Exit Mechanism Issues List

6.26 Exit Mechanism Issues List

This issues list describes the mechanisms that venture partners can use to exit from a venture. It also describes the events that might trigger a right to exit. Next, it describes some of the specific issues that arise in drafting different types of exit provisions. The outline assumes that the venture has two partners, but much of the discussion would apply to ventures with a larger number of partners.

Types of Exit Mechanisms

There are various types of exit mechanisms. Whether a particular mechanism is appropriate for a given joint venture will depend greatly on the venture's business, the interests of the parties and their relative bargaining power.

• Sale of entire venture to a third party. The joint venture agreement might provide that upon the occurrence of specified triggering events, the venture partners would sell the venture to a third party buyer. This sale might take the form of a sale of the venture assets, a sale of venture interests, or a public offering. A public offering exit might be structured as a series of transactions - first the venture or its partners would sell some stock in an initial public offering, and then the venture partners would sell their remaining shares in subsequent offerings.

• Sale by a venture partner of its venture interest to a third party. The documents might provide that a venture partner would have the right to sell its venture interest to a third party in specified circumstances.

• Termination and liquidation of venture. The documents might provide that upon the occurrence of specified events, the venture would be terminated and liquidated. The venture assets would be distributed to the partners or sold to third parties.

• Call rights in favor of a venture partner. The documents might give one venture partner the right to buy out another partner's interest.

• Call rights in favor of the venture itself. The documents might give the venture itself the right to buy out a partner's interest.

• Put rights in favor of a venture partner. The joint venture agreement might provide that one partner has the right to put its venture interest to another partner or to the venture itself.

• Buy-sell provision. The documents might provide for a forced auction process. A partner would trigger this process by naming a price at which it would be willing either to buy or sell its venture interest. The other partner would have the right to decide whether it wanted to be a buyer or seller at that price.

There are many variations on each of these exit mechanisms.

Exit Triggers

There are a variety of situations in which venture partners might decide that an exit is appropriate.

• Venture success. If the venture is very successful, one or both partners might decide that they wish to reap the benefits of their investment. Note that partners may have different views of what constitutes venture success.

• Venture failure. One or both partners might want to exit if the venture does not achieve its objectives. As in the case of determining success, the venture partners may have different views of what constitutes venture failure.

• Partner breach. A nonbreaching partner may want to exit if its partner has breached the joint venture agreement. Alternatively, it may want to force the breaching partner to exit.

• Deadlock and dispute resolution. If the partners become deadlocked or cannot resolve a disputed issue, they may conclude that the venture should be terminated.

• Venture partner change in control. If a venture partner is acquired by another company or otherwise becomes the subject of a change in control, the documents may establish that the other partner has the right to exit.

• Passage of time. Venture agreements sometimes provide for an exit simply upon the passage of time.

Matching Exit Mechanisms to Exit Triggers

Exit mechanisms should be matched to exit triggers since a specific mechanism will work better in some circumstances than others.

• Sale of entire venture. Selling the entire venture can be an effective solution for both venture success or venture failure. It may also be an effective solution in the event of venture deadlock or change in control. A sale of the venture may be less desirable where a partner breaches-the nonbreaching partner may not be willing WANT OR NOT WANT? to continue to operate the venture business.

• Sale by venture partner of its venture interest to a third party. The sale by a venture partner of its interest in the venture may be an effective way for it to reap the benefits of venture success. It may also be a good way for an unhappy partner to escape a venture that it views as a failure. Similarly, such a sale may provide an escape route when a partner is acquired by an undesirable third party. A sale may be an effective solution where a partner breaches-either the breaching partner or the nonbreaching partner may sell out. It may be an effective solution for deadlock.

• Sale by venture partner of its venture interest to the venture. Providing for the sale of a venture interest to the venture itself may be useful where the venture has been successful, and one partner wants to exit but the other does not. It may also be useful where one partner believes the venture has not been successful, where one partner has breached or where there is a deadlock. It will be less useful where both partners want to exit.

• Termination and liquidation of venture. Terminating the venture may be a sensible exit mechanism where the venture has been successful, both parties want to exit and both parties believe that significant value can be realized by liquidating and selling the venture business. It may also be sensible where the venture has not been successful and both parties want to exit. Termination will be less desirable where one partner wishes to continue operating the venture business, or when it will be difficult to find third-party buyers. It will also be less desirable in the event of a change in control of one of the venture partners.

• Call rights in favor of a venture partner. Giving a venture partner call rights may not be an appropriate exit mechanism where both parties want to exit because the venture has succeeded or failed. However, where just one wants to exit, allowing for a call right gives the partner who wants to stay some flexibility, and may enable the other partner to exit. Call rights can be useful where a partner has breached the agreement or where there is a deadlock. They also may be useful where there is a change in control.

• Call rights in favor of the venture itself. Call rights in favor of the venture may be desirable for the same reasons that call rights in favor of a venture partner are desirable.

• Put rights in favor of a venture partner. Giving a venture partner the right to put its venture interest to the venture or another venture partner will facilitate the exit by that partner, whether the partner wants to leave because of success, failure, breach by the other partner, change in control or deadlock. This exit mechanism imposes a financial burden on the nonexiting partner.

• Buy-sell provision. This device may work in the case of a deadlock or breach. It will not be useful if both parties want to exit because of venture success or venture failure. In theory, buy-sell provisions keep the partners honest. Because the partner that initiates the process may be forced to sell at the price it names, it will have an incentive not to quote an unduly low price.

Exit by Sale of the Venture

• What are the circumstances that will trigger a sale of the venture? Venture success? How is success measured? Achievement of milestones? Agreement by both parties? Should there be a right to force a sale after a certain period of time?

• Must all partners agree to sell, or can one partner force a sale on the other partners?

• How will the venture be sold? By investment bankers? Must both partners agree?

• Are there circumstances in which the sale will not be permitted? E.g., should a period of time elapse before any forced sale would be permitted?

• Are there any restrictions on how a sale may be conducted? Must the sale be conducted through an auction?

• Can the parties agree on whether the sale will be an asset sale or a sale of venture interests?

• What are the tax consequences of a sale?

• Are there securities law or other regulatory issues?

• What if the venture partners want to retain the right to use intellectual property developed by the venture?

• Are there assets that the venture partners conveyed to the venture, and that they would not want to convey to a third party?

Exit by Sale of Venture Interest

• Can one partner unilaterally decide to sell? Or must that partner obtain the consent of the other partner?

• Must certain events happen before the partner can sell? E.g. , should sale be permitted only if the venture achieves certain milestones, or fails to achieve certain milestones? Should it be permitted only if one partner breaches? If breach triggers the right, can either partner sell, or only the non-breaching partner?

• If a partner decides to sell, must that partner give the other partner a right of first refusal?

• Does the nonselling partner have the right to approve the buyer?

• What are the tax consequences of a sale?

• Are there securities law or other regulatory issues?

Exit by Termination

• Must both parties agree on termination? Is termination automatic upon the occurrence of certain events, e. g. , failure to achieve milestones, deadlock or breach?

• Upon termination, how will liquidation be managed?

• Who decides whether assets are distributed or sold?

• If assets are distributed to partners, who gets what?

• If property includes intellectual property, should both partners have a license to use the property going forward?

• What are the tax consequences? What other regulatory issues apply?

Designing Put Rights

• Is the put right a right to put the venture interest to another partner, or to the venture itself? Does the venture have the financial wherewithal to satisfy a put right? What about the venture partners?

• What triggers the put right? Venture failure? Venture success? Breach? Deadlock? If the right is triggered by failure or success, how are they defined? If the right is triggered by breach, how is breach defined? Does the breaching partner have a right to attempt a cure? How is deadlock defined?

• What is the price of the venture interest upon the exercise of the put right? Is it a formula price based on a multiple of EBITDA or earnings? Is it based on a calculation of net worth? Are third-party appraisals used? Are other valuation methodologies appropriate? Should the price be determined by the venture board?

• Does the party that must acquire the interest upon the occurrence of a put have an obligation to pay the put price immediately, or can it pay in installments?

• What are the tax and other regulatory issues?

• What happens to the venture's intellectual property? What happens to intellectual property it obtained from the venture partner who sells out?

Designing Call Rights

• Is the call right a right in favor of one partner to buy out another partner, or is it a right in favor of the venture to buy out a venture partner?

• Is the call right triggered by a breach? Venture failure or success? Deadlock? If so, how are these events determined?

• What is the price of the venture upon call? Is a formula used to determine price? Or is some other approach used? See additional possibilities referred to above with respect to issues in designing put rights.

• Must the call price be paid immediately or can it be paid in installments?

• What are the tax and other regulatory issues?

• What happens to the venture's intellectual property? What happens to intellectual property it received from the venture partner whose interest is called?

Designing Buy-Sell Provisions

• May the buy-sell be triggered at any time, or only upon success, failure, passage of time, breach or deadlock? How will the parties determine whether one of these triggers has been pushed?

• Can either party initiate buy-sell?

• How do you structure the buy-sell so that it is fair to parties with unequal economic power? A party that is cash strapped may not be able to respond as it would like to an offer by the other partner to buy or sell at a particular price.

• Does the buy-sell provide for a multi-round process? I.e., is it structured so that the process ends after one party names the price at which it would be willing to buy or sell, and the other party responds. Alternatively, can the other party "bid up," i.e., respond by naming a higher price at which it would be willing to buy or sell to the initiating party-so that the initiating party then has to decide whether it wants to buy or sell at the new price? Does this process continue in iterative rounds?

• What are the tax and regulatory issues?

• What happens to the venture's intellectual property? What happens to intellectual property obtained from the venture partner who sells out in the buy-sell?