Structuring Strategic Alliances, Straightline

Acquisitions focus on a transition from seller to buyer at closing, whereas a partnership involves a strategic alliance to jointly acquire, operate and ultimately sell assets or equity. Ideally, negotiations lead to a partnership with mutually agreed provisions for risk allocation, revenue sharing, governance and a future exit. Some key considerations of the negotiating team are:

Structure

A strategic alliance (“Partnership”) can be created by contract or by forming an entity. If assets are jointly operated by contract, the parties may have formed, and thereby become liable for, the obligations of a general partnership under state law. By forming an entity such as a limited liability company (“LLC”) or limited partnership (“LP”) to hold assets, liability exposure for the LLC’s or LP’s activities may be limited to the LLC’s or LP’s assets.

• LLC or LP—The LLC or LP form affords the owners pass-through treatment for federal income tax purposes, and flexibility in limiting fiduciary duties and determining revenue sharing, voting rights and control over exits.
• Series LLC—The Series LLC is a variation of a traditional LLC that recently became available in several states. The Series LLC can create one or more series having its own assets, liabilities and owners. If the statutory requirements are met, only the assets of a given series are available to satisfy liabilities of that series. This structure may avoid forming many entities, but it is currently uncertain how a Series LLC would be treated in litigation in a state without a Series LLC statute.

Capitalizing the Partnership

Assets may be contributed at formation or through cash calls over time. For example:

• Equity—Equity may be contributed to a newly-formed LLC if key assets are subject to a purchase option that would trigger on transfer.
• Assets—Conversely, it may be desirable to contribute assets to a newly-formed LLC if:
• The existing entity has a long operating history or potentially significant historical liabilities.
• The existing entity is an “S” corporation, as “S” corporations may have only one equity class and, with few exceptions, may only be owned by individuals.

Allocating Risk

Indemnities address the partners’ concerns that contributed assets may fail to perform as agreed (typically, if representations and warranties are breached). In addition to cash payments by the breaching partner, indemnification claims may be funded as follows:

• Partnership revenue otherwise payable to the breaching partner can be paid to the non-breaching partner to satisfy the indemnification claim.
• The breaching partner can forfeit equity in the Partnership with a value equal to the indemnification claim.

Equity Classes

Partners can share revenue equally, but it is more typical to create two or more equity classes, often including a class of equity to incentivize personnel. Having many equity classes affords a platform for sharing ratios for distributions, maximum capital commitments and cash call amounts on a class-by-class basis.

Sharing Revenue

Addressing revenue-sharing considerations can avoid disputes, especially if fewer than all partners will decide the amount and timing of distributions. For example:

• Tax—Net income of the Partnership will be allocated among the owners for federal income tax purposes and taxable to the owners whether or not cash is actually distributed to the partners. As a result, distributions sufficient to fund the partners’ tax payments are often mandatory.
• Preferred Return—Often, at least one equity class is entitled to receive a preferred return on its investment (in addition to its other revenue entitlements). Partners typically negotiate in advance whether tax distributions will be treated as an advance against the preferred return.

Avoiding Deadlock

Partners may negotiate veto rights or supermajority voting for key Partnership decisions, such as approving an annual budget, cash calls, admitting new partners and contracts, asset sales or acquisitions over a threshold amount. Disputes can be avoided by establishing pre-set percentage changes for successive annual budgets which automatically apply if the partners fail to agree.

Exit Events

Planning for a future exit reduces the potential for disputes and provides clear methods for liquidating an investment. Examples include:

• Benchmarks—A partner may be entitled to cease funding cash calls and convert its equity to debt if specified benchmarks are not met.
• Drag-Along—Typically, partners with a controlling interest may sell the entity without consent, and the other partners waive dissenters’ or appraisal rights so long as the sale agreements have pre-agreed terms, such as liability limitations. In certain cases, instead of this type of right, the partners agree to cause the entity to be auctioned after a period of time. If partners are ultimately unable to agree on drag-along terms, often a partner is given a “put” right for a period of time to require the Partnership to purchase its equity at a pre-agreed price.
• First Refusal and First Offer—If a third party offers to buy a partner’s equity, the other partners often have a “first refusal” right to acquire the selling partner’s equity at the price offered by the third party. Because of the chilling effect that this has on potential buyers, each partner may instead have a right of “first offer” to bid on equity that is for sale. The selling partner then may accept a partner’s bid or sell to a third party for a price exceeding the bid.