Breaking down common terms, must-haves, potential snags of operating contracts
By David Longinotti
Joint ventures between equity providers and developers will spur growth in the new era of senior care project development. Stakeholders will need to negotiate joint venture agreements, typically in the form of limited liability company operating agreements, or OPAs, to reflect their proposed partnerships.
Understanding the following OPA deal points in the context of new project development could be the difference between success and failure in these negotiations.
1 Capital contributions
There is a great deal of cost uncertainty in new project construction, so joint venture stakeholders may find themselves having to ante up additional capital to fund project completion for any number of reasons.
Stakeholders should have a frank discussion up-front of what capital will be required of each of them in connection with the project. If the developer partner’s resources are limited, it will want to limit its obligation to an initial capital buy-in, and have the right — but not the obligation — to participate in any additional capital calls. If it does not participate, the developer will want to assure that its interest is not diluted by a factor greater than one.
The equity partner, meanwhile, will probably want just the opposite — that is, participation by the developer partner at every step along the way as required, and consequences for failure to do so, including a dilution multiplier. The equity partner may have a point, especially if the additional call is needed due to price overruns attributable to the developer’s acts.
2 Managing member
The managing member will be primarily responsible for administration of this particular JV, but not necessarily development of the project.
Typically, a separate development agreement will charge the developer with design and construction responsibility. For this reason, the equity partner, who may invest 80 percent or more of the equity required, will likely want to serve as a managing member to protect its investment, although that is not always the case.
When the equity partner serves as managing member, the developer needs to assure it has a say in key decision-making, typically by insisting on unanimous member consent for certain “major decisions,” as discussed below.
3 Major decisions
Fair-minded OPAs typically specify a list of “major decisions” that need to be approved by both parties. These "major decisions” act as a limitation on the powers of the managing member. The most obvious major decisions are additional capital calls, annual budgets and reserve limitations, the incurrence of indebtedness and a sale of the project, but major decisions will vary in each case.
Typically, if there is an unresolved dispute about a major decision, one party will have the right to buy out the interest of the other party, or the parties will agree to some dispute resolution mechanism.
4 Net operating cash flow
The definition of net operating cash flow becomes critical once the project is stabilized because it will determine what is available for distribution to the partners.
Typically, net operating cash flow for a particular reporting period is defined as receipts from operations from whatever source, plus normal and customary reserves existing at the beginning or a particular reporting period and less all cash amounts paid (including debt service) and cash reserves required to be maintained at the end of the period. That being said, the definition is subject to negotiation and nuance, thus the need to establish from the outset how net operating cash flow will be calculated.
Profit distribution rights are called “waterfalls” because they describe how profit distributions flow between members.
Distribution rights are the heart of every joint venture and vary depending on cost of funds, risk and negotiating leverage. For new construction, which poses a higher risk than the acquisition of a stabilized property, equity holders may require a preferred return in the 14 to 17 percent range, maybe more.
The developer in particular needs to clarify how a return is measured (typically "cash on cash" or, less typically, internal return on investment or "IRR"), whether it is guaranteed or compounds, and how net operating cash flow is applied to it.
The back end of a waterfall (after a preferred return is achieved) may include a premium for the developer as a success fee in the form of a share of net profits greater than its membership interest. A 50/50 split in this case is not uncommon.
The developer should assure that these waterfall distributions are structured as “carried interest” to achieve capital gains treatment under current tax laws, for so long as they last.
6 Fiduciary duties
Each partner will owe fiduciary duties of care and loyalty to the other, unless the OPA somehow limits these duties.
The equity/majority partner may want to eliminate its fiduciary duty to the minority member if it can. However, the elimination of a fiduciary duty by contract is somewhat unique to Delaware Corporate Law (see Section 18-1101(c) of the Delaware Limited Liability Company Act).
If the managing member expressly agrees to bear a fiduciary duty, it should clarify in the OPA that its enforcement of any express power, right or remedy as a manager or member in the OPA (e.g., a buyout right) will not be deemed a breach of fiduciary duty.
Payment and completion guaranties are routine in construction lending arrangements. Potential JV partners should discuss up-front who will provide these guaranties when debt financing is contemplated.
The OPA should give each party the ability to approve any guaranty they may agree to bear, and it should also provide for a separate contribution agreement whereby the parties agree to share the burden of any guaranty claim.
One equitable approach is to share any liability pro rata, according to each member’s respective investment. Typically these contribution agreements will carve out any liability arising from either party’s “bad boy” acts and will contain an appropriate indemnification (by the bad actor, in favor of the other partner) in these cases of malfeasance.
8 Buyout rights
Buyout rights after project stabilization are common. The equity investor is likely looking for a liquidity event to provide return to its own investors or another accretive transaction. The parties may also want to establish a buyout right if there is a dispute about a major decision (or for other reasons).
Two common vehicles are used to effect such a purchase. Firstly, the OPA may simply empower the equity/majority owner to purchase the minority owner’s interest at its current fair market value. This reposes a great deal of power in the majority owner, and in this case the issues of what constitutes fair market value, who decides it, and how disputes are resolved must be addressed.
Alternatively, the OPA may allow either party, upon a triggering event, to make an offer to the other party to purchase its interest, creating an obligation by the offeree to either sell its interest at the offered price or purchase the offeror's interest at a price based on the offeror's own valuation. This alternative rarely favors the developer member unless it is well-funded and capable of funding a buyout.
9 Drag along and tag along rights
Sales of stabilized projects are almost always structured as asset sales, but there may be good tax or other reasons in particular cases to arrange for the sale of equity.
In this case, it is important for the equity investor/majority owner to be able to "drag along," or require the minority developer member if it is otherwise unwilling, or for the minority owner to have the right to "tag along," or participate with the majority owner in its proposed transaction. In either case, the rights should include the responsibility of prior notice of the transaction and, in the case of a "tag along" right, a reasonable period in which to elect to participate.
Also, either provision should provide that all equity participants to a transaction participate on the same general terms and conditions.