CREATING JOINT VENTURES AND BUSINESS ALLIANCES
By Richard J. Sowan
Despite a healthy backlog of contracts, the current construction industry complaints — declining margins due to increasing labor costs, and increased competition from aggressive bidding — do sound very familiar to anyone involved in the industry during the late 1980s, when a lot of companies were eager to do business in Texas. Companies today are experiencing some of the same pressures they did then. And back then, the two primary approaches to mitigating those pressures were mergers and acquisitions, and joint ventures or business alliances.
Private equity and Wall Street suggest M&A, an attempt to leverage the perceived advantages of size and resources to win new business, is the better of the two choices. The traditional model has been to buy a competitor, both achieving scale and eliminating competition. However, mergers and acquisitions are very expensive and fraught with integration problems usually not addressed until the deal is done.
Joint ventures and business alliances, on the other hand, were a common solution in the 1980s when a company needed to add muscle to a project. Instead of acquiring another entity or hiring special expertise, a company would form a joint venture or a business alliance with a trusted partner to complete a project. This more nimble approach to dealing with business opportunities avoids both the risk of going it alone and the grind of searching for an acquisition target, not to mention the resulting debt and trying to blend formerly independent business cultures.
Joint ventures and business alliances have several key differences:
- In a joint venture, two or more partners contribute assets to a new entity and share in earnings and losses. A joint venture agreement explains each partner’s responsibilities as well as the risks and rewards of ownership. A joint venture defines its direction, has its own management team and dissolves upon completion of the project.
- A business alliance uses the strengths of a combined effort. These are created by contracts that spell out the risks and rewards for each party, and they might not require a contribution of assets. Earnings can be shared however the contract allows, and success is measured by predefined metrics.
How Are These Structures Different From Traditional M&As?
Acquisitions can go bad for a number of reasons, and when they do, there is no turning back. The changing environment can make it difficult to innovate, operate and compete. Technology innovations, environmental considerations and rapid shifts in tastes have a profound impact on all businesses. Tying up capital and resources in an acquisition could negatively affect a company’s ability to adapt to a changing environment. A more nimble joint venture or business alliance would avoid those pitfalls.
Who Is The Right Partner?
Every company knows its competitors, but it can be beneficial to consider looking at non-traditional partners who might even be in different industries. Availability of labor or complementary skillsets may provide cost-cutting and other advantages.
What Are The Accounting And Tax Implications?
Three elements generally drive the accounting for a joint venture: control of the venture or alliance, allocation of profits and process for winding up the contract. A tax return will be prepared and a K-1 issued to each partner.
Depending on who controls a joint venture, the results will either be consolidated or accounted for as an equity method investment. If the joint venture’s risks and rewards are shared equally, both partners will likely use the equity method. In this case, each partner records its proportionate share of the assets of the joint venture in the balance sheet, and adds its equity in the earnings from the joint venture to the income statement.
However, if one partner absorbs a majority of the risks and rewards of the joint venture, that partner will consolidate 100 percent of the joint venture and show a non-controlling interest (what we used to refer to as a “minority interest”) for the non-controlling partner.
A business alliance, on the other hand, has a much simpler accounting structure. Revenue billed to the alliance is recognized when earned, and costs are recognized when incurred. All this activity is included in each partner’s income statement as revenues and expenses, and no tax returns are necessary. The accounting for the business alliance is preferable to most companies.
What Are The First Steps?
The first step is to find a partner company with a similar objective and internal culture, and to align on the goals for the joint venture or alliance. Then, both partners designate teams to provide management structure and direction for the alliance, and establish a board of directors to govern the project.
Though M&A may be a company’s first instinct when it comes time to scale, the reality is that there are cleaner, more agile solutions in our rapidly shifting corporate landscape. Business owners should think carefully about their options, because a joint venture or a business alliance may be more beneficial than a traditional M&A.
Richard J. Sowan, CPA, is the managing partner and senior audit partner for BKM Sowan Horan, LLP, a nationally recognized public accounting firm with offices in Dallas, Austin and Puerto Rico.