Insight And Pointers On Startup And Venture Investment In Japan For Foreign Investors – Corporate/Commercial Law

Introduction

Japanese startups and venture businesses have recently
experienced significant growth and development. At the same time,
interest and investments in such business ventures have also
strengthened.

Previously, startups in Japan raised funds largely in a way
similar to SMEs. Often, equity financing would be obtained from
financial institutions. In recent years, however, the rise of
independent venture capital and the increasing availability of
financing from overseas have changed the way startups conduct
fundraising.

Investments in startups can be structured in many ways,
depending on the goals and objectives of the investors and the
startups involved. For example, industrial investors are
increasingly exploring the option of acquiring minority stakes in
startups with the aim of establishing business collaborations or
partnerships with them. More and more investors lately are also
considering full acquisitions of startups in the earlier stages of
growth in order to obtain their technologies and talented staff
(aka “acqui-hiring”).

Public listings (IPOs) used to constitute the main exit strategy
for Japanese startups. With the growth of the Japanese M&A
market, however, more and more startup founders are opting for
M&A as a way of exit. According to a survey of large companies
and startups on M&A, conducted in March 2021 by the Ministry of
Economy, Trade and Industry (“METI“),
there is positive outlook on the growth prospects of startups and
the potential of M&A to enhance medium- to long-term corporate
value.

With the growth and development of the startup ecosystem in
Japan, foreign investors are expected to be more active in the
Japanese market. This article explores some of key points to
consider when companies invest in Japanese startups from
overseas.

What to know about Startup/Venture Investment in
Japan

Corporate Governance

Under the Companies Act of Japan, companies are classified into
stock companies (kabusiki-kaisha) and membership companies
(mochibun-kaisha). Startups are structured as stock
companies in most cases and transfers of shares in startups are
generally restricted under their articles of incorporation. The
governance structure of a stock company varies widely under the
Companies Act. For example, although stock companies always appoint
directors, they can be referred to as (i) companies “without a
board of directors” as a decision-making body, or (ii)
“companies with a board of directors” that makes
important decision regarding the company. Stock companies with
boards of directors are also required to have auditors.

Although a Japanese startup does not have a board of directors
in practice at the time of incorporation, a board of directors will
usually be appointed around the time of its series A funding.
Accordingly, when a startup contemplates fundraising from overseas,
it will often have a governance structure that includes a board of
directors.

The board of directors is a body consisting of directors
appointed by shareholders. The board is collectively in charge of
making decisions regarding a company’s operations and
supervising directors in the exercise of their duties. When a
company has a board of directors, matters regarding the company
that may be decided by shareholders will be restricted to those
stipulated in the Companies Act and the company’s articles of
incorporation. Any director is, in principle, permitted to call a
board meeting and board resolutions must be made by the majority
vote of directors present at the meeting, where the majority of
directors entitled to vote are present (although directors with
special interests in a matter are not permitted to vote on that
matter).

Investment Agreements and Shareholders Agreements

Investment agreements and shareholder agreements, which are
agreements that startups enter into with their investors, are also
unique in Japan. In particular, funds and companies that invest in
Japanese startups tend to request a certain degree of control over
the management of the startups during the investment period.
Specific rights that investors commonly seek include the right to
appoint a director of a startup and the right of veto on certain
management and operational matters.

Common equity funding has conventionally been the method of
fundraising by Japanese startups. However, preferred shares have
recently become the norm, especially in series A and subsequent
fundraisings. A reason for this is that preferred shares allow
flexibility in valuations as compared to common stocks. Investors
also consider it important, for purposes of risk allocation, that
preferred shareholders have priority in the distribution of
residual assets upon dissolution or liquidation of the startup, to
enable them to secure their investments. Additionally, preferred
shares allow investors to secure upside in M&A by using certain
pricing mechanisms that are akin to having preferential treatment
in a distribution of residual assets when a startup embarks on an
M&A exit (or deemed liquidation).

Under the Companies Act, preferred shareholders may be given the
right to appoint or veto the appointment of directors. However, in
the context of investments in Japanese startups via subscription
for preferred shares, such rights are not commonly given. With that
said, investment or shareholder agreements can provide for such
rights as a matter of contract, as a way of restricting startups or
their management shareholders. This approach is frequently adopted
to avoid the procedural complexity of holding a general meeting of
preferred shareholders (i.e., a meeting of class shareholders) for
purposes of exercising director nomination or veto rights.
(Although shareholders’ resolutions in writing are possible
under the Companies Act, they are only permitted in situations
where all preferred shareholders of the relevant class have
unanimously approved a resolution.) Another reason for the
widespread use of contract to restrict startups or their management
shareholders is that this approach allow preferred shareholders to
exercise contractual remedies, such as put options in particular,
in the event of a breach of contract by the startup or management
shareholders with respect to the right to elect or veto the
election of directors.

These rights to appoint or veto directors are usually demanded
by majority shareholders. Foreign investors are usually minority
investors when they invest in Japanese startups, but even so, they
may request a certain degree of involvement in the management or
operations of the startups, depending on the size of their stake
and other factors. Such involvement could take the form of observer
rights in board meetings (without voting rights) or limited veto
rights in respect of important matters.

Put options are often used in investment and/or shareholder
agreements in Japan, but are not common in certain jurisdictions,
such as the U.S. This is because historically fundraising from
financial institutions (or from investment funds established by or
related to financial institutions) was common in the
startup/venture market, and Japanese banks would seek individual
guarantees from founders with a put option mechanism, in much the
same way as they would request guarantees from the shareholders of
SMEs when providing loans. A typical trigger event for the exercise
of such put option right is where the startups failed to achieve
their IPO exit strategies within a certain period of time.
Additionally, in Japan, it is also not uncommon for investment and
shareholder agreements for startups to contain mechanisms that
enable shareholders to exercise put options when contractual
obligations (including the obligation to appoint directors or veto
rights) or warranties have been breached by the startups or their
founders.

In many instances of investments in Japanese startups,
investors’ veto rights, rights of director election, and put
options are set forth in investment and shareholder agreements for
each series of funding. This explains why contractual relationships
between startups and their investors get increasingly complicated
toward the middle or later stages of a startup’s expansion
after a series of fundraising have been conducted. When foreign
investors invest in Japanese startups, it is vital that they review
and understand the terms of past investment and shareholder
agreements in the process of due diligence with the assistance of
local counsel, to ensure that they are given the shareholder rights
they wish to secure with their investments. Where foreign investors
contemplate the acquisition of a Japanese startup, it is also
important that they understand the rights of existing shareholders
in the course of legal due diligence, to avoid impediments to the
transaction.

Regulatory Filings

When foreign investors contemplate investments in or acquisition
of Japanese startups, they should also carefully consider the
relevant regulatory filing requirements involved in advance.

Given the global trend of closer scrutiny of inward foreign
investments or foreign direct investment (FDI), the Japanese
government has amended the Japan’s inward foreign investment
regulations to broaden the scope of transactions for which prior
notification to the authorities are required. Under current
regulations, acquisition of shares in unlisted companies (such as
startups) in Japan by foreign investors or, sometimes, appointment
of directors in startups by foreign investors may be subject to
such prior notification requirement if the target company falls
within certain designated business sectors. Due to the highly
technical and legal nature of analyzing the need for compliance
with such prior notification requirement, however, consultation
with experienced local counsel in the initial stages of planning
investments into Japanese startups is crucial. (In this connection,
further details and practical pointers can be found at the article
entitled “Insights and Pointers
on Inward Direct Investment Regulations in Japan for Foreign
Investors”.)

Merger filing is another key regulatory area related to
investment in or acquisition of startups in Japan. The relevant
regulations apply not only to the acquisition of control in a
company, but also requires prior notification to be made to the
Japan Fair Trade Commission (the “JFTC“)
for acquisitions of 20% or more of the voting rights in a Japanese
company (including startups) if certain statutory turnover
thresholds are met. As noted in the article entitled “
Insight and Pointers on Recent Merger Control Trends in Japan for
Foreign Investors”, the JFTC has shown growing interest in
M&A transactions and investments involving tech-oriented and
data-driven businesses, which are business fields that many
startups are active in. The JFTC’s increasing focus on these
areas is reflected in the guidelines (“Guidelines
on Business Partnership Contracts with Startups
Formulated”) that it issued jointly with METI in March
2021 on business alliances and partnerships with startups.

Recent Trend and Tips

Startups in Japan are attracting growing attention from foreign
investors. It is therefore critical to understand the
characteristics of the Japanese startup landscape, and the relevant
contract practices and regulatory requirements outlined in this
article. Other factors, such as language, communication and
cultural issues, which may arise when foreign investors invest in,
partner with, or acquire Japanese startups, also require careful
consideration. Even in cases where only a minority stake in a
startup is contemplated, it is necessary, with the aforementioned
issues in mind, to consider the angle from which due diligence
investigations should be approached. New developments in the legal
framework governing investments in startups is anticipated with the
continuing evolution of the startup environment in Japan. To meet
the practical challenges stemming from these developments,
collaboration with local counsel will be essential.

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.