STRUCTURING JOINT VENTURES
Di Stefano, Paul J
Key steps in moving from concept to structure
Agency principals are routinely approached with opportunities to expand their insurance operations. Various scenarios are possible. The agency might have the opportunity to open a wholesale operation. A producer or a group of producers might like to affiliate with the agency. Principals of another agency might want to develop a model that capitalizes on the strengths of the two agencies to take advantage of a sales opportunity. As a result of these discussions, a win-win scenario may pop up where the parties get excited about implementing a joint business model.
After the initial exuberance subsides, the real task begins of reaching a comprehensive agreement and deciding how to structure the deal. The first challenge may be how to divide ownership of the business produced in the new venture. In many cases involving an agency and outside producers, the agency may be reluctant to give the producers an equity stake in the agency because it is difficult to quantify the financial value of a start-up operation. Producers may be reluctant to simply have ownership in a book of business, in part because that approach does not address the issue of company relationships.
In fact, one of the most common situations in which Harbor Capital has assisted is a case where producers with specific underwriting expertise have sought to “partner up” with an agency that could provide working capital as well as the infrastructure needed to take advantage of a potential new business opportunity.
One way to “partner up” is to set up an initial joint venture so that the new business model has time to clearly demonstrate its value. Joint ventures can be appropriate for situations where a producer joins an agency to capitalize on a niche program or where two agencies want to combine forces for a trial period before a formal merger or acquisition. In contemplating a joint venture, the parties must consider a number of factors, including:
* Capital calls
* Employment agreements
* Exit strategies
* Buyout formulas
* Payout mechanisms
* Super majority protections
A key question is whether the joint venture will be structured as a partnership, corporation or limited liability company that may have direct ownership of the new venture or may act as a management company for the venture. In one case we encountered, the company relationships of one of the parties were based on personal connections and could not be transferred into a new entity. The solution in that case was to form a management company in which both parties had equity. The management company would derive fee revenue from servicing the joint venture relationship without being a party to the agency agreement and would be able to distribute the profits to the owners of the management company, who were the joint venture partners.
Despite all parties’ best efforts, budgets and pro forma financial statements may overstate revenue and understate expenses. This concern can be addressed by including a provision that the joint venture partners contribute capital in the event that initial expectations are not met. This issue could be of particular concern to a minority joint venture partner. If the majority partner were required to totally fund the capital shortfall, that partner might be issued additional equity. This would dilute the minority partner’s equity position.
In establishing a joint venture, the partners must protect their respective interests by reaching agreement on the distribution of profits. Partners may not have the same appetite for distributable income. The minority partner may be squeezed out if the only way to obtain accumulated distributions is by selling the minority position.
In many joint ventures, the minority partner is primarily responsible for managing operations. Because that partner will be devoting all of his or her time and effort to establishing the venture, the employment agreement should include an appropriate compensation structure. The employment agreement should also establish the level of decision-making authority this individual will have. The agreement further should address issues such as termination provisions, non-competition and non-solicitation restrictions, and equity buyback.
Because in most cases the market for joint ventures is limited, one of the partners is likely to buy out the other party. While the discussion of exit strategies may seem counterproductive at the time the joint venture is being established, the joint venture documents should contain provisions that cover a departure. The exit provisions can be triggered by specific time frames or performance benchmarks that activate put and call mechanisms for both parties. Another option is to force the sale of the business.
Buyout formulas/payout structures
Two important components of the exit strategy are the valuation mechanism for the joint venture and the manner in which the proceeds would be paid to the exiting partner. Formulas can be established with regard to revenue or EBITDA (earnings before interest, taxes, depreciation and amortization), which values the joint venture, or the joint venture agreement may require the hiring of an appraisal expert to value the entity as of the buyout date.
Once the valuation has been established, the next issue to be addressed is how the proceeds will be paid. In most cases the proceeds will be paid over a period of time, so an appropriate interest rate must be established. The joint venture agreement also should address what recourse the seller will have in the event of default.
Super majority protections
In most cases where ownership is not equal between two parties, the agreement should give the minority partner veto power in specified decisions, such as incurring debt, selling the assets of the joint venture, relocating the operation, changing the mission of the joint venture, and agreements with entities owned by the majority partner.
Nail down the details
The complexities of establishing a joint venture can easily be overlooked during the initial blue-sky discussions about the possibilities of working together. The parties must structure a deal that addresses all the situations that may arise in the new relationship. Rather than stumble after a positive beginning, it may be beneficial to call in a consultant who has helped guide other clients successfully through this process. The concept may be great, but a structure must be put in place to make the concept a reality and execute the business model.
By Paul J. Di Stefano, CPA, CPCU
Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a New York-based national financial and management consulting firm that offers services to the insurance industry. Services include agency appraisals, merger and acquisition representation, and strategic and management consulting. Harbor Capital Advisors can be reached at www.harborcapitaladvisors.com or at (800) 858-2732.
Copyright Rough Notes Co., Inc. Mar 2005
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