Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate Joint Ventures, October 2010
The buy-sell shotgun is based upon a very simple principle – a joint venture participant should be willing to sell its interest in the project at the same per unit price that it would be willing to buy a similar interest from its fellow joint venture participant. It is very much like two brothers trying to agree on how to divide up the last piece of pie left over from the prior night's dinner. One brother says: "You divide and I'll choose". There is nothing quite like that rule to discipline the brother who is cutting the pie to be as fair as possible, as he does not know which of the two slices his brother will select.
The Ideal Situation
The buy-sell shotgun works best where:
1. the joint venture participants have approximately equal financial strength;
2. the joint venture involves only two joint venture participants, each holding approximately equal interests of a similar nature in the project;
3. the project has been substantially completed;
4. both joint venture participants are well informed about the project and have the requisite development and management expertise to run the project;
5. the project is fully financed by non-recourse, several and proportional, fully assumable project financing with no separate financing by any of the joint venture participants; and
6. neither joint venture participant is in default of its obligations contained in the joint venture agreement.
Of course, it does not always work out that way. What do we suggest?
Inequality of Financial Strength
Negotiating a joint venture agreement is much like negotiating a marriage contract. In the case of the marriage contract, you do not want to discuss all of the awkward issues which prudence dictates should be addressed in a timely fashion before the wedding. The problem is that if you negotiate too thoroughly, the romance is gone before the wedding even takes place – or there may be no wedding at all! The same logic applies in the context of a joint venture agreement.
Inequality of financial strength is just one of the many awkward issues which need to be addressed in negotiating a joint venture agreement.
The problem for the joint venture participant in the relatively weaker financial position is that the more financially robust joint venture participant may, at some future date, invoke the shotgun provisions contained in the joint venture agreement for no reason other than to gain an economic advantage. Knowing that the more financially constrained joint venture participant would be unable to reverse the shotgun and buy out the more financially robust joint venture participant, the latter would be able to deliver a "low-ball" shotgun notice and force the former to sell its interest in the project at a relatively low price.
There are a number of measures which the more financially constrained joint venture participant may take to guard against this scenario.
First, it could insist upon delayed payment terms, with vendor take-back financing, in the event the shotgun was reversed.
Secondly, and more commonly, the more financially constrained joint venture participant could bargain for a longer time period to respond to the buy-sell shotgun notice and/or a prolonged period of time in which to close the transaction after agreeing to buy. This extra time would give the more financially constrained joint venture participant an opportunity to arrange financing, to put together a syndicate of investors, or to find another party willing to assist in buying out and replacing the more financially robust joint venture participant.
Some joint venture participants seek to impose a minimum unit price that may be offered under the buysell shotgun. In our view, this approach distorts the economics of the situation and should be avoided.
Inequality of Ownership Interests
Inequality of ownership interests also creates difficulties.
In many circumstances, the joint venture will not be a 50/50 deal between the two parties. In theory, the buy-sell shotgun could still work quite well in other circumstances, such as a 60/40 joint venture. But if the respective interests of the joint venture participants are not equal, the joint venture agreement should provide that any offer made pursuant to a buy-sell shotgun should be adjusted to reflect such disparity in order to achieve a per unit price for such interests.
The further removed from the 50/50 joint venture, the greater the likelihood that the interests of the joint venture participant having the minority interest in the project will be prejudiced in the event of the exercise of the shotgun provisions under the joint venture agreement. To take a rather extreme example, in a 90/10 joint venture (the elephant and the mouse situation), the minority joint venture participant which receives a buy-sell shotgun notice from the joint venture participant having the majority interest in the project would almost invariably feel compelled to sell, for, in order to reverse the shotgun, the minority joint venture participant would have to increase its investment in the project by 900%. The majority joint venture participant, by comparison, would merely increase its interest in the project by approximately 11%.
One option to avoid the foregoing scenario would be to dispense with the buy-sell shotgun provision in its entirety in such circumstances and replace it with a "put" in favour of the minority joint venture participant, coupled with a "piggyback" provision in connection with the sale by the majority joint venture participant of its interest in the project.
This combination has several advantages for both the majority joint venture participant and the minority joint venture participant. The majority joint venture participant will be assured that it will not lose its interest in the project through the application of the shotgun. On the other hand, the minority joint venture participant will be secure in the knowledge that it will not be forced to have to buy out the interest of the majority joint venture participant in order to sever the joint venture. Essentially, the minority joint venture participant is able to extricate itself from the joint venture if it is not happy with the decisions being made by the majority joint venture participant.
Because of the unilateral nature of the "put", joint venture agreements generally provide for a specific period of time for the majority joint venture participant to arrange financing to purchase the interest of the minority joint venture participant. The value of the "put" may be based on the "rolled up" cost or the fair market value of the property, as determined by appraisal, or the greater of the two amounts.
The "piggyback" provision provides the minority joint venture participant with the right to dispose of its interest in the project at the same time as the majority joint venture participant disposes of its interest, with the result that the minority joint venture participant is able to share pro rata in the sale proceeds and is not compelled to enter into an "elephant and mouse" relationship with a new joint venture participant or to sell its minority interest at a discount.
More Than Two Parties
What happens if there are more than two joint venture participants? Take, for example, a three-party joint venture. The interests may be shared equally, with each joint venture participant holding a one-third interest or perhaps the interests are divided into certain proportions, such as 50/25/25 or 40/40/20. Generally speaking, whatever the original proportions, most joint venture participants want to end up with approximately the same balance of power among the remaining joint venture participants after the exercise of the multi-party shotgun as that which previously existed.
In a three-party joint venture, there are three types of provisions that should be included in the joint venture agreement:
1. A one-on-one shotgun allows two joint venture participants to fight it out amongst themselves while the third joint venture participant remains neutral sitting on the side lines.
2. A two-on-one shotgun – the "gang-up" – is generally initiated by two joint venture participants seeking to remove one troublesome joint venture participant.
3. The "David and Goliath" shotgun, which involves a one-on-two joint venture situation.
Needless to say, these provisions become very complicated.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.