Making Strategic Alliances Work: Clear Governance Rules

This is part three of our four-part series on strategic alliances. In this article, we’ll go over the importance of establishing clear governance rules when entering into a strategic alliance.

As noted in part one, strategic alliances are usually intended to be open-ended. Over time, markets, technologies and overall strategies of alliance partners are likely to change. As a result, strategic alliances should be governed by a clear, fair and flexible set of rules. To paraphrase Robert Frost, “good agreements make good partners.”

Alliance operating agreements (whether partnership agreements, LLC (or LLP) operating agreements or looser contractual arrangements) should be as clear and easy to understand as possible.

Agreements should also be flexible. Rather than trying to anticipate every problem or dispute that could arise among the partners, the governing documents should place greater emphasis on the process for resolving business disputes among the partners.

To continue with the marriage analogy, during the “courtship” period, before documents are signed and a strategic alliance is actually formed, the partners are generally cooperative and willing to overlook potential problems in order to achieve formation of the alliance and reap the anticipated rewards. However, without a clear understanding at the outset, cooperation can quickly turn to rancor. Agreements can be especially problematic when dealing with entrepreneurial companies. Too often, they “do the deal” first and worry about the agreements later — a sure recipe for problems.

Typically, alliance agreements will address issues that fall into four main areas: partner contributions and distributions, control, allocation of risks and rewards, and alliance termination strategies. Obviously, when it comes to actually drafting alliance agreements, you should consult a qualified corporate attorney with experience in negotiating such documents.

Partner Contributions and Distributions

Alliances are ongoing relationships. Alliance partners will usually be expected to make contributions to the alliance (especially if there is a separate legal entity in the form of a partnership or corporate joint venture) at the beginning and during the lifetime of the alliance. Contributions may take the form of cash, property (production facilities, desks, computers), intellectual property (patents, transfer of rights, ideas, expertise), research capabilities (technology or products to be developed), or market access (one partner may bring an established distribution channel to the alliance).

When considering a strategic alliance, a certain amount of due diligence is required. One must evaluate, based on available evidence, whether the potential alliance partner has sufficient long-term financial strength, expertise, distribution channels, and rights to intellectual property to make the contributions called for in the alliance agreement.

Alliance governance documents typically cover the following specific issues:

Capital call process. How are capital calls determined? Are they determined by the governing board/committee, by the managing partner, or by a vote of the partners? Can the capital call be funded with hard assets instead of cash?
Failure to make a required capital contribution. If one partner refuses to make an additional capital contribution, the agreement should spell out the rights of the other partners, the impact on the refusing partner’s ownership position, etc. Frequently, the partners that do contribute will have the right to exercise an exit strategy, such as a right to purchase the interests of non-contributing parties at a discount, and terminate the alliance.
Intellectual property. Agreements should define whether intellectual property is contributed (meaning the title passes to the alliance) or merely licensed from the contributing partner. If licensed, the agreement should outline permitted uses, territories, exclusivity (or if not exclusive, restrictions on licensing to non-alliance entities), rights to sublicense, etc.

The most significant issue to address is the valuation of intellectual property contributions.

“Hard” assets are usually relatively easy to value. A building, a desk, a computer, can all be appraised relatively easily. Valuation of intellectual property is much more complicated and methods should be agreed to in advance, if possible.

Research and development. When a partner is contributing development efforts, agreements frequently specify the tasks to be completed, milestones or target dates, and whether the partner’s obligations are absolute or are simply to use its best efforts. Because alliances may be formed in rapidly changing environments or may have long lives, the agreements should be flexible enough to allow for changes in assigned research tasks and target dates.
Market access. The agreement should specify the obligations of the partner providing market access, such as a general “best efforts” obligation or specific sales targets. Also, the agreement should indicate what steps will be taken if the sales targets are not met.
As with making contributions, the agreements should clearly indicate when distributions can be made, in what sequence and to whom. Distributions may be in the form of cash, hard assets or intellectual property.

Control

Alliances are collaborative relationships in which each party retains its own management structure and shares control over the alliance’s pooled resources. Alliance agreements help outline how two or more management structures will actually share control over the alliance assets.

Alliance governance documents typically cover the following specific control-related issues:

admission of new partners or the sale of additional securities
appointment of board members, officers, managers or outside professionals
compensation of the management of the alliance
terms of transactions with partners and/or their affiliates
conditions under which the terms of the alliance agreement may be modified and the mechanics for doing so.

Allocation of Risks and Rewards

The sharing of risks and rewards is often one of the most contentious issues in alliance transactions. Each partner wishes to bear the least possible risk while having the maximum potential for reward.

Risks are shared/allocated through the use of warranty disclaimers, contractual limitations on liability and exclusion of consequential, special and incidental damages. Rewards are generally shared/allocated through provisions for profit sharing, royalties and transfer pricing as well as the disposition of any intellectual property developed through the alliance’s efforts.

Termination Strategies

Alliances may terminate for any number of reasons. The collaborative relationship may break down. The alliance may accomplish its mission and therefore outlive its purpose. Partner strategies may change, eliminating the need for the alliance.

When and how alliances terminate should be negotiated in advance if possible, allowing for a more or less graceful exit by the alliance partners. There is a great deal of value in knowing that there is a clear way out of an alliance if need be, and in knowing how shared assets will be distributed or disposed of if a partner exits. Termination events may include failure to achieve objectives, success in achieving objectives, expiration of term, partner disputes that cannot be resolved, change in control of any alliance partner or adverse action by regulatory authorities.

Finally, keep in mind that alliances end, and endings are not necessarily failures. The only thing that really counts is whether an alliance fulfilled its strategic purpose before termination.

By Thomas Pietras