Strategic Alliances in IT

January 1, 2003

One frequently sees references to organisations forming a “strategic partnership” or “alliance” with another entity in the IT sector. Such relationships are often key to their future growth and profitability, or even their very survival. However, such arrangements can take many forms and can easily turn into a costly quagmire if they are not carefully assessed and structured at the outset.

1. Why might you need an alliance?

There are many different reasons why you might look beyond the resources of your own organisation in order to create a form of partnership or alliance with a third party, including:

· access to technology (in terms of the contribution that the other party’s existing products or knowhow can make to your business)

· access to resources (the other party can help provide people or assets you would have difficulty providing yourself)

· input of funding (the other party can provide funds to either add to your own, or be matched against your non-monetary contributions)

· publicity/market impact (the other party has a brand which you would like to associate yourself with)

· creating links to new markets (whether in terms of simple geography or regulatory approvals, etc)

· as a precursor to a full merger or acquisition (as a form of commercial “suck it and see”).

Just as the reasons for entering into the arrangement can vary, so can the form it will take, ranging from a simple “arms length” contractual relationship (eg a marketing or distribution agreement) to a fully capitalised and resourced full function JV, with its own legal and market identity. The choice of form will be dependent upon the nature and circumstances of the arrangement between the parties, and will largely be influenced by the following factors.

(a) The Interests of the Parties

Do they intend to establish a “new business” incorporating their respective inputs, or are their vistas more limited? Do they have a past history of dealing with each other and a sense of trust which that can engender?

(b) Length of their relationship

Is it to be for a short, defined span (eg as in the case of a teaming arrangement to pursue the award of a particular contract/project) or more long lasting? The more long lasting the arrangement, the greater the lure of a more formal structure.

(c) Intended Benefits

Do the parties want to achieve improved cashflow, the creation of new materials or assets, or a business which will grow in value over time? For example, if the venture is likely to make losses for the early years, then a contractual arrangement or a form of partnership may be preferable to setting up a corporate JV.

(d) Location of the Parties

Are they located in the same jurisdiction, or even in the same continent? In this regard, a corporate JV may not be particularly tax efficient if losses incurred in one jurisdiction are not available to be set off against profits in another.

(e) Law and Regulation

What restrictions may exist in respect of the parties’ intended operations? In particular, what tax and competition law implications might there be?

For the remainder of this article, I will concentrate on the two most likely forms of alliances, ie the pure contractual arrangement (as with teaming agreements, research and development agreements, and marketing/distribution agreements), and the corporate JV (whereby a separate corporate vehicle is established to act as the means for the parties to achieve the desired aims of their alliance).

2. Issues with Contractual Alliance

When dealing with strategic partnerships based on contractual frameworks alone, there will be a number of key issues to address, as follows.

(a) Control and governance

There will be no central entity with its own management structure, and accordingly the contract itself will need to provide the details of how the parties will work together; for example, will there be regular meetings, and if so who will attend and how will decisions be taken (eg by simple majority or requiring unanimity?). Will both parties be bound to comply with such decisions and if not, what will the consequences of non-agreement be? Potential deadlock, and finding ways to get around it, will be a key concern (see further in relation to corporate JV below).

(b) Provision of Information

The nature of the cooperation between the parties will invariably require that they provide details to each other as to their respective activities, eg in relation to progress being made in a development task, or in respect of a marketing campaign. The nature and frequency of such reporting obligations will need to be clearly set out, and the requirement to maintain confidentiality in respect of any disclosed information (both during the term of the contract and thereafter) will need to be expressly detailed.

(c) Intellectual Property Rights

The creation and use of new materials developed by the parties may be the primary purpose for the contractual relationship or may be purely incidental (as, for example, with the case of a teaming agreement aimed solely at winning a particular project which may, as a kind of by-product, generate copyright materials in the form of presentations and financial models, etc). In any event, however, the rights of ownership and use of both newly generated and pre-existing materials will need to be clearly set out; will there for example be unlimited rights of use, or will any rights be just for defined purposes? If revenues can be generated in respect of the licensing of such materials to third parties, what profit share/royalty arrangements (if any) will there be with the other alliance party?

(d) Sharing the Rewards

Without the means of extracting value via an increase in share value or the payment of dividends, the parties will need to agree in the contract how they will each benefit from their alliance. In simpler cases (eg distribution agreements), this will be relatively straightforward, as one party will receive the sale value of its products, less an agreed commission to the other. In more sophisticated models, however, there may be entitlements to a proportion of the future profits of the other party, or payments linked to increases in the share value of one party or the other (to pick but two examples), which will need a means of calculation to avoid potential future dispute.

(e) Termination

One must inevitably also consider the future and accordingly plan for the natural expiry or prior termination of the contract. Accordingly, the contract will need to specify (i) how long the relationship will last, (ii) how it may be terminated in advance of this date (eg if the other party is in breach or becomes insolvent), and (iii) what the consequences of such a termination will be. Usually, the parties will, as a minimum, wish to provide for the return of any confidential or proprietary materials provided to the other party, and the ending of any licences which may have been granted (eg in relation to the use of trade marks, or certain business premises).

(f) Restrictions

The contract may create various on what either or both of the participants may do. For example, in a teaming agreement for a bid to be made for a particular project, there is likely to be a prohibition on working with anyone else in order to secure the relevant work; in a marketing or distribution agreement, there may be restrictions on dealing with competing products or services. In each case, care must be taken to ensure that the restrictions remain within the ambit permitted by the EU and UK competition laws.

3. Issues with Corporate JVs

The creation of a separate legal entity through which the parties will seek to achieve their required ends will usually (although not necessarily) be a somewhat more complex and time-consuming endeavour than one based solely on a bilateral contract. The potential issues which might arise are too numerous to list exhaustively, but those of key relevance will invariably include:

(a) Sharing of Risk and Revenues

The parties will need to agree on both how to put funds in to the joint venture, and how to get it out again. Dealing with the question of getting funds in, the parties will need to decide between equity investment (which gives the JV some “substance” and is a good indicator of commitment, but may be hard to get out if things go wrong) or debt finance (which involves less commitment but may limit the JV’s ability to raise further monies via external borrowings). The parties will also need to agree a means of attributing value to non-monetary investments (eg in the form of technology, personnel, provision of premises etc). When it comes to getting money out again, the parties should provide in their Shareholders Agreement for an agreed dividend policy (remembering that there will need to be properly distributable cash in the form of profits in order to pay dividends, albeit not for loan repayments).

(b) Future Revenue Requirements

The JVs needs may change or grow over time, and the parties should seek to pre-empt the likely issues which this may raise. For example, if more funding is required, will the parties be obliged to provide it, or will it be entirely discretionary? If only one party is willing to put in more funds and in doing so receive shares in return, will it be precluded from thereby gaining a majority shareholding and control over the JV? Will both parties need to give their approval to proposed new borrowings and/or to provide guarantees to back bank loans?

(c) Governance Structure

Who will be on the Board, and who will be able to appoint/replace new directors? What will the required quorum be (and will this be set so as to ensure that the parties always have an even balance of representatives at every meeting)? One should also consider reporting obligations; companies ordinarily have relatively limited reporting obligations in their Articles of Association and/or under company law, and so the parties may wish to provide for more detailed, regular updates to be provided to them as to the status and operations of the JV. In all events, it is essential to ensure that these matters are carefully set out in either the form of amendments to the company’s constitution or a Shareholders Agreement, or else the directors appointed to run the JV may be placed in a difficult position of conflict of interest, as their duties as directors will be owed to the JV itself, and not the “parent” companies which created it.

(d) Minority Protection

If the JV is not to be owned on a simple 50/50 basis, the question will arise as to what rights and protections the minority shareholder(s) will have. The usual approach is to provide, via the Shareholders Agreement, a list of key actions which cannot be undertaken without the minority shareholders’ consent. Examples may include changing the company’s constitution, issuing new shares, borrowing, entering into material contracts, selling assets, and so on. Clearly, the length of the list will depend upon the bargaining power of the relevant minority shareholder!

(e) Dealing with Deadlock

Occasionally, disputes may arise which the parties cannot readily resolve by discussion between them. The question is how to try to resolve them. One approach is to impose a “cooling off” period for both parties to reconsider their positions, possibly with the fall back of a reference of the dispute to each parties’ senior management or even up to the present companies’ Boards of Directors (which may focus the minds of those involved in the running of the JV!). Further fall backs may include expert determination or some other form of binding or non-binding ADR.

(f) Termination

Ultimately, the prospect of termination will still need to be addressed, whether by reason of agreement that the aims of the JV are not being realised, a failure to get round a deadlock issue, or by reason of one party not meeting its obligations. The issues here will usually surround the questions of valuations of shareholdings, and the possible application of “Drag and Tag” rights (ie the rights of one shareholder to insist that the other shareholder sells his shares as well when a buyer has been found for the JV as a whole, or alternatively to insist that his shares be bought at the same time as a third party purchases the other JV party’s shares). In any event, the parties will have to consider what further use (if any) either of them can make of any assets or IP rights generated or acquired by the JV during the time it was in operation.

4. Conclusion

Although, as can be seen from the above, there are many issues to be carefully thought through before embarking on any form of “alliance”, it is undoubtedly the case that a successful alliance can transform an organisation’s business and prospects; as Jack Welsh, former CEO of GEC, was once heard to comment, “If you think you can go it alone in today’s global economy, you are highly mistaken”. Hopefully, if one has carefully picked one’s way through the potential beartraps and found an alliance partner with compatible aims and culture, there will be benefits to be realised and profits to be made.

Kit Burden, Partner, Commercial & Technology Group, Barlow Lyde & Gilbert