One of the most difficult topics to discuss when negotiating the formation of a joint venture is what business lawyers call “investment restrictions.” This sterile label belies the truly passionate nature of the subject, namely the extent to which the owners of the joint venture will be monogamous.

“Monogamy” in the joint venture context means abstinence from investing in another entity whose business is the same as or similar to that of the joint venture. However, unlike individuals approaching marriage where both parties, at least for negotiation purposes, are almost certain to say that monogamy is a sacrosanct value, joint venturers often have very different views regarding investment restrictions.

Suppose for example that two parties propose the formation of a joint venture to develop software for medical diagnostic purposes. One party is a large, established software development company; the other is a financial investor whose only contribution to the joint venture will be cash. In such a situation, the established software developer will probably want maximum flexibility for itself to acquire in the future other software companies or to make investments in such companies, including those that may develop medical diagnostic applications. Conversely, the financial investor will probably worry that such competition may erode the value of its investment in the joint venture.

Joint venture agreements sometimes explicitly impose investment restrictions on the venture owners. However, the absence of express investment restrictions in a joint venture agreement does not mean that the owners may safely invest on their own in entities that are in the same line of business as is the venture.

Joint ventures frequently take the form of closely held business entities in which each of the venturers owns equity. The parties may organize the venture as a corporation, a partnership, a limited liability company or as some other type of entity under non-U.S. law. Various judge-made rules have evolved over time that may prevent a joint venture owner from investing in another entity in a similar line of business even if the joint venture agreement is silent on the subject, at least not without first offering the investment opportunity either to the joint venture or to the other owners. Such common law restrictions are especially likely to apply to a joint venture owner who controls the venture, but in some jurisdictions these rules may apply even to minority owners.

Unfortunately, the application of these rules is often highly uncertain. The rules may vary depending upon the type of legal entity used to create the joint venture, the jurisdiction where the parties form the venture and the discretion of the court that hears the case. This uncertainty can have a chilling effect on investment because a joint venture owner may find it difficult to know a priori which investments are legal and which are not.

Even if legally unrestricted, a joint venturer who, without prior agreement among the other owners of the venture, decides to invest unilaterally in another entity having a similar line of business risks a serious rupture in the relationship between the venturers. A party who behaves in such a manner will probably not scale the moral high ground on the strength of a claim that “no controlling legal authority” prohibited the investment.

As tempting as it may be to avoid a touchy subject, one should not enter a joint venture agreement without a candid discussion of investment restrictions. Such discussion and explicit attention to the subject in the joint venture agreement has two significant benefits. First, most jurisdictions will enforce a negotiated agreement that defines the precise parameters of applicable investment restrictions. Therefore, well-drafted investment restrictions will actually have the effect of liberating the parties from the pall of uncertainty cast by ill-defined common law rules that may apply if the joint venture agreement is silent.

Second, up-front negotiation permits the parties to understand each other’s interests and desires and clearly to know what to expect from each other in terms of exclusivity. Such candor reduces the risk of future damage to the relationship that may otherwise result from an absence of articulated shared values.

The parties’ task is to craft tailored investment restrictions that allow each party a reasonable degree of freedom with respect to its own future corporate development while at the same time protecting the parties’ legitimate interest in the value of their investment in their joint venture. In the example described above, it is unrealistic for the financial investor to expect the software development company to agree to a complete prohibition on all future investments in the software industry. Similarly, the software developer should not anticipate that the financial investor would allow complete freedom in this regard. In such a situation, the joint venture agreement might, for example, restrict certain types of investments (such as investments that allow the investor to obtain control of another entity) while permitting the parties to make other types of investments (such as the acquisition of minority interests) freely. The joint venture agreement could restrict investments in certain markets while allowing them in others. As to those investments that the agreement restricts, there might be an outright prohibition on certain investments (at least for a period of time) or there might be a clearly defined right of first refusal procedure with which a party may be required to comply before making an investment on its own. The catalog of ways in which the parties can design investment restrictions is as unlimited as their imaginations.

The parties should also think carefully about the way in which they define the scope of the joint venture. Typically the parties will be free to invest on their own in companies whose businesses are not within the scope of the joint venture’s business but restricted as to investment when scopes overlap. In the example above, the parties’ realistic evaluation of their opportunities and competencies may lead them to conclude that the joint venture will develop software not for all medical diagnostic purposes but only for diagnosing orthopedic abnormalities (at least at the outset). They may also decide that the venture will operate only in certain functional markets (e.g., developing products for hospitals but not for independent physicians) or in specific geographic markets. As the parties narrow the defined scope of the joint venture, the investment restriction issue becomes easier to handle.

In a joint venture, as in marriage, if one wishes a relationship that will be to any extent open, one should discuss this desire with one’s partner and come to a clear agreement before saying, “I do.”

This article appeared in The Deal.



Joe Basile, Partner



Joe Basile is a partner at Bingham McCutchen and is a member of the firm’s Corporate Acquisitions practice group. He can be reached at jjbasile@bingham.com .