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
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.
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.