One of our Limited Partners was considering an investment in a new joint venture with a company that has been quite successful in the sports marketing world.
The investment would work as follows:
· A new subsidiary of the Successful Sports Marketing Company (“Parent Company”) would be set up — and two parties would contribute to it.
o Our investor would capitalize the Joint Venture (“The JV”)
o And the Parent Company would do most of the work, put some capital in to have some skin in the game, etc. Basically the Parent Company would “do the work.”
My Limited Partner asked me to hop on a phone call and “do diligence.” And all of my diligence surrounded Conflicts of Interest.
Why are there conflicts of interest in this type of structure? While — let me outline a few below:
(1) Expense allocation: The CEO of the Parent Company owns 100% of his business. But will own less of this subsidiary. So he is more motivated for his parent company to earn profits than he is motivated for the Joint Venture to earn money. He gets 100% of every profitable dollar from parent co — and ~50% of every dollar from The JV. This means he’s more motivated for the JV to pay expenses than he is for his Parent Co.
a. Example: office space — who covers the rent of the JV. If 5 people are working for the JV that means they have to work somewhere, the JV should pay for some office space — but the Parent Co will need to lease space somehow.
b. Employee allocation: will the CEO bill any of his time to the subsidiary? What if he has a marketing employee who works on deals for both The JV and the Parent Co? Should that employee’s salary be split 50/50? What if the CEO decides it should be covered 100% by the JV? Will my Limited Partner know if that’s fair or not, or how the time is actually being split?
c. Size of compensation: new businesses often pay under market to its first employees with the promise of growth opportunities. What happens if a full time employee of Parent Co spends part of their time on The JV? They will be allocating their fully loaded cost 30/70 (or whatever the ratio is) and now The JV is being burdened by excess costs that a new co would not normally afford — so the JV (while being able to leverage the resources of Parent Co) may be dragged down by them as well
a. The JV is supposed to go after a certain segment of the sports market. But what happens if the Parent Co makes a sale to a customer in the JV’s target market? Will the Parent Co share a percentage of that revenue? All of it? Is it obligated to?
(3) Liquidation Events:
a. What happens if the Parent Co gets purchased? Does the subsidiary get any of the proceeds of the sale? Does it get Tag Along Rights? If so — how are the Tag Along rights valued? How much should the subsidiary get?
b. And let’s imagine that the Subsidiary still exists after the sale — but my Limited Partner didn’t get to sell into the first acquisition? Will the subsidiary now be ignored? Will the operating rules change? Will the expense allocations change? Will the trust my Limited Partner have with Parent Co CEO no longer matter because Parent Co CEO isn’t the boss anymore?
I ended the call by telling my Limited Partner that he should make the investment if:
· If trusts the CEO of the Parent Company to tread him fairly when conflicts of interest arise.
I also suggested the deal be made on a convertible note that can be called at my Limited Partner’s option in the next 3 years. No matter how well the docs are written, these corner cases will keep coming up — and until both parties know how the other will act — it’s impossible to know if they want to be in the deal together.