03 Jun Exiting a Commercial Real Estate Joint Venture

Just as important as knowing the proper way to close down a business is knowing how to exit a joint venture.  A very popular type of joint venture is the commercial real estate joint venture, which can be a long-term, significant financial commitment involving the financing, acquisition, ownership, development and the operation of real property.  It is critical that you understand your options for existing the investment before you enter into it.  There are  several exit mechanisms you can use and include in your operating agreement for your real estate joint venture, including: (1) transferring your joint venture interests; (2) a right of first refusal; (3) the right of first offer; (4) drag along and tag along rights; (5) put and call rights; and (6) buy/sell rights.  We will address the first three exit strategies in this article.

Transferring Your Joint Venture Interests

Your ability to transfer your interests in a joint venture is one of the most important considerations when entering into a joint venture.  However, even an unrestricted right to transfer your joint venture interests is quite often difficult to market because many third party investors are leery of entering into an existing, unknown joint venture.  And if the interest you are trying to transfer is a minority interest with limited control rights, your ability to transfer might be even more limited.  Thus using this mechanism as an exit strategy only makes sense if you own a majority interest in the joint venture, and can meet the specific requirements that typically come with an investor’s right to transfer.

The decision to invest in a joint venture hinges greatly on the identity of the other parties in the joint venture and their contributions to the project, so before you consider this as an exit strategy you must be ready and able to provide your partners with the assurance that the new joint venture party is committed to the partnership, and that the new partner has the financial strength, experience, track record and reputation to keep the venture going successfully.

For this reason many joint ventures put transfer restrictions on its members, such as deferring exits and lock out periods.  For example, in a real estate joint venture, the developer partner will likely require that the equity partner remain in the joint venture to provide the necessary financing if cost overruns or delay occur.  The equity partner could also in this scenario require the developer partner to remain in the joint venture because of its construction expertise and familiarity with the project.  Completion of credit guaranties could also limit your ability to exit the joint venture.

The Right of First Refusal

The right of first refusal is the most common exit strategy used in a commercial real estate joint venture.  The right of first refusal gives you the ability to sell your interest in the joint venture to an identified third party buyer on written terms which are subject to the right of your other partner/s to purchase your rights by matching the offer you made to the third party.  This option gives you the ability to sell your interests and exit the project while also giving your partner/s the right to control who obtains an interest in the joint venture.  However often your partner/s will still want to control any new partners entering the joint venture even if they decide not to exercise their right of first refusal, so it is critical that you negotiate in advance a limited approval right over the incoming partner, or a set of parameters defining the permitted transferee to address financial status, experience and reputation.

However you will want to consider the potential drawbacks of tailoring your right of first refusal interests, so as to prevent the trigger of the right with a transfer of an equity interest, or the chilling effect that the right could have on your ability to market and sell your joint venture interests.  You can always tailor the right of first refusal to address these issues, by for example agreeing to pay a break-up fee if the deal falls through, or tailoring the right to address a sale of the underlying property, not merely a sale of your interests.

The Right of First Offer

The right of first offer is somewhat similar to the right of first refusal, but is much less restricting because no third-party offer is needed to use this exit mechanism.  With the right of first offer, you need only deliver an offer to the non-selling partner/s stating the terms on which you intend to sell your interest in the joint venture, and the non-selling partner has a specific time by which to decide to purchase your interests.  If the non-selling partner decides not to purchase your interest, then you are free and clear to market your interests to a third party on the same terms offered to the non-selling partner.

One drawback to this exit mechanism is that you must set a price without knowing the true value of your interests on the open market.  Because of this you run the risk of undervaluing your interests, and ultimately selling your interest for way under market value should your partner decide not to purchase.

Make sure you protect your ability to successfully exit a joint venture before you enter into it.  Call Edwards Law today for free consultation about your options.