Deconstructing the JV on a Real Estate Project

December 24, 2012

The term Joint Venture (JV) has certain legal implications when used. In reality, when entering into a so called JV, one should replace this with the term “general partnership” due to its legal treatment. The technical description of a JV is an undertaking by two or more persons, without a corporate or partnership designation, formed for the purpose of carrying out a single business enterprise for profit.

A JV is a Partnership

Since a JV is treated like a partnership, it is given the same type of liability and tax considerations. Most joint ventures are run through separate entities instead of individuals to limit liability and certain tax consequences, i.e. instead of two individuals entering into a joint venture, two LLC’s would be the parties to the JV.

There are Three Major Characteristics of a JV

The line between a partnership and a JV is narrowly drawn, but simplistically, a JV is a temporary or short-term project where a partnership is an on-going business. A JV has similar characteristics to a partnership that a party to a JV should be acutely aware:

  1. Common interest in a business venture
  2. Equal right to govern the conduct of the venture
  3. Sharing of profit and losses

A Writing Is More Important Than You Think

Absent a formal detailed written agreement, the Uniform Partnership Act (UPA) is what governs the terms between the parties–which means that where a court finds a JV exists between the parties, the court will fill in missing terms that the parties have yet to agree. This can be chaotic for the parties if they failed to contemplate some of the basic terms and are not familiar with the UPA. Relying to heavily on the UPA’s default terms takes away some of the advantages of entering in to a JV, such as the flexibility of the structure.

JV’s Do Have Advantages If Done Properly

JV’s are easy to create and can be very flexible for each transaction. In fact, the JV is so easy to create, a mere verbal agreement to the characteristics described above is enough to create a JV because the UPA will usually fill in the rest of the terms. In fact, if done correctly, JV’s can be an effective and still risk conservative tool to manage investments with a short life span as in many real estate investments.

Important Terms in a JV

Here are some common and important terms that should be discussed fully before entering into a JV.

Structure and Parties

As discussed above, JV’s are legally referred to two or more parties (individuals or entities) coming together for a common interest in a business venture; however, it may be that two individuals or entities come together to form an LLC which they may also colloquially call a joint venture.  A JV agreement should spell out specifically who are the parties and whether you entering into a JV or some other entity with shared ownership.

Purpose or Scope

Probably the most important step in assessing risk is defining and limiting the scope to the JV. The scope o

jv real estate

f the JV will determine the capacity of decision making by the respective parties. If one of the parties has full management control, this scope would limit his or her authority. Furthermore, if the parties have other dealings, the JV should be specific in its scope in order to limit the terms of the agreement to this transaction only unless desired otherwise.

Contribution and Schedule

Contribution can be defined with more than just money contribution but also labor, skill, or other property. This is especially applicable with real estate transactions, e.g.a hard money investor and and a contractor going into a project to flip a home. The schedule will also specify when and in what conditions these contributions are to be made. Sometimes there is an initial contribution with additional contribution specified upon certain events or contingencies.

This additional contribution is especially important as this will help contemplate unintended occurrences where additional capital, service, or property is needed to make the JV successful. For example, if a rehab has a specific budget but suddenly there is a catastrophic repair that is required that was not contemplated  that additional capital will be needed. Do the parties have to contribute? If they do, do they obtain additional profit?

Effect of Contribution Failure

Contemplating default of a party for failing to contribute is paramount in legal risk management of a JV. This is often overlooked and is the cause of disputes when contributions fail to meet expectations. The failure to provide “additional” contribution versus “initial” contribution should likely have different consequences as the latter is likely to have additional risk.

Management and Control

In any project of any sort, deciding who makes decisions and how they are made is essential in avoiding dispute. Usually, each party of a JV has equal management and control, but this is a recipe for disaster. Where there is an odd number of parties with similar levels of expertise and contribution, a voting system usually manages well; but, a single fair and experienced manager comes with the least conflict and risk. Management can also be formalized as in a corporation with equivalent functions to a CEO, CFO, etc.

Even where a system is in place, it may need a variance where certain major decisions are  made, such as when there is a need for another capital call or the JV needs to be terminated early, etc.

Other Duties and Rights

JV’s allow quite a bit of creativity. In doing so, you will see sections that focus on other specific rights or duties of the respective parties. These may include confidentiality, intellectual property, and other contingencies that may be specific to the particular deal, e.g. the parties may choose to set a criteria on approving rehab expenditures above certain budget limits.

Indemnification

Indemnification is another good tool to protect individual parties of the JV who have less control. The party who is in a poor position to prevent certain harms should be indemnified by those that are in the position to prevent harms. Indemnification provides one party to reimburse the other for certain liabilities. Indemnification is generally not granted in situations of gross negligence, willful or intentional misconduct, criminal misconduct, breach of fiduciary duty, or fraud. The JV will specify whether indemnification of ordinary negligence will be permitted.

Apportionment of Profit and Loss

These are terms that are rarely not discussed but can sometimes be oversimplified. For example, parties may decide on percentages but not on how profit is actually calculated or adjusted depending on varying contingencies.

Legal Title

In a real estate transaction,  it should be specified who or how the legal title should be distributed. Transferring legal title to a party as trustee for the joint venture is usually most appropriate.

Insurance Requirements

A quick and dirty way to avoid the unlimited liability of  a JV is to insure the JV and its members are protected under an adequate policy.

Buy-Sell, Dissolution, and Termination

Because JV’s are quick and short term transactions, many times the same kind of thought process of “what-if’s” are not properly considered. What happens if one of the parties is incapacitated or breaches his or her duty is usually not contemplated and is left to the courts to fill in the blank? Again, there is quite a bit of certainty on how a court handles such situations, but the point of a contract is to come to terms before a dispute, not after. Another example is dealing with a party who would like to withdraw or another one that wants to be admitted into the JV.

Records and Accounting

Specifying how records are held helps bringing clarity to the parties to be able to cooperate in the management of the JV, especially when one party is running the venture.

Dispute Resolution

With JV’s put together quickly, sometimes even with proper legal counsel it can be difficult to contemplate upcoming issues and disputes. Additionally, some things may be out of the party’s control. Parties may specify where and how disputes are handled including requiring mediation and/or arbitration instead of leaving it to a court.

 

Nasir Pasha

By

Nasir N. Pasha is the managing attorney of Pasha Law, providing essential legal services and support to businesses and corporations in California, Illinois, New York, and Texas. He oversees all of the firm’s operations and is a pivotal force in maintaining client relationships and ensuring that each transaction is brought to its best possible conclusion.

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