3 pitfalls in a joint venture startup founders need to avoid

Startup founders need to be aware of the legal pitfalls that joint ventures and strategic alliances can bring as they try to conserve cash now that technology valuations are falling.

Any deal represents an opportunity for both parties to pursue their strategic goals with no acquisition risk. But the relationship needs the right structures in place so both parties benefit, which also means flexibility to cope with changing circumstances.

Falling growth projections have hit startup valuations hard and reduced the amount of capital expected to flow into the technology sector for the foreseeable future.

Layoffs that have been prevalent in the US have hit Australian shores. Neobank Volt has decided to shut up shop (Startup Daily) after failing to secure new capital. There is likely more of this to come.

The message from VCs to Australian and US startups has been clear: conserve cash as much as possible to see you through this downturn.

As a result, we’re expecting to see an increase in joint ventures and strategic alliances (JVs) amongst Australia’s startup community, as companies look for ways to save cash, retain talent, and maintain strategic roadmaps in an environment of tighter investor purse strings. 

To quickly set the scene, a JV is a transaction where two companies agree to combine certain resources and leverage their respective tactical and strategic strengths for a specific project. This may be a similar product or service to what one or both of them offer, or it may even be the creation of an entirely new venture with a different core business or market.

JVs are common in certain sectors such as the resources industry, rain or shine. The Harvard Business Review reports companies including Rio Tinto and Shell rely on joint ventures for up to 25 per cent or more of revenue. HBR also names Amazon, GlaxoSmithKline, Lockheed Martin, Siemens, and Volkswagen as frequent users.

JVs can take different forms. In an incorporated joint venture, a new company is registered, with the parties involved being shareholders in the new company. A Shareholders’ Agreement will lay out the rights and obligations of the parties and the mechanics of how the joint venture will be carried out. This is really akin to a two-founder startup situation.

Strategic alliances have a similar principle behind them, but the parties don’t establish a separate entity to hold the combined venture. These arrangements may include distribution partnerships and referral arrangements, or sometimes even joint research and development agreements. We have already seen an uptick in companies looking to forge new distribution arrangements as they rapidly seek out new revenue streams.

The big attraction of JVs is access to expertise, a pool of capital or other resources held by a JV partner without the risks associated with a buyout or merger. This can be especially useful during a downturn.

But there are three main reasons why joint ventures and strategic alliances don’t work out; a failure to properly define the inputs and outputs for each JV partner; a failure to align the incentives of the JV and each of its partners; and a failure to anticipate external changes.

The likelihood of success of a joint venture will be decided in the negotiation phase. Successful joint ventures will have defined and aligned on a range of high level issues, including their contributions to the JV, their rights to the benefits produced by the JV, and the degree to which each partner can continue to operate freely outside of or even in competition with the JV.

3 things to consider

Firstly, companies considering JVs as a strategic option need to find the right partner(s). The selection criteria should be based on the actual need. For example, a startup may have great talent and ideas but a lack of capital and infrastructure, meaning their best JV partner is likely to be a BigCo likely to have both. However, companies should also ensure that the partner is a cultural fit as well. While it by no means should be a deal breaker, the parties should acknowledge that a cultural mismatch might exist and seek alignment on governance rules and structures in order to avoid or minimise friction down the line. 

Secondly, the parties should clearly define the types and values of their contributions. The success of the JV will depend on its having access to enough human capital, financial capital and other assets (including intellectual property) to sustain it, given its anticipated business plan. Although some contributions will be readily valued in current dollar terms, others such as IP licensences and non-compete agreements will also need to be valued to ensure the parties are each contributing their agreed proportionate share. 

Thirdly, the partners should define the structure and operating model of the joint venture. It is critical for a joint venture to have detailed management structure, operating model, and performance metrics and for the partners to ensure that all the parties have respective incentives that are properly aligned with the overall success of the venture. This includes mechanisms to ensure the resilience of the JV in the face of changing business conditions.

Finally, the parties should adequately consider how to exit the joint venture in a way which everyone can agree to, up front. Sometimes this means buy-out rights. In other cases this means the parties may spin out the venture.  

Joint ventures fail when the parties are not aligned. While joint ventures may represent a crucial and timely tool for reducing cash burn while maintaining momentum during a downturn, they require a certain amount of care and foresight to make sure the project begins and stays on point.

Founders that take the time to properly conceptualise and negotiate the legal structures of a joint venture with the right partner may find the economic slowdown becomes a blip in the rearview mirror sooner than their peers.

• Anthony Bekker is founder and MD, APAC, of Australian-US technology legal advisory firm BizTech Lawyersb & Chris Spillman is MD, Americas, at BizTech Lawyers