Starting a joint venture: Part 1

The term “joint venture” stretches back to the discovery of the New World, and played a fundamental role in propelling Europe from economic afterthought to financial juggernaut. In that seafaring era, Europe’s gaze rested far from home. But ocean-striding ships bursting with gear and crew were too costly for individual investors to provision on their own. So many investors would pay for these expensive expeditions by pooling their resources into single-purpose partnerships. Eventually these partnerships became known as “joint adventures” and later as just “joint ventures.”

To understand some of the issues in a modern joint venture, let’s explore a scenario. Fred, the owner of 1001 Inventions Corp., loves to tinker in his garage, and regularly generates interesting product ideas. But each time he tries to sell them in the market, he fails. No one buys them, no one even hears about them.

Enter Mike, owner of Marketing Mayhem, Inc. He can sell anything. Just don’t ask him to think up a new product.

Sensing a profitable match, Fred and Mike meet to discuss how they can help each other. One discussion leads to another and then another. Eventually they decide to pursue a joint venture. Fred will focus on improving his current set of products, and Mike will make sure the world is falling over itself to buy them.

To fund the joint venture’s expansion, Fred and Mike decide they need to bring in some people with deep pockets. After dozens of pitches, they talk two investors, Ivan and Evander, into putting up some cash.

The four joint-venture partners agree on how to split up their stakes: Fred and Mike’s companies will each receive 30% for their sweat equity and Ivan and Evander will each receive 20% for financing the project.

Now for the technical part: How should they structure the joint venture? They have five choices: a C corporation, an S corporation, a general partnership, a limited partnership, and a limited liability company.

A C corporation won’t work well here for tax reasons. A C corporation generally does not make sense as the legal structure for a joint venture unless one of the partners is both a corporation and owns at least 80% of the joint venture. That’s because those criteria must be met for a partner to file a consolidated tax return, which in turn would allow that partner to use the joint venture’s losses (if any) to offset taxable gains from its other businesses.

How about an S corporation? Nope. The type of people who can own an S corporation is limited. It does not include corporations, so Fred and Mike’s companies do not qualify. It also wouldn’t be available if any of the partners were not citizens or residents of the US.

Another option is a general partnership. But as you’ll recall from previous columns, general partners have unlimited personal liability for the company’s debts, including liabilities arising from other general partners’ mistakes. Thus, a general partnership is seldom a wise choice.

The next choice is a limited partnership. This option works well when one party will serve as the general partner and everyone else wants to be a limited partner. But it can get complicated when two parties want to serve as a general partner. In such case, the partners need to spell out how control will be handled at both the limited-partnership and general-partnership levels. There is a simpler way to handle these issues, as we’ll see next.

That brings us to the last, and usually best, choice: Forming an LLC.

In our hypothetical, an LLC offers better tax treatment than a C corporation. That’s because an LLC, unlike a C corporation, allows each of its owners to use their share of the LLC’s losses to offset gains in other parts of the owner’s tax returns. By contrast, using a C corporation would mean none of the owners would be able to use the joint venture’s losses (because none of the owners is a C corporation owning at least 80% of the joint venture).

Meanwhile, an LLC beats an S corporation because anyone can own an LLC, which as we learned above, is not the case for an S corporation. Therefore, while Fred and Mike’s corporations could not own a piece of the joint venture if it was set up as an S corporation, they can own an LLC.

Moving to a general partnership: The reason why an LLC is normally superior is easy—limited liability. An LLC has it; a general partnership doesn’t.

With that said, the partners could solve this issue. But it would involve creating additional LLCs, S corporations, or C corporations—just as Fred and Mike accidentally did by owning C corporations. But with an LLC, there’s no need to create those extra companies. One would be enough (unless the owners needed a sophisticated asset-protection strategy for reasons beyond the scope of our example).

And, finally, an LLC trumps a limited partnership for two reasons. First, control issues can be fully addressed in a single document—the LLC’s operating agreement. And, second, if Ivan and Evander (our cash-only silent investors) ever wanted to take an active role in the company, an LLC would continue to give them limited liability while a limited partnership would not. That’s because under a limited partnership, if limited partners begin to actively manage the company, they become general partners and therefore fully and personably liable for the joint venture.

For those of you interested in a broader spread of practical issues that potential JV partners should at least graze through before setting off on a joint adventure, stay tuned for Part 2.

This column is for informational purposes only and is not intended as legal advice. For your specific case, consult a lawyer.

Jordan Sundell (Special to the Saipan Tribune)
Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including JZ Group. His columns—focused mainly on real estate and small business—are published every other Tuesday. Contact Sundell at jsundell@jzgroupinc.com.