<div><em><strong>Madhavi Pandrangi</strong> on what happens when one of the JV partners buys out the other</em><br><br><br>It is often observed that when a joint venture dissolves, the separation process is messy and marked by dissent. This can happen whether the split is by mutual consent of the JV partners, or by one party deciding to end the partnership. This article examines situations where one of the JV partners buys out the other, keeping the company’s operations ongoing. Dissolving the company itself is another ballgame with enough complexities to deserve a separate discussion by itself.</div><div> </div><div>The key area of difference is valuation of the outgoing partner’s stake, often resulting in protracted negotiations and sometimes ending in arbitration. Intuitively, one would expect the purchase consideration to be at fair market value, but that is where the complications start. The possibilities for variation are numerous– the method of valuation, projections for the business, discount rate applied, choice of comparable companies, application of premium or discount, treatment of contingent liabilities, etc.– and lead to a wide range in value expectations. Human bias comes into play – we have come across instances where the seller comes up with hockey stick projections for the business and views the business as low risk with a correspondingly lower cost of capital, while the buyer assumes just the opposite! It is difficult to reconcile such wide variances in value expectations and this leads to escalation of the conflict.</div><div> </div><div>None of the above is new, and many joint venture partners try and ward off future problems by including a clause relating to valuation within the JV agreement itself. This is eminently sensible, but like anything worthwhile in life or in business, needs to be thought through properly in order to be really useful. Based on our experience, a few common issuesto be taken care of whilst drafting the JV agreement are listed below:</div><div> </div><div><strong>Category I: Valuation process</strong></div><div> </div><div>1.<span class="Apple-tab-span" style="white-space:pre"> </span>Valuer appointment: The JV agreement may specify that exit by either of the JV partners would be at fair market value, to be determined by an independent valuer. Some JV agreements even name one or more reputed valuers who are acceptable to both parties. </div><div>2.<span class="Apple-tab-span" style="white-space:pre"> </span>Valuation process: However, the agreement stays silent on the process itself – would both parties agree on the financial projections to be provided to the valuer? What happens if they are unable to agree on the business plan? Is there an alternative route, such as appointment of twovaluersand taking an average of their valuation conclusions, or providingasingle valuer the liberty (and the responsibility) to consider his best estimates of future performance, after listening to all parties?A formal process including agreed timelines for provision of information by each side and for completion of the valuation would help reduce uncertainty. Depending on the size of the transaction, it may be a good idea to provide for appointment of a third valuer if differencesin value estimates by the two valuersexceed an agreed threshold limit.</div><div>3.<span class="Apple-tab-span" style="white-space:pre"> </span>Data to be used for valuation: The financial projections to be considered as a basis for valuation are often the main area of dispute between the parties, and the bias exhibited by each party (whether the seller or the buyer) is naturally reflected in the DCF value that results. Setting a system of medium-term plans to be prepared annually on rolling basis (e.g. current year plus three to five years, as may be feasible) will ensure that whenever the time for dissolution comes, there would be a basic set of projections ready to be used, which are pre-approved by both parties.</div><div>4.<span class="Apple-tab-span" style="white-space:pre"> </span>Regulatory requirements: the final transaction price would be subject to the prevailing regulatory guidelines, particularly in the case of cross-border transactions. Currently, the Reserve Bank of India has mandated that valuation of equity shares should be at market value in the case of listed companies and at fair value in the case of unlisted companies, considering internationally accepted valuation methodologies. Given that the fair value thus determined would form a floor or ceiling price for the transaction, and would over-ride any pre-decided exit valuation between the two parties, it becomes all the more important that the parties are in agreement over selection of the valuer and that standard valuation methodologies are adopted.</div><div> </div><div><strong>Category II: valuation methodology</strong></div><div> </div><div>1.<span class="Apple-tab-span" style="white-space:pre"> </span>Linking exit to a multiple without providing for a loss situation: a popular option is to link the exit valuation to an agreed multiple. This seems fair, as the valuation paid to the exiting partner is linked squarely to performance – but what happens in situations where the company has incurred a loss? What if the company was profitable until the preceding year, or has broken even for the first time, or if it has never been able to generate profits? What if the underlying financial statements for the period ending on the exit date are not audited/ are subject to management’s bias? If the stipulated valuation methodology does not cover suchcontingencies, it can throw the valuation wide open to each party’s mode of interpretation. </div><div>2.<span class="Apple-tab-span" style="white-space:pre"> </span>Stipulation of only one methodology: in our experience, it is preferable to leave the choice of valuation methodology to the independent valuer, rather than specifying the approach in the JV agreement. There is no “one size fits all” principle in valuations, and adopting a combination of approaches is preferable as it reduces the chances of error or bias in the analysis. </div><div> </div><div><strong>Category III: valuation subject</strong></div><div> </div><div>3.<span class="Apple-tab-span" style="white-space:pre"> </span><strong>Including asset valuation in the agreed valuation guidelines: </strong>sometimes, the JV agreement guidelines for fair market value include consideration of the asset value at the exit date. However, the agreement does not clarify whether assets should be revalued or considered at book value, and whether the asset valuation is to be used as a reasonableness check or as a primary valuation approach. Asset valuations would typically form the minimum value for the business, and can be particularly important in businesses which have interests in real estate. However, the book value of assets does not reflect future earnings capacity. Further, while surplus assets may be revalued, the earnings from operating assets are already reflected in earnings based valuation models. Inclusion of such a clause without specifying how the assets are to be considered leads to ambiguity and hence offers scope for different treatment by both parties.</div><div> </div><div>4.<span class="Apple-tab-span" style="white-space:pre"> </span><strong>Financial instruments</strong> – option to convert has value implications: structuring of investments as a combination of equity and convertible instruments is a popular option, particularly with private equity investors. The terms of the debentures and preference shares often give the holder the option to convert the instrument into equity shares at any point during the tenor of the instrument. Such an option gives rise to value in the hands of the debenture or preference shareholders and should be factored into the exit price. If the exit is to happen before the expiry of the instrument, valuation of both the existing equity shares and the convertible instruments may be needed. Differential rights in the form of voting and dividend rights in the hands of the equity holders versus right to preference dividend/ interest in the hands of the preference share/ debenture holders need to be considered. </div><div> </div><div>It is never easy to visualize what may happen when the time comes to dissolve the JV, particularly in the heady days leading to the entity being formed. In our experience, it is usually helpful to stipulatein the JV agreement that the exit price would be based on fair market value as determined by an independent valuer, based on a mutually agreed or Board-approved set of projections. That said, the scope for differences in opinions and valuation expectations will always be high and it is not possible to cover every contingency. While an experienced valuer should be able to handle the process in as painless a manner as possible, the parties should be prepared for the long haul unless both come to the table with a reasonable approach and a mutual will to get it done. </div><div> </div><div><em>The author, Madhavi Pandrangi, is Associate Director, Price Waterhouse & Co LLP</em></div><div> </div>
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