Get by With a Little Help From Your Friends: Important Considerations to Make When Entering Into a Joint Venture in Construction
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As the construction industry continues to boom, joint ventures have become increasingly common for contractors. Entering into a joint venture with another company can have enormous upside: it can provide a contractor with access to a new market, a broader geographic reach, new building techniques or knowledge, access to new and evolving equipment, and additional financing and bonding capacity. Further, a joint venture instantly increases working capital, manpower, equipment, specialized expertise and talent, and other resources that can be committed to a large project. Lastly, by allocating risk associated with a project among two or more contractors, each contractor’s risk is reduced.
However, there are a number of drawbacks to a joint venture. The primary disadvantage of a joint venture is the potential for joint and several liability of each partner for all losses or damages.[1] Another disadvantage is the loss of a single, authoritative chain of command and control. In addition, the contractor members must set up new, nontraditional organizations to complete the work and cooperate as partners.
Notwithstanding these disadvantages, joint ventures are preferred in most circumstances in which contract performance requires a high level of collaboration. There are many pitfalls to consider before entering into a joint venture. This blog will explore the most common issues, as well as some practices that can help guide a contractor through entering into a joint venture.
Before Deciding Whether a Joint Venture is Right for You
Contractors considering a joint venture must start with a truthful assessment of what their company could gain. Management must have a strong understanding of the goals it hopes to accomplish and precisely how a joint venture would advance the company’s ability to accomplish them.
Next, contractors must examine prospective collaborators. Extensive due diligence must be done on potential partners in order to lower the risk of a joint venture. The level of due diligence required is contingent on the amount of risk involved. At the very least, a contractor should examine a potential partner in the following areas:
- Financial strength: confirm the company’s working capital, equity, cash flow, projected revenues, and other key financial metrics;
- Capacity: confirm bonding capacity and current banking and financing obligations;
- Capability: confirm owner references concerning performance, quality, and satisfaction;
- Legal claims history: if practical, look back at least 7 years. While it might be unrealistic to find a clean record free of disputes, there should be a clear understanding of a potential partner’s legal history. This should include investigating the issues involved in the lawsuits, arbitrations, or other past legal disputes to determine if those disputes divulge a pattern that reflects negatively on the potential partner’s ability to perform ethically, legally, and cooperatively.
- Past Joint Venture experience: If practical, talk to past joint venture partners and ask how the potential partner operated, what its strengths and weaknesses were, and whether they would consider entering into another joint venture with this potential partner.[2]
A key consideration in this preliminary phase is making sure that the joint venture is qualified to do business. The Department of Business and Professional Regulation in Florida requires and issues licenses for entities and individuals to qualify to construct improvements to real property in Florida. Only a properly qualified business organization may engage in contracting as defined by sections 489.105(3) and (6) of the Florida Statutes. A joint venture, including those composed of qualified business organizations,[3] is itself considered a separate and distinct business organization, and must be qualified to do business. Fla. Admin. Code Ann. r. 61G4-15.001.
Additionally, after your joint venture is qualified, your joint venture must also meet these 5 requirements, pursuant to Florida law:
- There must be a written joint venture agreement;
- One of the partners must be a business entity properly qualified by a licensed contractor;
- Each partner must sign a statement of authority giving the licensed contractor full authority to conduct the contracting business of the participant;
- Copies of the agreement and statements of authority must be received and approved by the Board Office prior to the time of the bid,
- And if the joint venture is awarded the contract, the licensed contractor must qualify the joint venture within 90 days.
See Fla. Admin. Code Ann. r. 61G4-15.0022.
Creating and Assembling the Joint Venture
After thoroughly investigating and finally determining the joint venture is for you, it is time to draft the joint venture agreement. Drafting the joint venture agreement is much like setting up a new business, such that the agreement is much like an operating agreement. There are a number of issues that must be addressed when drafting the joint venture agreement. The next sections discuss the five general areas of concern that should be negotiated thoroughly and drafted in detail.
Choosing the Entity Type
There are many ways to structure a joint venture, including partnerships, corporations, and limited liability companies (“LLCs”). Both members entering into the joint venture should thoroughly consider and jointly agree on which of these is the best type for their venture.
Corporations offer the most liability protection but present some tax drawbacks, including double taxation[4] of the joint venture’s profits. Also, the corporation structure offers little to no flexibility in apportioning profits, losses, and liabilities among the joint venture’s owners.
Partnerships provide little liability protection,[5] but offer “pass-through” tax treatment. This means that there is no entity-level taxation. Instead, the joint venture’s income, deductions, and credits are passed through to the partners and then reported on their personal tax returns. See IRS.gov. Partnerships also offer the most flexibility in allocating profits, losses, and liabilities among partners according to their specific contributions to the venture, rather than their percentage of ownership interests.
For most joint ventures, an LLC is the ideal structure. The LLC provides joint venture members with the limited liability of a corporation and the pass-through taxation of a partnership. See IRS.gov. The LLC represents an admirable choice when joint venture members want to share control and profits but are reluctant to assume joint and several liability.
Ownership, Profit Share, and Governance
The next issue to address is the overall ownership percentages and governance. Each member’s ownership share must be exactly spelled out in the agreement. Further, the level of control each member exercises over the joint venture’s operations may mirror the member’s relative capital contributions, but other factors reflecting control may also be considered. For instance, one member may bring knowledge, local contacts, or bonding capacity. The relative value of each of those contributions may be represented in the level of control or income allocation provided for in the joint venture agreement.
The agreement should also very clearly outline each member’s share of profits and losses generated from the project. This can be, but need not be, the same as each member’s ownership percentage. In addition, “profit” can have many different definitions according to different people. All terms relating to distributions of cash from the joint venture must be very clearly defined in the agreement. Further, there should also be guidelines set forth for reimbursement of expenses incurred by each party, prior to and during the bid process, if appropriate, and after the contract is awarded to the joint venture.
Capital
The agreement should thoroughly set out the expectations for capital requirements of the joint venture, both initially and through the life of the project. Ongoing cash contributions result when the job turns out to be longer than expected and capital calls need to be made in order to continue to fund the project. The agreement should outline who on the management team is responsible for identifying the circumstances for which a capital call should be made and what steps to take if a member fails to meet a capital call. Nevertheless, the agreement should clearly outline remedies for failure of a party to make any required capital contribution.[6] Another issue to address relates to the eventual distribution of profits and losses and return of capital when the venture wraps up or is otherwise terminated. The agreement should outline how and when profits and losses will be allocated to avoid an uncertain future.
Management and Operational Issues
More often than not, the most difficult task in creating a joint venture is determining how the joint venture will be managed and how the work will be done. Common problems particular to joint ventures include, but are not limited to, too many levels of management, not making it clear when the project manager can act without the management committee, and not providing for resolution of deadlocks.[7] The agreement should identify the managing partner and members of the management committee, along with a schedule of regular management committee meetings. The partners must also agree on their roles and responsibilities for particular facets of the project. Further, there should be clearly defined accountability for critical management roles such as:
- Project management;
- Obtaining materials and supplies;
- Subcontractor management;
- Safety;
- Billing;
- Accounting; and
- Permitting and licensing.
The joint venture partners should also consider worst case scenarios and draft in exit strategies to avoid disputes and possible litigation. Areas to address include remedies for breach, default, or insolvency, permissible and prohibited transfer to third parties, and the causes and effects of liquidation of the joint venture.
Risk, Financial, and Accounting Management
To better allocate risk, the agreement should establish basic transaction authority and instances where signatures of both partners will be required. The agreement should also list authority, policies, and procedures for other financial transactions such as:
- Borrowing;
- Expenditures and cash transfers;
- Accounting and recordkeeping;
- Monthly financial statement reviews;
- Audited financial statements;
- Billing and cash receipts management;
- Procurement and cash disbursements;
- Payroll and human resources expenses;
- Job costing and cost-to-completion estimates; and
- Excess cash investment policy.
A critical issue of concern in the agreement relates to internal billing practices. Typically, each partner bills the joint venture for work it performs itself, so billing rates and procedures must be established upfront. Include both direct and indirect costs and determine how the costs will be passed through to the project owner and any fees the joint venture will add for managing.
The agreement should also cover what liabilities are to be insured and by whom, as well as how indemnification will be handled. In particular, the agreement should identify who is responsible for making sure the joint venture has adequate coverage for all potential liabilities, including worker’s compensation, vehicles and equipment, general liability, and other insurable risks. It also should outline the favored method for insuring these risks. Other key issues to cover include: when there is a claim, who pays the deductible and in what proportion; who chooses legal counsel; and who determines whether the joint venture itself makes a claim. Further, the agreement should contain indemnity provisions that limit each party’s liability exposure to its respective percentage ownership, unless the claim is a direct result of that member’s wrongdoing.
The joint venture must also select its accounting method, just like any new business. A joint venture’s ability to use cash basis accounting is contingent upon whether its construction contracts are subject to IRC § 460. Typically, at least one partner is very large, which means the percentage-of-completion method must be used on tax returns, even if the lead partner is a smaller company that would not otherwise have to. It is important that all accounting method elections be made on the initial tax return so as to establish the precedent for all succeeding returns. For any and all accounting methods, the joint venture must clearly and accurately project taxable income for its members’ year-end tax planning purposes. This requirement should be specified in the agreement, along with the responsibility for handling such basic accounting decisions as hiring a tax preparer.
It is very important to have the accounting and finance departments of the joint venture parties review these provisions to ensure that they are able to comply with them.
Conclusion
Although there a number of potential benefits, one should be cautious about entering into a joint venture with another company. There are several key issues to pay considerable attention to when entering into a joint venture, including choosing the entity type, drafting into the agreement adequate management provisions, delineating accounting methods and procedures, and outlining capital contributions. If a big project is looming, make sure to thoroughly assess your company’s internal situation and to thoroughly vet all potential joint venture partners. As long as you do your due diligence in assessing potential partners, evaluating your own company, and drafting the joint venture agreement, the joint venture should go off without a hitch and open doors for future opportunities.
[1] This disadvantage results only if the joint venture chooses the partnership entity type, discussed below.
[2] This information could be the most critical to consider when deciding whether to enter into the joint venture arrangement with this potential partner.
[3] An out-of-state contractor that does not hold a valid Florida contractor’s license cannot perform construction services in Florida unless they acquire a license pursuant to section 489 of the Florida statutes, find a licensed qualifying agent to “qualify” their out-of-state entity, or enter into a duly-prepared and recognized joint venture agreement with a Florida-licensed entity.
[4] The profits of the corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed. See IRS.gov.
[5] Partners are jointly and severally liable for the losses and liabilities of the partnership. Stated differently, there is no “corporate veil” that protects the partnership’s owners from liability, like there is with the corporate and LLC structure.
[6] Typically, the other member or members can cover the additional capital contribution, which, in turn, increases their share of profits and disbursement by their increased total capital contribution but maintains their original share of liabilities. However, the agreement should clearly identify what to do in a situation where the other members are unable or unwilling to cover another member’s capital contribution.
[7] This last problem is critical, and there should be agreed-upon dispute resolution procedures so that critical decisions can be made in a timely and efficient manner, even when members have differing opinions.