Grim Tales

Larger partners may make you feel safer when embarking on joint ventures. But they just may want to eat you.
Nikos ValanceJuly 1, 2000

Contemplating a joint venture with someone bigger than you? There’s a strong temptation to cast caution to the wind. So long as you aren’t hooking up with a direct competitor, your secrets will be safe, right?

Not necessarily. In fact, the experiences of Clean Fuels Technology Inc. (formerly known as A-55 Inc.), an emulsified-fuels-technology company based in Reno, Nevada, and Interactive Network, a now- defunct Silicon Valley software maker, suggest that ventures with noncompetitors may be just as risky as partnerships with companies in the same business, at least when the alliance involves a much more powerful partner. And the risk may be especially acute when you’re counting on such an ally to finance and distribute new technology.

Both Clean Fuels and Interactive were looking for such help from larger noncompetitors–Caterpillar Inc. in the case of Clean Fuels, Tele- Communications Inc. (TCI) in Interactive’s case. But instead of getting help with new technology, Clean Fuels and Interactive lost it, and they have spent much time and effort to win it back through the legal system. Yet neither company went into their ventures with their eyes closed. Indeed, both relied on the kind of formal agreement that experts contend is an absolute necessity in such undertakings. (Caterpillar and TCI’s parent, AT&T Corp., failed to respond to requests for interviews.)

So what did they do wrong? In Clean Fuels’s case, experts suggest that management committed the cardinal, if sometimes inevitable, sin of betting on only one partner–Caterpillar, the Peoria, Illinois, heavy-equipment manufacturer–instead of spreading the risk among more. Interactive, on the other hand, allied with several partners, but evidently dropped its guard and fell prey to one. Taken together, their stories offer some valuable lessons on the pitfalls of teaming up with a larger partner and shed some light on how to structure such deals. Ultimately, says one former Interactive board member who asked not to be identified, “It’s not always possible to know as much as you want to about a possible partner.” And as a junior partner in these relationships, he says, it is wise to remember that “a strategic investor clearly has his own agenda. If you don’t understand that up front, you may be in for some surprises.”

She’s the One

For Clean Fuels, the eventual surprises in its venture with Caterpillar were not apparent at the outset. Clean Fuels had developed and patented a form of fuel that uses emulsions of water and petroleum as replacements for traditional fuels, lowering emissions of oxides of nitrogen and other gases from diesel engines. As the single largest manufacturer of diesel engines that would use the fuel, Caterpillar seemed like the single best choice of partners. It agreed to commercialize the technology in 1994, not long before demand for it was likely to rise, propelled by stricter federal emissions standards. These were, in fact, boosted in 1998, and are slated for another increase in 2002.

When the venture was dissolved in October 1996, Clean Fuels acquired all rights to the technology. Under the terms of the joint venture agreement, Caterpillar was to remain a licensee of the technology for use in its own engines. However, testimony provided during a 16-day hearing in Denver late last year showed that just before the partnership ended, Caterpillar filed patents and patent applications with the government for the same technology. In August 1999, Caterpillar announced it was joining with Lubrizol Corp., a $1.8 billion Cleveland-based fuel-additives company, to develop and market a low-emission diesel fuel called PuriNOx.

Earlier this year, however, an arbitrator found that Caterpillar, led by then-CEO Don Fites, fraudulently and deceitfully filed 18 applications for patents belonging to Clean Fuels, and had breached its fiduciary duties and license agreement. “Under the guise of the ‘joint venture,’ Caterpillar misappropriated the technology,” the arbitrator said. He further found that “fraudulent and deceitful conduct permeated the parties’ relationship;” that Caterpillar used the information it took from Clean Fuels to develop PuriNOx with Lubrizol; and that Caterpillar “concealed its misappropriation” from Clean Fuels. The ruling orders Caterpillar to return all the patents and any profits derived from the technology.

Nonetheless, negotiations between the companies are continuing, and there are even unconfirmed reports that a new partnership between them is in the works. Observers aren’t surprised. “The only way [for Clean Fuels] to extract value was with that company,” says a consultant who asked not to be identified. “It’s the Liz Taylor syndrome,” he adds, likening Caterpillar to a corporate version of Richard Burton. “The business reasons for forming the first partnership probably still hold because the ongoing value still relied on the complementarity of the two partners.” What’s more, he says, now that an arbitrator has ruled in its favor, “Clean Fuels may be in a better position to negotiate sweeter terms.”

Can Three Tango?

While Clean Fuels’s experience underscores the risk of relying on one partner, Interactive’s experience with TCI suggests that spreading risk among several is easier said than done. What’s more, Interactive’s venture with TCI shows how easy it is for a powerful partner to subvert a standard agreement.

Interactive’s Yale-educated founder and chairman, David Lockton, learned that the hard way after signing a partnership agreement, in 1992, with the cable giant (which was acquired by AT&T last year). Now 62, Lockton had developed a software-driven device that allowed home viewers to play along with TV sports or game shows for prizes. Having helped get 12 other companies off the ground before starting Interactive, Lockton could confidently predict that his service would revolutionize TV viewers’ relationships with their sets and attract one million subscribers within a year of its launch.

Wall Street went along, with some analysts expecting the industry to be worth as much as $14 billion in a few years. NBC was so impressed it acquired a 10 percent stake in the company. No less wowed was John Malone, TCI’s powerful chief executive. In return for a 22 percent equity stake worth $13 million, Malone promised to finance and distribute Interactive’s product.

But today Interactive is dormant, some five years after it took TCI to court. Among Interactive’s allegations: breach of contract and fiduciary duty, interference with contractual relations and economic advantage, abuse of control, fraud, deceit, and unfair competition. Interactive and TCI settled the dispute in 1998, when TCI agreed to pay Interactive $12.5 million, return patents it acquired from the company, and convert to equity worth $5 a share some $33 million debt it had extended to Interactive. Lockton no longer controls Interactive. He has filed his own suit leveling similar charges against AT&T and Interactive’s second board of directors, formed after he reconstituted the company, around the end of 1995, but which he charges was subsequently bought off by TCI. That suit is still pending.

What happened? Lockton declined to comment, but court documents and background interviews with sources familiar with the case reveal a tale tawdry enough to cause the most intrepid entrepreneur to think twice about partnerships with the powerful, even when more than one power is involved.

Zinged by Malone

When TCI made its investment, Interactive, like many start-ups, was still in the red–losing $25 million in 1993 on $1 million in revenue. But the product had tested well in such markets as San Francisco and Chicago. In the Bay Area, Interactive claimed a test-market customer base of 5,000 households, each of which paid $25 a month for the service. Its stock, which traded on Nasdaq, climbed from $8 to $15 that year.

But life with John Malone began to grow difficult the following year. According to Interactive’s complaint, TCI failed to deliver new cable boxes it had promised in return for a fee from Interactive and its agreement not to buy from TCI’s competitors. As a result, Interactive needed to raise more money for its launch. So it began planning a $22 million offshore private placement using the investment bank Lazard Freres & Co. LLC. But TCI convinced Interactive’s board to drop the idea and dispense with Lazard in favor of its own plan to roll out the service.

According to Interactive’s complaint, TCI proposed a $65 million offering, guaranteed by TCI and Sony Corp., with an additional $30 million in equity to be sold to TCI and Sony with NBC as a junior partner. Interactive assented, only to see Sony pull out without explanation. (Sony was having problems with TCI on other fronts.) With Sony gone and NBC’s interest limited, Interactive had only TCI to rely on, and TCI clearly knew it.

To make up for Sony’s departure, TCI agreed to give Interactive $10 million as convertible debt, on the condition that Interactive first obtain $15 million more in debt from other TCI-approved investors, plus another $25 million in new public equity–all within two weeks. What’s more, TCI demanded that title to the patents and technology be given to secured creditors, and named itself agent for them. Interactive could regain control of the patents only if it raised an additional $45 million in equity.

It managed to raise the $15 million from approved investors such as NBC, Motorola, and Sprint, as well as an additional $25 million from a European offering, filling the company’s coffers and enabling it to pay its creditors. Nonetheless, according to Interactive’s lawsuit, TCI, in control of the purse strings as the major shareholder, continued to block Interactive’s efforts to raise more money independently, even as plans for the national launch went nowhere. Meanwhile, unbeknownst to Interactive, TCI had been investing in one of Interactive’s competitors, Zing Systems, which would eventually go bankrupt.

After Interactive also went belly up, in 1998, Lockton lost control of the company and its intellectual property to TCI (and now AT&T), and though he has spent three years in court, he still hasn’t gotten it back. “I don’t think TCI had an evil plan from the beginning,” notes a former Interactive board member who asked not to be identified. “But as things moved along,” he adds, “it occurred to them that they could squeeze Lockton out and take over the company. And they did.”

Should Interactive have seen TCI coming? The former Interactive board member suggests that very few entrepreneurs would have been able to do so. “When TCI made its offer, it seemed so enticing,” he says. “The entire board went along with it. It wasn’t just Dave Lockton’s misjudgment.”

Guessing at Motives

So what lesson might entrepreneurs draw from Lockton’s mishaps? “Be careful who you get into bed with,” says the former Interactive board member. Obvious advice? Perhaps, but not as simple to follow as it sounds. “There are some people who have less than lovely reputations, but who have behaved honorably when they didn’t have to,” he says.

But the opposite is also true. “There is always an element of risk,” he continues. Yet he points out that negotiations can give you “an idea of what hidden motives there might be.” And he says it’s wise to trust that inkling, citing talks that he himself had recently with a Fortune 50 company. This former board member and others working on his side developed a strong sense that their potential partner would not play the role they wanted, yet would be privy to their intellectual property, so they decided not to go ahead with the deal. “We backed away from the deal despite the financial inducements,” he notes.

Naturally, consultants contend that carefully crafted agreements can eliminate surprises, and Clean Fuels and Interactive clearly would have found it more difficult to seek legal recourse without them. “We had a fairly well- defined arrangement with TCI,” notes the former board member. But that evidently didn’t stop TCI from undermining Lockton’s efforts. “The rug was pulled out from under Interactive,” he says. “We were encouraged to get cranked up for a national launch, and then the funding was not provided.”

Still, consultants say that many forms of risk can be taken into account in a formal agreement. Why weren’t they? According to a source close to Interactive, the company rushed into the partnership after TCI made its initial investment because its stock price had been falling, and it feared being taken over outright. But Interactive is far from alone in having failed to negotiate wisely under pressure.

“The problem with many joint ventures,” says Robert Uhlaner, a principal at McKinsey & Co., “is that very little up-front work is done in thinking about who, three years from now, will have the rights to which assets and products, whether the business succeeds or fails.” (See “Venturing Out,”CFO, September 1999).

That up-front work should be no different from what goes on in other deals, says the consultant. “A joint venture partnership is tantamount to a bilateral asset purchase,” he contends. “Partner A purchases assets from Partner B. Very few partnerships bother to model it that way, and so there are surprises. What’s being put at risk is the intellectual property. And because lots of agreements are informal sales agreements, it’s tantamount to providing control.”

For that reason, says Uhlaner, it’s critical that exit conditions be established in case of under-performance. If poor performance persists for a number of quarters, one party would have the right, as a term in the initial agreement, to buy out the venture at a specified price. “The alternative,” he notes, “is to leave non- or under-performance to binding arbitration provisions with materiality as the trigger.”

Uhlaner goes so far as to suggest that if one partner finds it impossible to bring in a third, it should take that into account when pricing the deal.

Precision and Pragmatism

Above all, he advises, the terms of a joint venture should be no less precise than those for any deal. “In alliances,” says Uhlaner, “you often need the same degree of precision, especially around future scenarios for how performance or market conditions may unfold. Too often, deal terms and valuation are restricted to a single expected case, without consideration for the very different exposures either party may have. Since the point of a joint venture is that two parties have complementary contributions, they have very different exposures to market risk and incentives for performing.”

Ultimately, however, all joint ventures require a leap of faith. And that’s true even when dealing with a partner that’s similar in size. Consider another recent venture that went sour, this one involving two computer-chip vendors, Trident Microsystems, a Santa Clara, California-based manufacturer of 3-D video graphics and digital media chips, and VIA Technologies, a Taiwanese manufacturer of core-logic chip sets. The two companies formed a partnership about two years ago to develop and market integrated graphics and core logic chips. Last July, Trident sued VIA in U.S. District Court, accusing its partner of breach of contract, fraud, and patent infringement. Yet the two companies continued working together even as Trident pursued its suit, ensuring continued support for such customers as Compaq Computer Corp. and Hewlett-Packard Co. In April, Trident and VIA announced they had settled their differences, with VIA agreeing to pay Trident $10.2 million. And the partnership continues.

Such an outcome isn’t as unlikely as it sounds, says Gerry Liu, president of the video graphics and communications business unit of Trident. That’s because the two companies continued to cooperate throughout the dispute. “We always had that,” Liu says. “No matter what was happening, many other things got resolved along the line. There’s got to be a problem-solving attitude. It’s easy to fume, but you’ve got to have resolution.”

Of course, that assumes good faith on the other side. Absent that, you may have no choice but to go to court.

Whatever happens, Liu advises, “do not sacrifice customers or bona fide third parties.” In Trident and VIA’s case, he says, “if either side had dropped the ball, there would be no basis for success. Ultimately, it is the customer that pays the bills.”


Before signing up for a potential joint venture, address the following five questions about the deal’s structure.

  1. Is it possible to unwind the partnership while keeping the business system intact?
  2. Can the business system be adjusted quickly through a change of control and lost value recovered?
  3. Are exposures to risk asymmetric by virtue of the venture/parent structure between partners?
  4. Is optionality asymmetric between partners?
  5. Do the partners have different levels of risk tolerance?

To come to terms with the answers, consider the following six deal-structure options.

  1. Call/put option with performance triggers
  2. Dynamic transfer price, linked to performance
  3. Preferred stock or dividend to one partner
  4. Forward purchase option to one partner
  5. IPO option to shift risk to third parties
  6. Reliance on defined governance role

Source: Robert Uhlaner of McKinsey & Co.