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Contract Law

This article was reprinted with permission from the Carlsbad Business Journal.

Q: I'm looking to enter into a joint venture as a manager. What can you tell me about provisions for removal?

A: A typical joint venture arrangement involves one group providing most of the capital for the venture (the “Investors”), and another group or entity being responsible for running the day-to-day business (the “Manager”). Most often, the economic structure provides that cash is distributed first to the Investors until they have received a preferred return or internal rate of return on their investment, together with the return of their investment, and then there is a “shift” of the economic sharing ratios for the benefit of the Manager. In effect, the Manager becomes entitled to receive a share of the profits in excess of its capital investment (if any). The excess profit share is commonly referred to as a “promote.” In these situations, it is common for the Investors (especially institutional Investors) to negotiate to have the right to remove the Manager either for cause or not-for-cause. In negotiating removal provisions, there are a number of concepts for the Manager to consider, and a few of the more basic of those concepts include the following:

1. From the Manager’s perspective, it is important to draw a clear distinction between “cause” and “not-for-cause,” because removal of the Manager for cause typically results in a complete loss of the rights to the promote, whereas removal not-for-cause will often permit the Manager to continue to benefit from the promote. While it is not uncommon for Investors to try to include as a cause the failure to achieve specified performance results, the Manager should resist that treatment. Failure to achieve performance results may have nothing whatsoever to do with the efforts and capacities of the Manager, but instead are due entirely to market or other conditions. As a practical matter, the Manager will want to limit terminations for cause to “dark of the heart” types of conduct such as a court determination of willful bad conduct or gross negligence.

2. If removal is allowed, the Manager should require that the Investors in the venture remove the Manager from any venture guarantees, and if not removed, agree to indemnify the Manager from any losses suffered in respect of company-level debt until the guarantees are terminated. Depending on the financial capability of the venture, the Manager may consider insisting that the Investors separately guaranty the indemnification obligation.

3. In the case of not-for-cause removals, the Manager will also want to protect the inherent value of the promote accrued up to the time of removal. This can be accomplished by either requiring a current payout of the accrued promote (based on a hypothetical sale of the venture at fair market value), or a “book up” to the Manager’s capital account, with a requirement that book up amounts be distributed as a part of the distribution waterfall.

4. If the Manager does not wish to continue to be a part of the venture if removed, the Manager will want to require the venture to buy out the interest of the Manager (both the promote and equity positions, if any). Ideally, the buy out will be on an “all cash” basis at closing. If the buy out is to be paid over time, the Manager should assure itself that it has adequate security for the payment of the buy out price. Alternatively, if the Manager is willing to continue as an owner of the venture, care should be taken to assure that the Manager has adequate voting rights, and can protect itself from venture document changes that would adversely affect (directly or indirectly) its economic rights.

The removal provisions in venture documents can be particularly complex, involving a careful analysis of not only the removal provisions themselves, but the impact of those provisions on management rights, economic obligations and rights, tax allocation provisions, venture termination rights and applicable buy out provisions. Managers are well advised to have the assistance of experienced counsel in structuring and negotiating these types of agreements.

Changaris can be reached at mike.changaris@procopio.com.