Small Business Financing

Using a Joint Venture to Expand


In an environment where capital is scarce, I urge small business owners to consider collaborating with other businesses to reach new customers or broaden their offerings without the cost of developing additional expertise or hiring more employees. Unlike a merger, a joint venture lets two companies maintain separate identities. They can enter into the partnership understanding that it may be short-lived and predicate the steps to unwind it. To give you a sense of how such arrangements work, I spoke recently with two entrepreneurs who described the nuances and offered their advice.

Scott Stewart, founder of Westfield (N.J.)-based animation studio SpeakeasyFx, pursued a partnership when his TV and film clients trimmed their budgets during the Great Recession. Founded in 2003, SpeakeasyFx built a reputation for high-quality computer-generated animation, winning clients such as Sesame Workshop, which tapped the studio in 2008 to animate Abby's Flying Fairy School, Sesame's first foray into animated Muppets. The series won an Emmy and SpeakeasyFx won accolades for its part. Still, Stewart struggled to keep his staff busy during lulls.

In 2009, he began an informal collaboration with Erin Sarofsky, founder of Chicago-based production studio Sarofsky, to refer new business to each other. The pair had worked together in the past and began contracting with each other on complementary jobs. When a Sarofsky client needs 3D animation or complex special effects, SpeakeasyFx is its go-to resource. And when one of SpeakeasyFx's clients requires design-oriented work, such as in-camera film work, Stewart brings in Sarofsky's team.

Partner Expertise

Joint ventures make sense when a partner has expertise you don't have or don't want to build in-house. Although both SpeakeasyFx and Sarofsky are production companies, there is little overlap between their offerings. Their sales teams have even conceded that they could gather more business together than they can separately. "Because we each have so much invested into our own identities already, a joint venture offers the best of both worlds. We can still act independently of each other," says Sarofsky.

For 18 months, the relationship has proved fruitful, so much so that the companies are in talks to set up a New York City office together. But sharing a sales staff, office space, and even positioning themselves as a combined production facility means their companies will be more deeply intertwined, pressing the need to formalize their handshake agreement with something inked on paper. "In this economy of increasingly more significant budget reductions, it's important to understand that a handshake should not be taken lightly; the right relationships, even seemingly casual ones, can have a considerable impact on your company's sustainability," says Stewart.

Making the terms of the agreement clear is crucial. "With partnerships, the value is built over time and it is important to agree how that value will be shared," says attorney Robert Goldbaum, partner and head of law firm Paul, Weiss's asset-management transaction team in New York City. "It is rare to find a joint venture where both partners have benefited equally over many years. Without agreeing on the value of the split, it is likely that one partner may ultimately feel the need to change terms or unwind the venture—and will have the ability to do so."

When IBM (IBM) tapped Microsoft (MSFT) in the early 1980s to build an operating system for its computers, the software company gained unprecedented distribution from the arrangement. However, IBM did not share in Microsoft's success. In fact, the hardware giant suffered billions of dollars in losses and considered dismantling the company in the early 1990s while Microsoft was growing by leaps and bounds.

Structuring the Agreement

Joint ventures can either be structured as contractual agreements or as new legal entities. In a contractual joint venture, the working arrangement is detailed in a legal document that outlines the term of the partnership and how partners will get paid, share expenses, and protect confidential information. Though these agreements are inexpensive to structure, they are far from ironclad. Cost can vary significantly based on the terms of the deal, level of negotiation, and type of lawyer you use, starting around a few thousand dollars for a joint-venture agreement.

While both sides are protected for the term of the agreement, if one partner is seeing a greater benefit, there is little to stop it from ending the deal to reap the benefits on its own. Goldbaum recommends setting up a new legal entity in cases where real franchise value is expected to be created over time.

Partners should be prepared to deal with the tough questions surrounding ownership and control: Who owns what? How will decisions be made? The temptation to avoid these issues by creating a 50/50 split can also create a decision-making standstill down the road. How will the company unwind if things don't work out? Nobody likes to concede failure, and usually when it is time to discuss unwinding a joint venture, things have already been failing for a while.

Road Map for When Times Are Bad

Formalizing the arrangement when times are good gives both sides a road map for when times are bad. It also helps prevent either partner from engaging in questionable activity on the way out the door. Without a written agreement, there is nothing to stop one partner from raiding the other's employees or using confidential information.

Creating a new entity requires a detailed operating agreement, which is far more expensive to draft—likely starting at $20,000—than a simple contract. Don't fool yourself by thinking you will save money by ignoring thorny issues. You will be best served by working with a lawyer who has experience in your industry and understands the specific problems that can come up in your type of business.

A joint venture can be a powerful tool for growth when both partners bring something to the table. With little to no capital investment, companies can boost sales by broadening their market reach or improving their product offerings. But the true cost is the inevitable compromises that come with partnering with another company. When you buy something, you run it the way you want to. For a joint venture to succeed, partners must be willing to work through the same governance issues they would encounter in a merger. They should evaluate the opportunity through that lens, and plan accordingly.

Monica_mehta
Monica Mehta is managing principal of investment firm Seventh Capital in New York City. She has advised hundreds of small businesses over the past 15 years. Follow her on Twitter @monicamehtanyc or read more of her writing at monicamehta.com.

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