Protecting yourself going into a Joint Venture
This article is about Joint Ventures, or "JV's", which are generally short-term projects. Co-investing for the long term is a bit different and you have to consider long term life goals, a good article on that can be found here.
Today's topic is one we are asked about a fair bit – how to put together a joint venture. However this article should really be “how to put together a joint venture so you don’t lose the shirt off your back, your friends, your sanity, all your free time and a substantial amount of money”.
A joint venture (JV) is in theory a great concept. A group of people with different skills and resources collaborate on a business venture, typically one that is short-to-medium term in length. In real estate this usually takes the form of a group of people collaborating to purchase and renovate a property, with the intention of selling it at a profit.
Everybody likes the idea of creating extra wealth, especially creating extra wealth soon. The problem is when we get excited about all the money we’re about to make and don’t spend nearly enough time planning for things to go wrong.
I’ll use a common scenario to demonstrate what I mean.
John and Bob agree to work together on a property renovation. Bob has found a run-down property in a popular region that needs some serious TLC. He has spoken with local agents about what the house would sell for if it were renovated and has quotes from two local builders to do the work. John has enough equity to settle on the property so the loan on the property will be in his name. Bob and John will split the renovation cost and Bob will manage the project and sale with profits to be split equally. They draw up a simple JV agreement and get down to business.
With a project such as this, there are two types of due diligence; due diligence on the property and due diligence on the project.
Due diligence on the property for a planned “renovation flip” means asking these kinds of questions:
- How certain are we of the sale price?
- How long do we expect it to take before it sells?
- Who will cover the holding costs?
- What is our break-even point?
- What costs are involved in marketing and selling the property?
- How accurate is the builder’s estimate? How can we confirm this?
- Who so we think will eventually buy the renovated property and why?
- What is “Plan B” if we cannot sell for the planned price within the planned timeframe?
- What happens if one party wishes to exit the project (for whatever reason)?
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That’s all fairly standard stuff and the answers to these questions can form the bones of a reasonable JV agreement. However there is a second series of questions which people (especially friends) can skip over because they are awkward; that is checking out the people you plan on doing business with.
- What is the financial situation of all partners? Do they have stable and managed living costs?
- If the project loses money, are both sides able to cover that loss? Is this in the agreement?
- If the project takes 6 months longer than planned, how big a financial impact does that have on each partner?
- How long can the party paying any holding costs keep that up if the project should take longer to sell than expected?
- Do all the partners have extra funds available should the project run over budget?
- Do both partners really have the required experience and knowledge to make the project a success? How do you know?
These kinds of questions are hard to ask friends, so Bob and John probably skipped most of them. Can you see what kind of risk they were taking?
If you find yourself in this situation with one or more friends, it is a very good idea to get some independent advice on both the deal and the team involved.
Asking a third party to help out is a nice option for three reasons:
- A “detached” opinion from somebody not involved in the deal can uncover new risks
- The due diligence can be conducted thoroughly without impacting your friendship
- Neither party will be able to skim over a potential issue
They say “time heals all wounds” – however with a JV there is normally a fixed end-date to the project so the impact of something going wrong is magnified. Independent advice from an industry professional (such as a Solicitor or Financial Advisor) may cost a bit, however the “insurance” and “assurance” it can provide going into a joint venture is priceless.
By Nick Gentle