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Partnering-Up Overseas: A Due Diligence Checklist

Partnering-Up Overseas A Due Diligence Checklist Article by Jacob Stein

In a previous issue, we reviewed the foreign country due diligence that every U.S. investor should make before investing in or conducting business overseas. Once you have determined that the local market is one in which you can profit, the next step is the due diligence required of the partner or distributor with whom you contemplate doing business. Here is a due diligence checklist:
• Is your prospective partner trustworthy? If you cannot trust your partner, nothing else matters. You cannot learn whether your potential partner will steal your intellectual property from your potential partner. If your prospective partner has already burned through one or more foreign partners, you would like to know that. That’s why it is imperative to engage knowledgeable local legal counsel and auditors right from the start.
• Is your prospective partner’s corporate culture compatible with yours? Every business has a corporate culture. Some businesses know what their corporate culture is, and often tout it as an asset virtue. In some businesses, the employees know full well what the corporate culture is, even if management does not. A prospective partner’s corporate culture may work for it, but it may not be a corporate culture you are comfortable working with. In any event, job one must be to determine the prospective partner’s corporate culture. This cannot be done from a distance, and cannot be accomplished in a lawyer’s office. Your key managers who will be interfacing with their local counterparts on a day-in-day basis must visit the local business and should spend many days (preferably weeks) seeing how the local business is operated. They must obtain an understanding of how management deals with employees (and labor unions and works councils, if any). They must determine if the production standards are compatible with yours. Needless to say, they must determine if there are any unusual or illegal business practices with which local management is comfortable with but which you are not. You cannot learn this working off of a due diligence checklist; you need to be there.
• Is your prospective partner’s access to raw materials, parts and suppliers adequate to handle the increased business? If your prospective partner is a local manufacturer, it is likely that the proposed international joint venture (“IJV”) contemplates what may be a substantial increase in its output. If the proposed partner does not have the ability to access the raw materials, parts and supplies necessary to achieve the higher level of output, the venture will fail, even if you local partner benefits from the increased volume. Similarly, it is pointless to ramp up production if the local partner’s ability to deliver the increased production to market is exceeded.
Just as it is inherently risky for any U.S. manufacturer to rely on a sole source of parts or raw materials, the IJV could fail if your local partner relies upon a sole source of supply, especially if that sole source determines that it doesn’t wish to sell to a foreigner.
Your local partner may sell its products or services through a local sales force. That sales force may be adequate for its current level of sales, but may be wholly inadequate for the increased level of sales that the IJV contemplates. If an increase in the sales force is necessary, is such an increase feasible? And if so, how long will it take to ramp up the sales force, and what will it cost?
• Is your prospective partner reliant upon one or two key managers? As we all know, not every business owner actually runs the business. Very often, the fact that it is difficult to pull the owner off the golf course is not a detriment to the smooth operation of the business; his absence may enhance it. But if your prospective partner is run by one or two key managers, that is a fact that you must ascertain before you commit to the IJV. If the local partner is in fact run by a key employee, you must determine if that employee will continue with the IJV after it is formed.
Even if the business is not run by one or two key managers, it is often a mistake to rely solely upon the owner or chief executive of the business in the conduct of your operational due diligence. You should always get the perspective of the people on the factory floor and in the sales offices.
• Can the current plant accommodate increased production? That’s obvious. Here is what is not so obvious: If the plant is leased, when will the lease expire? If the lease will expire shortly, can the lease be renewed on favorable terms? If there is doubt as to whether a lease can be renewed, are there alternative premises to which to relocate if need be?
• Is your prospective partner compliant in all employment, tax and regulatory matters? U.S. businesses often enter into IJV’s assuming that if their partner has a problem with local tax collectors or other regulators, it’s their partner’s problem, not theirs. That’s a very short-sighted approach. For starters, your local partner may avoid the payment of its proper tax liability by making unauthorized payments to tax collectors that you might not be willing to make (you may not be prepared to violate the Foreign Corrupt Practices Act). The fact that your local partner may have successfully underpaid its taxes in the past is no guarantee that it will be able to so in the future. Even if you cannot be held directly liable for your partner’s prior tax liability, there is no guarantee that a local tax collector may not be able to seize IJV property or shut down your partner for non-payment of taxes.
In some countries – including all of the developed ones -- you can verify whether a government audit is underway and/or whether all of the taxes that are owed have been paid. In some countries, it’s not that easy. Needless to say, you or your due diligence team need to determine that all of the taxes have been paid and all of the licenses and permits necessary to operate the business have been obtained before you make a substantial investment in a foreign country.
• How financially strong is your partner? Entrepreneurs are optimists by nature. But it doesn’t hurt prior to finalizing an IJV to ask whether your local partner is financially strong enough to survive a downturn, or whether you will have to bail out your partner if there is a downturn. If possible, you should obtain your partner’s five most recent years’ financial statements prior to finalizing the deal. As indicated previously, if the financial statements purport to be “audited,” the people on your financial due diligence team need to ascertain that the auditing standards in the local country are comparable to the U.S. auditing standards.
• Is your partner ahead or behind the tech curve? This is especially true if the IJV is being formed for the principal purpose of exploiting technology and bringing an as-yet undeveloped product to market.
• Are all of the partner’s intellectual property and technology protected by patents, trademarks, etc? Determining that all of the IP that each partner owns and/or the IJV will develop is protected by patents, trademarks, copyrights, etc. is a key function of the legal due diligence team. The IP due diligence consists of a number a separate inquiries, among which are:
     •• Does your partner actually own the critical IP rights? It is possible that the rights to a patent are owned by an employee, who never actually assigned the patent to his employer. It’s embarrassing to learn this after the IJV has been formed.
     •• Has your partner licensed the rights to someone else? What’s worse, has the partner licensed the rights to a competitor? Even if your partner owns the local rights to a patent or trademark, he may not own the rights in a third country into which you might wish to expand the IJV.
     •• Are any of the IP rights subject to infringement claims? Conversely, your partner may believe that some other party is infringing on its IP. If your partner is contemplating litigation, you should know of it.
    •• When, if at all, do the rights to critical IP expire under local law? It is possible that the rights to a patent or trademark may be preserved in perpetuity by maintaining a minimum level of sales and by making a payment. But if the use of IP may sunset for whatever reason, you need to know that before you finalize an IJV to use that IP.
Most lawyers have their favorite war stories about deals that soured because of IP due diligence that wasn’t properly performed, or wasn’t performed at all. Here’s ours. In 1998, Volkswagen acquired the assets of Rolls Royce and Bentley. They paid $800 million for most of the hard assets necessary to manufacture these brands. But after the deal closed, Volkswagen learned – to its horror – that the $800 million price tag did not include the rights to the “Rolls Royce” trademarks, which meant that Volkswagen could build a car that looked exactly like a Rolls Royce; they just couldn’t call it one!
Here’s another. In 1990 Clorox Corporation acquired the business and trademarks of Pine-Sol. Clorox purchased Pine-Sol in the hopes of expanding the Pine-Sol brand into new areas. Only after the deal closed did Clorox learn of a 30-year old agreement that Pine-Sol had entered into with another party that restricted the use of the Pine-Sol brand to disinfectants. As a result, Clorox could use the Pine-Sol brand, but not for the exact purpose for which Clorox had made the acquisition.      
• How politically connected is your partner? We owe this bit of wisdom to one of the most successful transactional attorneys in India. He advises that when contemplating an IJV in India, you need to know if your potential partner is “in” with the local political party, which is going to make life easy, or on the “outs,” which is going to make life difficult. You need to learn this from outside local counsel, not from your partner. The worst that can happen is that your local partner was part of the “in” crowd, but that as a result of shifting local political fortunes, your partner is now on the outside looking in, and may need the IJV with you to survive.
You cannot know everything, and you will never know as much about a foreign country as you do your own. You may have thought that you had asked everything, only to learn that there is something obvious to everyone in the local market that is not obvious to you. That’s why it is imperative to engage local attorneys and accountants to assist you with respect to every aspect of the search, planning, negotiations, structuring and operations of an IJV. You must rely on your own local people.
- See more at:
Jacob Stein
16000 Ventura Boulevard, Suite 1000
91436 Los Angeles, CA
T: +1-818-933-3838