bertelsmann committed to fund the operations of each local entity up to an aggregate cap, provided certain country- and territory-specific investment criteria were met. If the venture were to breach the aggregate cap, Bertelsmann would make available a credit facility of a certain maximum amount that the venture was entitled to draw upon on a monthly basis under terms agreed to prior to the first drawdown. Bertelsmann would remit all funds to the venture entity after receiving an approved funding request. The venture was given the choice to raise external funding and required Bertelsmann to give a guarantee or security in lieu of a funding request. If the venture exercised this choice, and if Bertelsmann provided the corresponding guarantees and security, Bertelsmann’s financial obligation was proportionately and temporarily reduced until such time as Bertelsmann was released from the guarantee without payment, or until the security was returned.
- Alternative Energy JV Newco: Multi-year “burn rate” funding commitment. A natural resources company and a power plant operator recently formed a venture to develop, own, and operate wind, solar, and other clean energy projects in several emerging markets. While the owners were confident that the development costs of projects undertaken by the venture would be met through project financing individual SPVs, they wanted to secure the venture’s ability to meet its overheads at least until the initial slate of projects came on-stream and started generating revenue.
In an Annex to the venture agreement, the owners estimated the amount of cash the venture was expected to spend on primary overhead items (e.g., office space, personnel, consultancy and outsourced services, marketing and communications, information systems) for a period encompassing 5 years from launch. These expense headings were summed up to arrive at an annual burn rate (i.e., the amount of forecasted cash spend on overhead per year). The owners committed to provide, in proportion to their respective shareholding in the venture, the burn rate funding required by the venture during a defined “compulsory funding period” of 2 years. Failure to meet the burn rate funding commitment during this period constituted a material breach of the venture agreement and entitled the other owner to claim damages from the defaulting shareholder. To the extent the venture required burn rate funding beyond the “compulsory funding period,” the owners were not bound by any obligation. But if one owner disproportionately honored a funding request from the joint venture, then the other owner would be diluted.
- ADM-Metabolox: Activity-specific multi-year funding commitment: In 2006, Metabolix and Archer-Daniels-Midland (ADM) established a venture, Telles, to commercialize Metabolix’ bio plastics product. The venture agreement contemplated a two-phase business plan, comprising a construction and commercial phase. The commercial phase would commence after the venture achieved a specific business milestone of selling to third parties at least one million pounds of the product under qualifying sales criteria (e.g., payment terms, quality specifications, and order requirements).
The venture agreement established the funding commitments of the owners related to key value-chain activities during the construction phase (i.e., up until the venture hit its business milestone), recognizing that projected cost and commercialization targets would at best be tentative. Specifically, ADM committed to fund all costs related to the construction of the manufacturing facility and related production expenses. Metabolix committed to fund all costs related to the construction of a formulation/compounding facility. Metabolix continued to incur, and carry on its books, all research and product development, sales and marketing, administration, and other operating costs on behalf of the venture. Additionally, Metabolix agreed to forgo all royalty payments and service fees during the construction phase (implicitly funding the venture). Finally, the agreement contractually obligated ADM to absorb the venture’s negative cash flow (or losses) until it started recording positive cash flows.
The owners tracked all capital expenditures made on behalf of the venture through a Ledger Account. The Account was credited with expenses incurred by ADM on the manufacturing facility. Metabolix’ expenditures against the formulation facility were debited to the Account. The Account would receive a further credit for any negative cash flows that ADM absorbed or a debit for distributions made to ADM.
After the venture hit its business milestone (and entered the commercial phase), all subsequent operating expenses under headings borne by the owners would transfer to the venture’s books. Metabolix would start receiving royalties on product sales, fees for research and product development, marketing, and other services it would continue to perform for the venture. ADM would receive priority distributions of residual earnings from the venture till the balance in the Ledger Account was reduced to zero.
These three examples make the point that different multi-year funding structures are more appropriate in certain situations than others. For example, the structure used by the venture between Bertelsmann and Lycos is ideal when the near- to medium-term funding requirements of the venture are fairly certain under base case projections (e.g., rate at which venture will expand into each in-scope country, market adoption rate). But there is a high probability that funding requirements could dramatically increase if say, the venture expands more aggressively than projected, or the market adoption rate is far lower than estimated. The “burn rate” funding commitment is appropriate if the owners can predict the venture’s periodic burn rate over a few years, and like the clean energy venture, there is a definite interval before which the venture will start reducing its burn rate (e.g., by generating revenue, or reaching breakeven). The activity-specific commitment adopted by Telles is suited to ventures in novel product-markets with an uncertain commercialization timeline, and where the parents perform value-chain activities on behalf of the venture.
The owners’ funding commitments under each multi-year structure is usually linked to other deal terms that serve to either reinforce the owners’ obligations, or reduce their obligations and protect their interests (the latter being particularly valuable if one owner is a minority or non-operating partner, yet disproportionately funding the venture). These terms include:
- Material breach: Failure of an owner to meet a future funding commitment constitutes breach, which would result in certain rights and remedies as defined within those sections of the agreement (e.g., entitle other owners to sue for immediate specific performance and claim damages they may have suffered)
- Contingencies: Future funding commitments could be structured to be contingent upon the JV (or other owner) meeting certain pre-agreed milestones (e.g., regulatory approval, initial third party sales, third-party funding)
- Interest payments and penalties: Failure of an owner to meet a future funding commitment could result in penal interest payments (e.g., compounded daily, prime + 5%) on the delinquent amount, or other penalties
- Offsets: If the JV receives external financing, the owners receive the right (but not the obligation) to offset some of their funding obligations. But the owner using the offset retains the responsibility to repay the principal and interest on the external financing