The Benefits and Pitfalls of the Joint Venture

BY: SCOTT V. DERCO, CPA SAX MACY FROMM & CO., PC

EXECUTIVE SUMMARY A joint venture is one arrangement contractors can use to compete and grow in a dynamic environment such as construction. This article discusses the nature of the joint venture agreement, highlighting the advantages and disadvantages of each.

he construction industry may be one of the most difficult and unpredictable environments in which to operate. For starters, contractors are constantly exposed to such risks as labor disputes, work stoppages, and unreliable subcontractors. They must establish a fixed contract price based on rough estimates to complete the project. They must be able to mobilize their workforce to sometimes remote unfamiliar locations. Bad weather and poor economic conditions also affect them. These risk factors make construction companies more susceptible to failure than businesses in most other industries. One way that contractors can better compete and grow in this dynamic environment is by forming a joint venture. A joint venture is an arrangement in which two or more contractors are able to combine their talents and resources to better compete in a particular market. This alliance may be formed to complete an individual project or an indefinite number of projects over time. Although many benefits are associated with forming a joint venture, many potential pitfalls also can make this an unprofitable arrangement for a contractor. The following sections discuss some of the advantages and potential pitfalls of the joint venture, as well as some of the details that should be considered when preparing a joint venture agreement. Advantages of the Joint Venture as a Separate Entity Local contacts. When a contractor considers bidding on work in an unfamiliar area, it may be advantageous to leverage the knowledge and

resources of a joint venture partner that has an understanding of this market. The advantages of local contacts include the following: 1. The partner may have relationships with the project owner, architect, and engineer. 2. The partner has experience with local subcontractors, suppliers, and unions. 3. The partner is familiar with local business rules and practices. Combined talents and resources. A joint venture allows two or more contractors to pool their individual areas of expertise and resources, such as financial strength, workforce, equipment, and bonding capacity, while sharing the risks involved in completing a particular project. Additional working capital sources. The formation of a joint venture may allow the combined entity to have a stronger capital base from which to draw, such as additional cash, financing, and capital contributions from shareholders of each company. This can prevent cash shortfalls, which could hinder the profitable completion of the project. Increased bidding power and bonding capacity. The resources of the combined entity may provide more bidding power and bonding capacity than the individual entities could, thus allowing the combined entity to bid on larger projects. Better bidding and estimating. If the joint venture partner is well informed on the business practices in the local construction market, it may be advantageous to draw on its insights in preparing more accurate bids. For example, the partner may be more familiar with the local labor cost, which

includes union and other burden expenses. The partner may also be familiar with the local suppliers and the pricing of equipment rentals, as well as local laws and ordinances, which may be overlooked by a contractor who has not worked in the local business environment. Other benefits that could result from the formation of a joint venture include the possible reduction in overall insurance costs, as well as a sharing of the liability and risk among the venture partners. Pitfalls of the Joint Venture as a Separate Entity There is significant risk associated with the formation of a joint venture. A contractor may commit resources to a project in which its partner, as well as the area, may be unfamiliar. This is why it is imperative that a contractor learns all that is possible about its potential partners business practices and financial condition, as well as its ability to complete the proposed project(s). This can be done by examining the most recent financial statements, credit history, and public records; consulting references from projects completed by the potential partner within the last three years; and contacting local trade association. A surety can also easily access information on a potential joint venture partner. Many problems can also be avoided if the joint venture agreement identifies and addresses these issues in a language that is clear and specific, so if a dispute does arise, the partners may turn to the agreement for guidance and resolution. Some potential problems include the following. Unclear assignment of responsibilities. Many of the responsibilities of each joint venture partner are implied at the start of the joint venture. However, all aspects of contract administration should be specifically outlined in the joint venture agreement. These responsibilities may include the following: 1. Who will have responsibility for creating the new entity? 2. Who will have responsibility for obtaining bonding and other insurance? 3. Who will have responsibility for monitoring the day-to-day operations?

4. Who will maintain books and records? Performance bonds. In bonding a joint venture, the financial strength of all joint venture partners is examined by the bonding company. Typically, the bonding company provides a performance bond in the name of the joint venture. However, in a silent joint venture agreement, one of the joint venture partners may provide the performance bond in its name for the joint venture. In the event that the joint venture cannot satisfy its obligations under the contract, the bonding company looks to the contractor that supplied the bond to complete the contract before the bonding company considers stepping in. In this situation, it would be beneficial to the stronger contractor if the weaker partner supplies the performance bond. Financing and working capital of the joint venture. If the joint venture is formed as an entity other than a corporation or a limited liability company (i.e., a partnership), there is a risk that one partner may be held responsible for the obligations of the joint venture if the other partner(s) become insolvent. To avoid this situation, it may be beneficial for each partner to borrow the funds and contribute or loan working capital to the joint venture as they are needed. Construction costs charged to the joint venture. In many cases, it is standard practice for the joint venture partners to provide equipment, materials, and services to the new entity. However, problems may arise when one partner believes that the other is charging excessive rates or prices for these items, thus draining capital and profits from the joint venture. A solution to this problem is to address a standard billing rate structure for these items in the joint venture agreement; the structure is agreed to by all parties to avoid future disputes. Distributions to joint venture partners. In most cases, joint venture partners would like to begin receiving distributions as soon as possible. When the project is in the early stages and is profitable, it is very tempting to take out cash distributions. This practice should be avoided, however, because if the job encounters problems in later stages, the

partners may have to make cash contributions to ensure there is an uninterrupted workflow. Cash management considerations. When there are large sums of idle cash available, an important issue to consider is which partner controls the cash. Problems may arise when certain partners borrow cash from the joint venture for their use, repaying the loans as funds are needed. This can be a very risky practice, especially if one partner is withdrawing these funds to cover cash shortages on its own projects. To avoid cash flow problems, it is critical that a cash management plan be developed early in the relationship. Considerations When Preparing the Agreement If the contractor decides to enter into a joint venture, all parties involved should prepare a joint venture agreement. This document ensures that the partnership runs smoothly by providing a point of reference to resolve conflicts quickly, as well as to document the responsibilities of all the joint venture participants. The following issues should be considered when preparing the joint venture agreement, as well as for administration of the new entity: An understanding of the responsibilities and level of control of each partner should be reached. An agreement on how profits, losses, and liabilities will be shared by the venturers should be established. A clear understanding should be established concerning the interests and liabilities of the participants in the construction contract and all money, equipment, materials, and supplies acquired or received in connection with performance of the contract. Terms and conditions should be established for each participant in regards to initial capital contributions, the obligations of each participant to provide additional working capital, conditions under which excess working capital may be withdrawn, and penalties if a partner fails to provide additional contributions or defaults. What form will the entity take (i.e., partnership, LLC, or corporation)? In addition,

careful consideration should be given to the tax implications associated with establishing each type of entity. How will the joint venture be administered? Who will provide accounting services? Who will have check writing authority? Who will control the management of the project and run the day-to-day operations in the field? If one partner is to provide accounting and main office support to the joint ventures, how will it be paid for these services? Specific wording should be included that details how a party can voluntarily terminate from the entity, as well as how the remaining parties will administer the continuing obligations of the joint venture. A standard billing rate schedule should be established to avoid a situation in which one partner is overcharging the joint venture for such construction costs as equipment rentals, materials, and labor. Clear and specific wording should be included to define construction costs of the joint venture, as well as what costs are reimbursable to each venturer. Bid security in the form of a bid bond or deposit may be considered for each participant. The type of insurance that will be carried by the joint venture should be specified. Separate bank accounts should be established in the name of the joint venture, as well as authorized individuals designated to make transactions, such as check signing, deposits, and withdrawals. Separate books and records should be maintained for the joint venture. All rights of the participants to examine the books and records should be specified. An outside accountant should be designated to perform an analysis of the books and records. In the event that one of the joint venture partners enters bankruptcy or becomes insolvent, the party involved may be entitled to accounting at the completion of the project to determine their proportionate share of profits or losses; however, they should no longer have authority to make decisions relating to the day-to-day operations of the joint venture.

Written permission must be given by all joint venture partners for a partner to assign its rights under the agreement. If controversies arise, procedures for settling the claim with an independent arbitrator should be established. The agreement should establish the state jurisdiction under which the law is interpreted. A vote of the board of directors or other adequate body of authority should be used to execute the agreement. The agreement should be signed by the board of directors and notarized.

Scott V. Derco, CPA, is a member of the Construction Industry Services Group at Sax Macy Fromm & Co., PC (SMF). SMF is located in Clifton, NJ and specializes in accounting, audit, tax, and management consulting for privately held and family owned businesses. Scott can be reached at sderco@smf-cpa.com or (973) 472-6250.

Although joint venture arrangements provide contractors with many opportunities to expand their businesses and spread risk, there are pitfalls and issues that should be considered when entering into such an arrangement. Contractors should use caution, address the issues, and come to a clear understanding with their venture partner(s) to increase the likelihood of success.

Reprinted from Journal of Construction Accounting and Taxation