What is a Joint Venture Agreement?
Joint venture agreements are the legal building blocks that a partnership needs to have a solid foundation. Just like a verbal partnership, a joint venture can be formed any way the partners see fit. However, a well-written agreement in most cases is preferred. Parties to the agreement can be individuals, groups, corporations or any combination of those entities. No matter who a party is , a joint venture is the formation of a separate business entity by two or more parties that wish to work together on an economic endeavor. The agreement will commonly define the exact terms of formation, organization, operation and eventual termination of the joint venture. Typically, the parties to the joint venture join in for a limited time and for a specific purpose. A joint venture in the real estate industry can be an easy way to combine resources and share profits.
Essential Elements of a Joint Venture Agreement for Real Estate
Depending on the size and scope of the proposed venture and resources of the developer/joint venture parties, one or several entities may be formed to properly accomplish the intent of the joint venture agreement. A developer may seek to form a limited liability company as a joint venture to develop a parcel of real estate. The developer partners may form one or more limited partnerships or limited liability companies to serve as part of the overall development including the operation of the managed property.
The joint venture agreement should provide the following components:
Capital Contributions: The capital contributions of each of the parties/joint venturers to the venture should be clearly defined in the joint venture agreement. All real estate joint ventures include various forms of capital from the partners. Capital contributions can take the form of real estate property, cash, intellectual property, real estate options, or contracts related to the development of the property.
Profit/Loss Share: Sometimes profits will be distributed or "split" evenly among the joint venture parties. Other times, the managers or those who contribute often do not share equally in the profits of the property. Whatever the method of distribution or sharing outlined in the joint venture agreement, the partners should, at some point, sit down and analyze whether it would make sense to change the percentage of distribution and/or recompense in exchange for additional efforts by specific parties of the venture. This is very common, and is encouraged to be initially discussed and analyzed in the joint venture agreement so both parties are aware of such a possibility.
Management Roles: (See blurb on shared roles section of this blog). In a basic joint venture arrangement, where each of two joint venture parties is going to be a signer of the checkbook, each joint venture party should address how they will exercise their roles. Each party should discuss, in the joint venture agreement, the division of responsibilities in the decision-making process. The agreement should clearly outline which party will handle day-to-day operations of the property, routine maintenance issues, capital improvements, leasing, marketing, tenant retention and viability, etc.
Various Types of Real Estate Joint Ventures
There are different types of joint ventures in real estate, which traditionally take a couple of forms: the equity joint venture and the contractual joint venture.
The equity joint venture is when an operation commences with a lot of investment by both parties. So imagine you have two property developers who typically work together on the same team, they may join forces to buy a property, improve upon it and then sell it for profit. The type and level of investment is very much going to depend on the resources and strategy of the parties involved. It is important to remember that whilst joint venturers share in distribution of profits and risks, there are no guarantees that the value of the property will appreciate as predicted.
One of the most common ways for real estate joint ventures to work is a contractual arrangement, often called an LLP (Limited Liability Partnership). LLP’s work particularly well for property investing in the commercial space, where parties with little or no engineering or architectural skills are able to pool their resources and identify opportunities.
LLP’s are partnerships between individuals who decide to run a business together and share business expenses, income, and any profits acquired from contracts. The business is held and conducted under a single business name. An LLP is a separate legal entity, which means that the business exists independently from its members. Each partner is solely responsible for his/her investments into the LLP and personal assets are protected to ensure there are no repercussions to the individual.
Advantages of Using Joint Venture Agreements
Entering into a joint venture agreement in a real estate deal provides a broad spectrum of benefits. The most significant of which is the ability to share resources and expertise to realize the goal of the project sooner and at less expense than if a single entity went it alone. Many times, the combined resources of partners can be used to gain financing that may have been difficult to secure individually. The combined worth of the partners can also be leveraged to gain better financing terms, and thus reduce the cost of carrying a project.
Joint venture agreements clearly set forth the legal parameters of the relationship between the parties and their respective interests in the project. The agreement also provides important information about the governance and administration of the project and defines the exit strategy. A well-drafted joint venture agreement also lays out the responsibilities of the partners, thus reducing the possibility of future misunderstandings.
Wealthy investors are reluctant to place their money at risk without assurances as to it safety. A properly written joint venture agreement between developers and wealth investors goes a long way to assuage those fears.
Risks Associated with Real Estate Joint Ventures
While the potential benefits of real estate joint ventures are numerous, there are also certain risks associated with these types of business agreements. When real estate industries and capital pools are limited, access to funding for new projects can be challenging. In turn, one business may enter into a joint venture agreement to get the financial backing necessary to proceed with a promising venture.
Like most business deals, real estate joint ventures are complex and make for an interesting case study of the risks involved. The first consideration after formation is the financial risk. Many businesses are already stretched thin financially, with loans and outstanding obligations. Partners must consider what will happen if the joint venture is not financially successful . Will debt obligations follow them after the project has ended? Will personal credit be affected if the partnership fails?
The second consideration is legal risk. Despite what is laid out in the joint venture agreement, the formation of the joint venture may have unanticipated legal ramifications. In extreme cases, one partner may even try to screw over the other by claiming that the joint venture agreement was entered into under duress. This is why it is critical to work with an experienced business lawyer who drafts clear and comprehensive joint venture agreements.
The third consideration is operational risk. The joint venture may not successfully be executed or administered. One party may neglect its financial obligations. There may be disputes about the administration of the project that necessitate litigation. Any of these scenarios can be damaging to the investments made by the partners in the joint venture.
Drafting a Real Estate Joint Venture Agreement
Step 1: Follow the Rules
The first step in any legal project is to make sure you know the rules of the game. In most cases, the "game" for real estate joint venture agreements will be one of several state partnership laws. These laws impose a number of requirements on the formation and operation of a partnership entity, many of which are intended to protect the creditors and/or owners of the partnership from improprieties.
When drafting a real estate joint venture agreement, in the interest of avoiding those improprieties, be sure that the agreement incorporates all of the rules imposed by applicable state law. Failure to do so could result in insufficient protection for the joint venture entity down the road, allowing creditors and/or owners to pierce the corporate veil of the entity and impose personal liability on the ownership interests of the parties.
Step 2: Run the Numbers
As with any real estate project, making the numbers work is critical to the success of forming a new real estate joint venture agreement. Take the time to perform an appropriate level of due diligence to ensure that the economic realities of the property and the financial acumen of the parties will create a profitable and productive joint venture partnership. In doing this, consider the amount of money and other contributions made by each party to the joint venture, as well as the anticipated cash flow from the operations of the business. The agreement should ensure that the contributions of the parties to the joint venture, and the anticipated financial returns from that venture, are structured to produce acceptable levels of risk and reward for each party.
Step 3: Make sure that the Entity is Properly Organized
It is common practice to form a joint venture entity to manage and operate the relationship between multiple entities that wish to invest in the same real estate project. Organizing the joint venture makes sense in many situations, as it can provide the joint venture partners with a level of liability protection that they may not otherwise have under applicable state or federal law. However, if the joint venture entity is not organized properly, the joint venture partners may not receive the level of protection they were counting on. The level of protection will also depend on the type of entity the joint venture adopts. The correct choice depends on the needs of the tax for the joint venture partners, as well as on the intended manner by which the joint venture will be capitalized.
Step 4: Consult an Experienced Real Estate Attorney
Given all of these potential traps for the unwary joint venture partner, it is critically important to consult an experienced real estate attorney to assist in structuring the real estate joint venture agreement, as well as in the formation of the joint venture entity. An experienced attorney can answer questions for the joint venture partners about the operation of the entity under applicable state and federal law, as well as about what sort of protections may apply to the ownership interests in the entity, and assist in ensuring compliance with those laws.
Compliance Issues and Legal Considerations
Within any investment, there are certain risks that accompany investing in real estate joint ventures. The biggest concern is default on the mortgage. Of course, there are many more law-related concerns and potential liabilities that come along with joint ventures including a general understanding of zoning laws and community regulations. Each state may adhere to different community regulations and zoning laws. Joint ventures should verify local zoning regulations in which the properties are located, including the county or municipality, improvable lots and as-platted setbacks. Communities may have strict rules about maintenance and continuous practices regardless of an owner’s usage of land. All of these rules will determine what should be constructed and how it should be improved. If the property is not in compliance, it can lead to significant fines, litigation, or even demolition of physical structures.
Fully investing in a joint venture agreement means that all parties should have necessary insurance coverage. Joint ventures should be adequately covered by a general liability insurance policy or commercial umbrella policy that is underwritten by a creditable insurance company. The coverage should be equivalent to the value of the assets. Each party to the joint venture should be included as an additional insured, in both respect to the improvements as well as the property itself, so that coverage is extended to all parties involved.
Mistakes to Avoid
The drafting of a joint venture agreement must address a variety of items. The joint venture agreement should not be treated in any way like a form agreement and should be customized to the deal and parties involved. Common mistakes that are made include:
- Insufficient details regarding what each of the parties is contributing to the joint venture.
- Not being clear regarding the objective of the joint venture and the joint venture’s assets.
- No procedure for how the joint venture decision process is working. Majority votes vs. a super majority vote, whether there is a board or managers, etc.
- Change of Control and what needs to take place for someone to assume the other partners interests.
- Exit strategy. What happens when one of the partners in a joint venture wants to exit? Here are some solutions:
A. Drag Along Rights. If one member wishes to sell their interest, majority owner(s) can force the sale.
B. Tag Along Rights. If majority owner(s) wishes to sell, minority members are given the option to join in the sale .
C. Buy/Sell Agreement. This is similar to a buy/sell agreement in a partnership where at certain times, certain parties can opt to exit based on a formula for the purchase price and mandatory seller liquidity timelines.
6. I.P. . Are all agreements protecting you? Before you enter into a joint venture, the joint venture agreement should address the joint landlords I.P. inventories. For example, any proprietary information, product, designs etc. You may want to include a non-compete clause as well. On the flip side, the same should go for your partner if they are bringing their own technology, product etc. into the agreement.
7. Fair Competition. As a joint landlord, you want your partner to be able to use their own systems, technology etc. As landlords, we should compete with contractors. Each landlord should have the exact same opportunity to quote, bid etc. That way both joint landlords have the same opportunity/ability to do work for our tenant.