“ Like all other business sectors, the SME sector has developed a market driven business model, which has its own set of challenges. ” Critical challenges in the SME sector includes limited access to bank debts, high cost of borrowing, limited equity, inadequate technology, inefficient marketing & promotion, non availability of high skilled labour at...
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Like all other business sectors, the SME sector has developed a market driven business model, which has its own set of challenges.
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Critical challenges in the SME sector includes limited access to bank debts, high cost of borrowing, limited equity, inadequate technology, inefficient marketing & promotion, non availability of high skilled labour at affordable cost, absence of diverse skill sets for developing new products etc. It is therefore imperative for most SMEs to leverage on each other's resources and infrastructure by setting joint ventures ("JV") to ensure higher degree of efficiency, market access, business diversification and profitability.
Appropriate documentation reflecting the actual understanding as regards risk and rewards is indispensable for building any successful JV. The life cycle of a JV involves various stages, of which the most critical is identification of appropriate JV partner. Post identification of the partner, thorough due diligence of the JV partner is extremely critical, as a JV not only involves sharing of expertise but also the liabilities. The next step is identification of the form of JV. A JV may be created in the form of a limited liability company [with agreed shareholding pattern], partnerships firm, co-operative alliances etc. Out of the said forms, a JV in the form of a limited liability company is the best as it has limited liability, perpetual succession. JV in such form is generally set up by incorporating a new company with agreed rights and responsibilities amongst the shareholders.
Once a partner is identified and the form of JV is agreed upon by the parties, the basic understanding of the JV partners requires to be recorded by a memorandum of understanding ["MOU"]. Post execution of the MOU, the parties needs to identify the detailed scope of each other’s roles, responsibility and sharing of profits.
It is advisable to appoint appropriate legal professional for drafting of the JV/ Shareholders Agreement not only to ensure that the entire understanding of the Parties are recorded in the executed documents but also to ensure that all legal and regulatory requirements are duly complied with. Sharing of rights, responsibilities and rewards in the JV mostly depends on the quantum of investment of the Parties in the JV.
Investment may be in the form of equity shares, preference shares, debentures or other relevant instruments. As the equity shareholding of the shareholders in the JV determines the control statutorily, it is important for the SMEs to place substantial importance to the equity capital structure of the JV. While deciding the equity shareholding pattern, it is important to understand that the Companies Act recognizes certain rights of the shareholders when they hold shares above 10%, 25%, 50%, 75% and 90% of the total equity shares in the JV.
Holding of above 10% shares gives the shareholder the right to challenge any variation of rights of any class of the shareholders. Further they also have the right to initiate proceeding for oppression and mismanagement. Holding of above 25% shares gives the shareholders the right block special resolution and above 50% gives control rights.
Shareholding above 75% allows the shareholder to even pass a special resolution, whereas holding of over 90% of the equity shares almost gives an absolute power to the SME to control the JV. However, subject to the said provisions of the Companies Act, additional rights can be conferred on the JV partners in the Shareholders Agreement.
The drafting of the Shareholders Agreement is one of the key requisites of a successful JV arrangement. Drafting of various facets of the Shareholders Agreement depends on the financial, tax and legal due diligence report. Legal due diligence process involves corporate matters, financing matters, material contracts, proprietary issues, litigation etc. It is advisable to execute a confidentiality agreement prior to disclosure of any information for the purpose of due diligence. With regards to facts and circumstances that cannot be ascertained in the due diligence process, appropriate representation and warranty is extremely critical breach whereof should result in compensation.
The most critical part in any JV is the decision of the capital and management structure. Normally, representation of directors in the Board of a JV is linked to the capital structure and the investment value. However, the minority shareholder also requires adequate voice in the management of the JV, particularly where the same is not a day to day affair of the Company. Accordingly, various reserve matters requires to be incorporated in the Shareholders Agreement, e.g, change in capital structure, merger, amalgamation, change in management structure etc. All the JV partners should have veto power with regard to the reserve matters.
The success of a JV depends on how a deadlock situation is handled. In this connection, the Shareholders Agreement requires to provide appropriate mechanism to handle a deadlock situation. One of the ways to handle a deadlock can be to allow the chairman to have casting vote in a deadlock situation, so that the interest of the JV is protected and there is no delay in execution of strategies in the best interest of the JV. Alternatively the deadlock issue can also be referred to an independent consultant having expertise to handle the issue.
The shareholders of a JV reserve certain pre emptive rights in the shareholders agreement [which is also recorded in the Articles of Association of the JV], in the form of Right of First Refusal (ROFR) or Right of First Offer (ROFO). ROFR provides a shareholder protection against entry of an outsider in the JV in case the other party intends to sell its shareholding in the JV. It is the right of a shareholder to match the price and terms offered by the third party to the other shareholder towards the sale of its shares in the JV.
Only if the shareholders refuse or fail to match the price/ terms, the other shareholder can sell the shares to the third party. ROFO also provides similar protection to a shareholder of the JV with the difference that in this case the shareholder, who intends to sell their shares, can only do so after offering the shares to the right holder. The right holder may choose a price and terms which may/ may not be accepted by the selling shareholder.
Another important aspect of a JV agreement is the existence of Tag Along and Drag-Along Right. A Tag Along Right primarily protects the minority shareholders such that in the event the majority shareholder of the JV sells its stake in the JV, the minority shareholder has the right to join the transaction and sell its stake in the JV. The Drag Along Right is reserved to protect the interest of the majority shareholders, whereby the right holder may force the other party to join the transaction for sale of its shares of the JV.
These rights may enable the shareholders to get a better value for the sale of their respective stakes as additional premium may be availed due to attaining of the controlling stake on account of the fact that the combined shareholding may provide controlling interest in the JV which may not be possible if only one shareholder is selling the shares.
The exit options in a JV are also extremely critical to attract quality JV partners. Exit option may range from put/ call option, IPO etc. A put option enables the right holder to sell their shares in the JV to the other party of the JV such that the other party must compulsorily purchase the shares offered. A call option enables the right-holder to call upon the other shareholder to compulsorily sell their shares to the right holder. However the enforceability of put/ call options have been the subject matter of debate for quite some time. In view of the relevant provisions of the SCRA and various verdicts of the courts of India, as on date it appears that an option with respect to shares in public limited companies (whether listed or not) is not enforceable.
It is advisable to record the important terms and conditions of the Shareholders Agreement in the Articles of Association of the JV Company. It helps in giving public notice as regards the various rights of the shareholders in the Company, which in turn reduces the scope of future fraud or misrepresentation to a third party. Further, it is important to note that it been held by the Hon'ble Supreme Court that restrictions on the transfer of shares contrary to the articles of association of a private company is not binding on the private company or its shareholders.
There are certain other regulatory issues particularly relating to JV particularly in the field of FDI, which may not be relevant in case of SME sector. However, in the event any SME is considering FDI in India, various regulations of RBI shall get attracted which would need to be duly complied with.
A joint venture may be formed in the form of partnership also, but the fact that a partnership firm does not have limited liability and perpetual succession, makes it a less desirable option compared to a limited liability company. However, after the emergence of the limited liability partnership, it has become a good option for the SME sector. Contractual JVs are also possible without having an independent entity, and the same is helpful where the extent of use of each other's capacities is limited. Creation of contractual JVs are normally done through execution of Co-operation agreement. This can be helpful in case of technology sharing, joint marketing etc.
Dispute resolution mechanism is another very important issue in any JV arrangement. Recent trend suggests that arbitration has become a very common mechanism of dispute resolution, largely due to the fact that can yield quicker results compared to litigation. India, as on date, is slowly shifting towards institutional arbitration in place of individual driven arbitration proceeding, which is expected to improve the arbitration process even more. Further, since the Arbitration panel not only consists of legal professional but also persons from the industry having technical knowledge on the issues of dispute, helps in quicker resolution of the dispute.
To conclude, success of a JV in any sector depends on good JV Agreements. Keeping in mind the challenges and limitations in the SME sector, it is all the more important to ensure that there is very limited scope of dispute by drafting of water tight JV agreements. Such agreements should clearly define the actual understanding of the Parties as regards leveraging of resources, sharing of expertise, quantum of investment, sharing of profits and losses etc. This would help the SME sector to focus on business development, which would result in higher profitability and quality, and thus make an even greater contribution in the overall higher growth of India.