Funding
Funding
The means of funding the joint venture will be determined by the financial requirements, the legal joint venture structure chosen and tax considerations.
In the case of a contractual joint venture, each party may be simply responsible for a particular proportion of the cost and expenditure. There may be provisions for a joint account with obligations for the parties to contribute cash in accordance with a business plan, project timeline or other appropriate terms. This should be provided for contractually.
In the case of corporate joint ventures, the shareholders’ agreement may require the parties to loan or subscribe monies by way of shares. Parties may be obliged to make further capital contributions by way of further equity. There may be a mechanism in the agreement providing for the fixing and payment of the required contributions.
If the agreement on contribution is not required to be unanimous, there must be a mechanism to deal with a default on the part of one party in making the contribution. This will generally involve a dilution of his shareholding.
Cash Calls
Some joint ventures may involve substantial capital investment over many years. A budget is generally approved. Cash calls are made in accordance with it, with obligations to pay from time to time.
The consequences of default, ill be provided for. There may or may not be an obligation on the non-defaulting participant to make up the share of a party who fails to contribute. The party in default may lose his voting and other participative rights. His shares may be diluted. Ultimately, his participation interest may be forfeited where the contributions are made by the other parties.
There may be an option for one party to take up a particular activity / project at its own risk within the scope of the agreement, which is not approved by the other parties or the relevant majority. In this case, that party so electing is usually exclusively responsible for the costs and risks and is entitled solely to the benefits of that activity or project, without risk to the joint venture or the other parties.
Obligation to Advance Monies
The general position with companies is that shareholders and their successors cannot be required to contribute anything more under the company constitution, beyond the initial subscription of the nominal value of the share and the share premium. Any further obligations may subsist only by contract.
The parties may agree in a shareholders’ agreement to provide finance of a specified amount on specified occasions. They may, collectively, commit to provide such finance as is required for the joint venture company’s activities or as is necessary to keep it solvent. It may undertake to provide guarantees to third-party lenders either limited or up to a certain amount.
The obligations are generally entered between the parties themselves. The joint venture company should not be a party. If the undertakings are given in favour of the joint venture company, joint venture company, it may have a right enforceable on an ongoing basis and by its liquidator on its liquidation to call upon the participators to meet any shortfalls.
Default in Funding
If there is default in funding, there will usually be provision for the dilution of the participator’s interests and ultimately for its forfeiture. A forfeiture may be void if it amounts to a penalty. However, provisions are generally upheld if they have justifiable commercial rationale and are a genuine pre-estimate of the liability concerned and reflect the value of the underlying entity in the absence of the contribution.
There may be an obligation to pay default interest at a higher rate to the company on default. Voting rights may be lost. The right to appoint a director may be suspended or lost. Rights to dividends may be lost. Ultimately, there may be a compulsory sale to the other joint venture parties with the price (if any) reflected in part or in whole by the default.
Partnership JV
If the joint venture is constituted as a partnership, the legal terms are contractual in nature. The default Partnership Act position provides for the contribution of capital, the sharing of profits and interest on capital. This will often be inappropriate to a joint venture and will be specifically varied.
A partnership joint venture agreement should provide for the capital contributions to be made by each party. Where the nature of the business requires further contributions, they should be provided for. They may be provided by loan or by the subscription of capital. The default interest rate is 5 percent on loans. Loans are often preferred. Interest is not payable on capital unless otherwise agreed.
Corporate JV
In the case of a corporate joint venture, there are a number of methods by which equity or funding capital may be contributed. It is possible to engineer the capital structure of a company as way desired.
The contribution may be by way of cash for ordinary share capital /equity shares. This may be the start-up capital of the company. Non-cash consideration may be contributed. This must be independently valued, in the case of a public limited company.
In all cases, the directors should be satisfied in accordance with their basic duties to the company that the consideration represents at least the nominal value of the shares and any premium attributed to it.
Share capital contributions are often supplemented by loans from the joint venture parties. The relative weighting of debt and equity is likely to be governed by tax, repayment and other practical considerations. Loan capital can be re-paid easily whereas share capital may be redeemed only on a winding up or where there are sufficient distributable profits for the repurchase or redemption of the shares.
Shareholders’ Loans
There is deductibility of interest on loans for the trade in the computation of income and corporation tax. Dividends are not a deductible expense or charge. In some cases, interest is deemed to be in the nature of a dividend and legislation denies the deductibility of the interest. This is on the basis that the loan is in the nature of capital.
The terms of the loan should be considered. The Companies Act 2014 provides for certain unfavourable default positions in relation to the terms of loans by directors, shareholders and participators to the company, in the absence of documentation otherwise.
The loans may be required to be subordinated to the obligations to external bank funders. They may be agreed to be subordinated to external creditors in the event of winding up.
Provision must be made for the timing of repayment, interest and security (if applicable). There may be a loan agreement. Loan notes may be issued by the joint venture company to the participators.
Loan Stock
Loans are attractive in that they may be usually repaid without tax costs or Company Act prohibitions on distribution. In contrast, the repayment of capital is strictly regulated or is not generally possible other than on winding up and in certain circumstances, from distributable profits. Capital repayments are not taxable. Dividends and interest are taxable as income for the recipient.
Loan stock is a formal loan agreement. It may be granted with rights equivalent to those of preference shares as set out above. Loan stock interest may or may not be allowed as a tax deduction against taxable profits, depending on its nature. Where it is in the nature of a security interest, tax legislation seeks to deny interest deductibility in some cases, effectively equating it with share capital.
External Borrowing
The parties may seek to fund longer term requirements and working capital by way of borrowing from an external financial institution. This may be from a bank, venture capitalist, project finance provider or otherwise.
In the case of project finance, the arrangement is structured so that the debt is serviced from the income of the joint venture without further recourse to the joint venture partners.
The parties may be required to give guarantees and security in order to obtain external finance. The joint ventures may agree to give guarantees in favour of a third-party lender. The extent of the obligation and commitment should be defined. Otherwise, the matter would have to be agreed at the relevant time.
The entities to give the relevant commitment should be specified. There should be provision for cross-agreements between the parties and cross-indemnities to ensure that if the guarantees are called, that each party makes its proportionate contribution only.
Preference Shares
Preference shares may be an element of the funding and capital structure arrangement. Preference shares have priority over ordinary and other classes of shares in accordance with the terms of preference. The preference usually relates to dividends where there are distributable profits and to repayment in a winding up.
Many types of preference share may be provided. Preference shares do not have a particular meaning as such. In broad terms, they are shares carrying rights, which have relative priority to those of other shares. The preference rights are attached by the company constitution/memorandum and Articles of Association.
Any class of preference share may be created provided that collectively, the mutual rights are compatible and logically interlock and do not abrogate the rights of other shareholders. The constitution will define what is permissible.
Priority of Preference Shareholders
There may be priority for preference shares over ordinary shares as regards dividend. There may be a fixed dividend and/or a participating dividend based on profit. The dividend rights may rank pari passu or equally with other shareholders after those latter shareholders have received the same rate of dividend as the preferred ordinary shareholder.
Preference shares may carry priority over other ordinary shares on the return of capital on a winding up. They may then rank pari passu with ordinary shareholders after the ordinary shareholders have received repayment of their capital.
Preference shares may be cumulative and entitle the holder to arrears of dividend before dividends are paid to any other classes of shareholders. There may be participating rights, which may be linked to profitability in defined terms.
Preference shares may be redeemable by either the company itself or by the shareholders. The right to redeem may arise on a specified date or in the circumstances specified. The redemption price may be specified. It may be at par or a premium.
Preference shares may carry rights to conversion into another class of shares, generally ordinary or other equity shares. The effect of conversion is to dilute the equity shareholders.
This may occur in certain circumstances, such as the failure to pay dividends, to meet other financial performance or the failure by the company to redeem the shares when due.
Tax issues
Some jurisdictions apply capital duty on the subscription for shares. Capital duty was abolished in Ireland in 2005 and earlier in the UK.
There may be an advantage for the participators in the joint venture to borrow in order to finance the investment into the joint venture company. The interest may be deductible against their own taxable profits, in circumstances where the joint venture company itself does not have profits against which interest may be deducted.
The shareholder may be in a jurisdiction which has a high corporate tax rate, which is more valuable relative to the deduction in a joint venture company which pays corporation tax in a jurisdiction with a lower rate.
Thin capitalisation rules apply in many jurisdictions to borrowing within groups and related entities as defined. They apply an arms’ length hypothetical capital and debt structure and make some or all interest non-deductible. They proceed on the basis of an appropriate debt to equity ratio and earnings to interest ratio.
Withholding taxes apply to the payment of certain interest. There are exemptions for most lending to financial institutions and lending from domestic entities. See generally the sections on corporation tax.