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2 November 2020 | Merger of two corporations

25. January 2022 | Mergers & Acquisitions

17. March 2022 | Due diligence at a joint venture: 9 points to look out for (this post)

Due diligence plays an important role in a planned joint venture. After all, it must analyse to what extent cooperation is meaningful and feasible. For this purpose, various factors are examined in a due diligence procedure. Among other things, the examination of finances, intangible rights, the assets to be transferred and the availability of suitable employees at the cooperation partner in a joint venture is on the due diligence checklist. But a close look at the corporate culture or the tax implications of a joint venture are also important. In addition, one should think about practical aspects that shape everyday business life in such an entrepreneurial relationship. But also a possible failure of the project involves many risks, which should be considered in a due diligence process for a joint venture.

If companies find that they can only tackle a promising project together with another partner, then they go in search of a suitable candidate. Even in the search for a partner, standards are set in the examination of the candidates who are relevant in the subsequent negotiations. A due diligence in the context of the negotiations on a joint venture is thus the logical follow-up step. After all, all parties want to be sure that the common goal is achievable. Therefore, due diligence procedures for a joint venture apply that a critical analysis of many factors illuminates the hedging of the project and the minimization of risks for the own company.

However, before we deal with the factors that are relevant in a due diligence to a joint venture, we would like to go into the different forms that a joint venture can take. A distinction is made between a contractual joint venture and an equity joint venture.

A contractual joint venture is a joint venture based solely on contractual relationships between the partners. Depending on the contractual drafting, this can be designed in many different forms. In most cases, this involves previously contractually determined services that the partner companies should contribute to achieving the common goal.

An equity joint venture, on the other hand, is a project in which the partners are considering setting up a joint venture. The joint venture company must then be regarded as a subsidiary vis-à-vis the partner companies. Externally, however, the joint venture company is independently oriented. Such an equity joint venture thus pursues the goals that the partner companies defined as a purpose when it was founded. Such equity joint ventures represent the majority.

Our comments on the factors that are important in the context of due diligence for a joint venture usually include aspects that affect both types of joint ventures. Nevertheless, the weighting can be quite different in individual cases. Therefore, our overview of some important factors regarding due diligence in the negotiations on a joint venture should be understood as a general recommendation. On the other hand, the selection of aspects for a due diligence examination, which we have put together here, is quite specific.

Often one of the most important components in the due diligence of the future partners for a joint venture is its finances. This is especially relevant with regard to an equity joint venture. If the data on the partner’s assets, cash flow and other individual factors reveal risks that could bring down the joint project, then this knowledge should be taken into account when deciding on the joint venture.

In addition to the financial situation of the potential partner company, other factors should also be considered. Because the credit rating and the possibilities of the partner in the procurement of financial resources can also be important for a joint venture. In this context, one should also have developed a good idea of the financial requirements of the project and consider the extent to which debt financing can reduce equity participation. Because the leverage effect helps the return on equity to a better effect. And this in turn could increase its own value. At the same time, the interest rates taken into account only have an impact on cash flow. Finally, such financing costs are tax deductible as operating expenses. And at the current interest rates, the cost of a loan is already quite manageable.

Furthermore, one should also get a clear picture about the economic conditions. Because if the trigger for a joint venture is a tension of an economic nature, then special circumstances must come together in such a joint project to help all partners to change the situation positively. Otherwise, you risk sharing the fate of STMicroelectronics or other failed joint ventures due to similar circumstances.

For example, considerations of trademark rights, source codes or special expertise are at the forefront of a due diligence analysis of a joint venture, as well as the customer base, market power or similar characteristics concerning the marketing of products. After all, you also want to benefit each other from a joint venture. You should know right from the start what you can expect for your own contribution.

In a joint venture involving joint research, development or implementation of technologies, knowledge of intangible rights, in particular patents, is also of intrinsic importance in the context of due diligence examination. Because if these conditions are missing, the project is hardly feasible. But also legal disputes, which a potential partner company leads over such rights, should be subject to a thorough examination.

From the previous point, one can also derive an examination of the general legal situation of the future partner in the context of due diligence. An analysis of the consequences, especially the financial consequences that can arise from legal disputes of the partner if they are lost, is therefore also important.

In addition, a joint venture can influence taxation in many ways. Therefore, one should talk in advance with a tax consultant about these consequences. Because if you want to optimize the taxes, then you should set this up right at the beginning of a company. After all, any subsequent change in the tax situation leads to follow-up costs that can be saved if the appropriate structures are established right from the start. Many take this step even when they realize that they basically pay more taxes than actually necessary. The question here, however, is whether you will become aware of it at all without appropriately sound tax advice.

In addition, it is necessary for an international reference anyway that you take a closer look at the future tax conditions. This includes, for example, an optimisation of the likely transfer prices and the avoidance of any associated double taxation. The latter can even happen despite a double taxation agreement. Then often only an understanding procedure can help. If a potential conflict with the tax authorities is foreseeable in the tax discussions on due diligence, perhaps a binding information by the tax office can provide clarity.

Furthermore, a due diligence procedure should check whether the assets that the potential partner wants to bring into the joint venture are actually able to serve the intended purpose. For example, if plants or machines are obsolete or require extensive repairs, this should also be taken into account when deciding on a joint venture.

But also the staffing of the future partner should have due diligence in mind. Because if a personnel contribution is provided by the partner in a joint venture, then you should check whether the corresponding employees are available for the future tasks or are available on the job market. A proven shortage of skilled workers in the companies and on the labour market can quickly make the joint venture look like an air lock.

In addition, a shortage of specialists at the partner for the joint venture can mean that the own contribution to this is greater. Therefore, the due diligence should check whether you have the appropriate capacities for a short-, medium- or even long-term assignment of your own employees. In this context, a discussion on the question of appropriate compensation should also be included in the negotiations.

Furthermore, due diligence should analyze the organizational structure of a possible partner company. Here, too, there can be potential risks, for example in decision-making or the implementation of decisions. If you are dependent on flexibility in the joint venture, then a slow decision-making process at the partner company is certainly not a good argument for future cooperation.

Another aspect here is whether there could be a risk of the partner recruiting important employees. If this cannot be clearly excluded, one should include appropriate provisions in the contracts for the joint venture, which ideally prevent a solicitation.

Also important, although often underestimated, is the question of whether the partners of a joint venture are actually able to cooperate harmoniously at the working level. An examination of the corporate culture in the context of a due diligence is therefore quite relevant. However, one should also be aware that a joint venture often leads to an alignment of corporate cultures. However, in the rarest cases this is done by all partners to the same extent. Therefore, certain discrepancies usually remain as divisive features in a joint venture. The question should therefore be extended to include an assessment of ways of bridging such trenches.

What arrangements are necessary, possible and also useful to mitigate a stalemate in future business decisions? Especially this question should be a good due diligence. Since this affects all partners of a joint venture equally, one should approach each other particularly openly and constructively. At the same time, seeking a solution to this issue can show how well-positioned the future partnership is. Thus, the organizational risk you take in a joint venture is certainly one of the most important points in due diligence.

No matter how you answer the previous questions, you should also reflect on the consequences that threaten if the joint venture fails. Are the consequences manageable? Or are the risks in individual cases so great that the joint venture, even with only a small risk of failure, is better shelved?

Either way, the due diligence-based negotiations with potential partners should definitely include this aspect of the joint venture.

In general, it can be said that due diligence in preparation for a joint venture is of great importance. After all, this is a cooperation that is hardly manageable in its complexity and its advantages and disadvantages. In particular, the later business day may reveal many aspects that were perhaps rated differently in the due diligence. This is why tailor-made due diligence support based on valuable experience is crucial. Because only if the risks as well as the opportunities of a joint venture in the due diligence can be realistically represented, there is reason for an optimistic view of such a project.