Reviewing Joint Venture (JV) Agreements: Designing Ownership Ratios and Exit Provisions

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When entering into a joint venture agreement (JV agreement), I think it is important to set out concretely not only what is agreed at formation but also the procedures for winding up the company or for the shareholders parting ways. At formation, negotiating time goes into agreeing on the ownership ratio and the business plan. On the other hand, how to deal with deadlocked decision-making, a situation where only one party agrees to an additional capital contribution, or a party's wish to withdraw from the business tends to be put off in the rush to set up the company. Since a joint venture is an undertaking that lasts for years, I think the arrangements for when the relationship stops working are precisely what should sit at the center of the agreement.

50:50 Ownership and Designing Deadlock Resolution

Parties sometimes want to set the ownership ratio of the joint venture company at 50:50 to show that it is a joint business between equals. If the voting rights of the common shares are also 50:50, no shareholder can secure a majority on its own at the shareholders' meeting. If each party also appoints the same number of directors to the board, a majority cannot be formed when opinions conflict. When both sides attend and the votes are tied, the proposal is not passed and is rejected. A situation may also arise in which the quorum is not met and the meeting itself cannot be held. A stalemate in which necessary management decisions cannot be made is called a deadlock, and the agreement should make clear what circumstances will be treated as a deadlock. Attention should also be paid to the use of class shares in which ownership ratios and voting ratios differ and to special provisions in the articles of incorporation.

Deadlocks surface at key management junctures, such as revising the business plan, deciding on additional capital contributions, and appointing officers. If the agreement does not set out a procedure for resolving them, the only option is repeated discussions between the responsible executives on each side; while talks drag on, business decisions stall, and dealings with business partners and cash flow are also adversely affected.

Other options include differentiating voting ratios, setting an odd number of directors, or appointing an independent director agreed by both parties. However, even with an odd number, there is still room for a stalemate due to absences, special interests, or special approval requirements. In a joint venture that values an equal partnership, the choice of such people itself also tends to become a new point of contention. If the parties maintain the 50:50 ratio, it is realistic to set out in the agreement a step-by-step procedure for resolving deadlocks. Proposals on which no agreement is reached after a certain period of discussion are escalated to higher-level discussions between the parties' representatives, and if positions remain apart, mediation by a third party is considered. Where there is a valid arbitration agreement covering legal disputes, arbitration is used. However, an arbitration agreement that resolves legal disputes will not necessarily resolve a stalemate over management decisions, so one possible design is a multi-stage procedure that ultimately leads to option clauses involving, for example, the purchase of shares.

Director Nomination Rights, Veto Matters, and Rules on Transactions with Parent Companies

In a joint venture with an ownership ratio close to 50:50, one approach is to divide director nomination rights according to the ownership ratio and make the people each company nominates the candidates for director. A nomination right is a contractual right to recommend candidates, and actual appointment requires a resolution of the shareholders' meeting in accordance with the Companies Act and the articles of incorporation. The directors chosen owe a duty of loyalty to the joint venture company under Article 355 of the Companies Act, not merely to follow the wishes of the parent company that recommended them. In addition, to prepare for evenly split votes, clauses are included giving one shareholder prior consent rights or veto rights over important matters.

Matters subject to veto rights include a wide range of items, such as changes to the business plan, approval of the annual budget, capital increases and large borrowings, and disposal of important assets or dissolution. What should be kept in mind is not to expand the scope of veto rights too far. If the scope is broad, one shareholder can block even routine operations, which in turn increases the chances of a deadlock. A functional division of roles is to narrow the scope to important matters concerning the joint venture company's capital structure and the core of its business, and to leave day-to-day execution of business to the board of directors and representative director in accordance with the allocation of authority under the Companies Act and the articles. How to set prior consent matters in a shareholders' agreement is also explained in detail in Key Points in Reviewing a Shareholders' Agreement: Prior Consent Matters, Information Rights, and Obligations of Management Shareholders.

For transactions between a parent company and the joint venture company, the parties often state expressly in the agreement that they will be conducted on fair terms between independent parties (arm's length) and provide for notice or prior approval for each transaction. Where a director dispatched from a parent company is involved in a transaction between the parent and the joint venture company, consideration should also be given to the rules on conflict-of-interest transactions under the Companies Act. When a director transacts with the company for themselves or for a third party, a company with a board of directors requires board approval. Having a dispatched director does not mean that every transaction with the parent is a conflict-of-interest transaction, but if a transaction meets the requirements of the items of Article 356, paragraph 1 of the Companies Act, the company follows the procedure of disclosing the material facts and obtaining approval in advance, and reporting without delay after the transaction. In addition, in light of Article 369, paragraph 2 of the Companies Act, under which a director with a special interest may not participate in the vote, the board's approval authority and how it will be operated should be determined in advance.

The parties may also include a non-compete clause restricting a parent company from engaging in the same or similar business as the joint venture or partnering with competitors. If the scope of business, territory, or period is too broad, it may unduly bind the parent's existing business and new initiatives; if too narrow, there is a concern that the joint venture company's business base will be undermined. Excessive non-compete restrictions between competitors and the sharing of price or customer information should also be checked from the standpoint of whether they raise issues under the Antimonopoly Act.

Dealing with Additional Capital Contributions and Dilution, and Information Access Rights

There will be situations after formation in which additional funding is needed to expand the business or cover losses. The focus is how to deal with a situation where only one shareholder agrees to an additional contribution and the other cannot or will not.

If the procedures for issuing new shares are carried out lawfully, the shareholding ratio of a shareholder who does not contribute may decline. However, the ratio does not automatically fall just because a contribution has been requested. The resolution to issue new shares, the issue price, and contractual consent procedures should be checked. Ordinary borrowing from financial institutions does not in itself cause dilution of shares. In a joint venture agreement, the shareholding ratio is often linked to director nomination rights, the requirements for exercising veto rights, and the distribution of residual assets on liquidation, so dilution may upset the original balance of power.

There is no system under which existing shareholders are automatically entitled to subscribe for new shares in every share issuance. The allotment to shareholders method of issuance under Article 202 of the Companies Act and contractual subscription rights should be considered separately. For that reason, it is effective to grant by contract a preemptive right (pro rata subscription right) to subscribe for new shares in proportion to the shareholding ratio at the time of a capital increase. If additional contributions are made mandatory, the agreement should state the maximum amount, the use of funds, the timing, and the penalty for failing to contribute. The parties should also determine in advance how dilution will be handled if a shareholder does not exercise its rights and how director nomination rights and veto rights will change if a shareholding ratio falls below a threshold.

Meanwhile, for shareholders to properly understand the joint venture company's situation and appropriately decide whether to exercise their veto rights, information access rights to financial and management information are essential. The agreement sets out obligations to submit monthly trial balances and business plans, contractual inspection rights separate from the right to request inspection of accounting books under Article 433 of the Companies Act, an obligation to accept external auditors, and the like. Because sharing confidential information with a parent company's competing business division would damage trust, the parties should limit who the information is shared with, for example to the investment management department, and make confidentiality obligations clear.

Put and Call Options, Share Transfer Restrictions, and Liquidation Procedures

What requires particularly careful consideration in a joint venture agreement are the arrangements for withdrawing from the business or terminating the agreement (exit). These set out how the shares will be dealt with when the business stalls or when one party changes its management policy and wants to withdraw.

Typical mechanisms are put options and call options. A put option is the right to require the other party to buy one's own shares, and a call option is the right to buy the other party's shares. Triggering events are set out, such as a deadlock that remains unresolved for a certain period, a material breach of the agreement, or a change of control. Here, a change of control should be defined in the agreement as something such as a substantive change in the parent company that holds management control of the company, rather than a temporary change in some shareholders. The agreement should also set out concretely the method of giving notice of exercise, the cure period, the exercise deadline, the payment method, the timing of the share transfer, and the arrangement of funds.

For the method of calculating the price, the parties can agree on a fair value calculation by a third-party valuation firm or a formula such as the net asset method or the DCF method. Another option is a Russian roulette clause, under which one party names a price per share and the other party chooses whether to buy or sell at that price. However, a Russian roulette clause tends to favor one side because of differences in financial resources and information, so it should not be viewed as a mechanism that always produces an objectively fair price. If the agreement simply says the method of setting the price "will be discussed separately," price negotiations will be difficult at the exit stage, and the parties will end up in a stalemate without being able to dispose of the shares.

Because a joint venture company is based on mutual trust, free transfer of its shares to third parties is generally restricted. Contractual transfer restrictions and transfer restrictions under the Companies Act based on the articles of incorporation should be provided for separately, distinguishing their requirements and effect. A transfer of shares in breach of an agreement between shareholders is not, by that fact alone, invalid as a share transfer under the Companies Act. The transfer restriction clause should address matters such as prior notice to the other shareholders, a right of first refusal allowing them to buy on the same terms, and whether transfers accompanying intragroup reorganizations are excepted.

If the joint venture cannot be unwound through a transfer or purchase of shares, the parties move to the procedure of dissolving and liquidating the company itself. In liquidation, the residual assets remaining after debts are paid are distributed to the shareholders. Agreeing in advance on how to appoint the liquidator and on voting policies makes it possible to carry out the actual liquidation smoothly. However, the termination of the joint venture agreement does not automatically dissolve the company. In addition, when it becomes clear that the assets of the company in liquidation are insufficient to pay its debts in full, the liquidator is obliged under Article 484 of the Companies Act to file immediately for the commencement of bankruptcy proceedings. The parties should check early whether the matter can be handled through ordinary liquidation, including the conditions for using special liquidation.

Designing the Agreement in Light of the Companies Act and Merger Control Rules

There is no single special statute that directly and uniformly governs joint venture agreements, so the agreement is designed by combining the provisions of the Companies Act on stock companies, merger control rules under the Antimonopoly Act, and general principles of contract law. Because the requirements of the Companies Act apply to resolutions of the shareholders' meeting and the board of directors, when including veto clauses or prior consent clauses, the parties should clearly distinguish their effect as a shareholders' agreement from the effect of resolutions and transactions under the Companies Act. If the parties want contractual consent requirements to be reflected in the company's internal effect as well, it is effective to align them with provisions of the articles of incorporation and the design of class shares within the scope permitted by the Companies Act.

For procedures such as share acquisitions, business transfers, and company splits in connection with forming a joint venture company, the parties should check the prior notification thresholds for business combinations applicable to each method. The Japan Fair Trade Commission's Q&A (Japanese) indicates that a share acquisition in jointly establishing a newly formed company with no domestic sales does not meet the notification thresholds, while also showing cases where notification is required because an existing business is succeeded to or because there are subsidiaries. The parties should not decide uniformly based only on the sales of the contributing companies, and even where notification is not required, they need to determine early whether any substantive issue of restraint of competition arises.

Professional Support from Forming a Joint Venture to Unwinding It

In reviewing a joint venture agreement, the focus of negotiations is not limited to the ownership ratio and business plan agreed at formation; it extends to designing the exit, such as the procedure when a deadlock arises, how to deal with dilution when a party cannot make an additional contribution, and how to dispose of the shares when the joint venture is unwound. At LegalAgent, we draft and support negotiations of joint venture agreements in the area of Business Alliances, JVs and Partnerships, and where share purchases or business liquidation in connection with unwinding a joint venture take on the character of a reorganization or business sale, we also draw on our expertise in M&A support. Please feel free to consult us when you receive a draft joint venture agreement or when you begin discussing basic terms with the other party.

Frequently asked questions

What problems arise when a joint venture company has a 50:50 ownership ratio?

The problem is a deadlock in decision-making, which halts management decisions. With equal voting rights, neither party can form a majority on its own at the shareholders' meeting or the board of directors, and a proposal with tied votes is rejected. If the contract does not set out a procedure for resolving this, business decisions may stall while discussions drag on, which could adversely affect dealings with business partners and cash flow.

What should we keep in mind when including a clause granting veto rights to one shareholder in a joint venture agreement?

The matters subject to veto rights should not be drawn too broadly and need to be limited to important matters fundamental to the business. If the scope is broad, one shareholder becomes able to block even day-to-day operations, which actually increases the opportunities for deadlock. A design that limits the scope to matters such as the capital structure and the disposal of important assets, and leaves day-to-day business execution to the board of directors or the representative director, is considered to work well.

What is the significance of providing for put options and call options in the termination procedures of a joint venture agreement?

They allow a party, when a deadlock or breach of contract occurs, to exit by having the other party purchase its shares, or to resolve the situation by purchasing the other party's shares. If the price and procedure are not set in advance, price negotiations may become difficult at the time of termination, creating a risk of a stalemate in which the shares cannot be disposed of. Including the selection of a valuation firm and a calculation formula in the contract is considered to lead to a smooth exit.