A Q&A guide to venture capital law in Japan.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
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This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.
Venture capital typically refers to investments in privately held companies with a rather short history. These investments aim to obtain capital gains if and when the companies are able to go public.
Private equity typically refers to investments in more mature companies, including but not limited to listed companies, which need funds to recover from credit problems or to grow.
While most of the major venture capital firms in Japan were established in the early 1990s, private capital became active after 2000. As private capital became active, a few venture capital firms also started private equity businesses, but the venture capital and private equity players are currently independent of each other. However, since venture capital business is now facing some difficulties (see below, Market trends), venture capital funds may target more mature businesses as buyout investments.
The investment methods of private equity are much wider than those of venture capital, including different types of debt financing.
The sources of funding of early stage companies are relatively few, and venture capital investments are the most important source of funding for these companies. Other sources of funding for early stage companies include government collaboration (such as grants and subsidies), and tie-ups with established companies for research and development.
Any particular venture capital fund can target a specific industry. Venture capital as a whole invests in a variety of businesses, including retail, media, financial, energy, IT, biotech, communications and healthcare.
Since 2008, the venture capital market in Japan has been shrinking. This trend is based on the data published by the Japan Venture Capital Association. For example:
Venture capital investments by member venture capital firms declined 17% to JPY18.1 billion (as at 1 November 2011, US$1 was about JPY77.9) in 2010, compared with JPY21.9 billion in 2009.
The number of investee companies that obtained venture capital financing from venture capital firms in 2010 was similar to that in 2009.
These declining market conditions have not changed in 2011. However, this trend may change in the near future considering the fact that the number of newly established venture capital funds in 2010 has reportedly more than doubled from 2009. The number of companies conducting an initial public offering (IPO) has also increased in 2011.
There are no recent or proposed regulatory changes affecting the venture capital industry.
Capital gains. When an angel investor buys shares in a specific small investee company (as defined in section 37-13 of the Act on Special Measures concerning Taxation) (Specific Small Company), the investor can deduct the purchase price of those shares from his capital gains earned on the disposal of other shares.
The capital loss relating to an angel investor’s shares in a Specific Small Company can be deducted from the investor's capital gains from the disposal of other shares, in the three-year period starting with the year of the capital loss (section 37-13-2, Act on Special Measures concerning Taxation).
Income tax. When an angel investor buys shares of start-up investee companies as defined under the Act on Special Measures concerning Taxation, the investor is entitled to deduct the purchase price (up to JPY10 million) from the investor's regular income as a donation deduction (section 41-19, Act on Special Measures concerning Taxation).
Venture capital funds typically receive funding from institutional investors and individuals. Institutional investors include financial institutions, corporate investors and funds of funds. The proportion of funding from government and private employee benefit plans is very small.
As venture capital business has been shrinking (see Question 1, Market trends), it is now very difficult for venture capital firms to set up a new fund with many outside investors. Currently, venture capital firms are relying heavily on their parent or group companies.
Venture capital funds are typically structured as partnerships, which are tax transparent (pass-through) entities for income tax purposes. Consequently, the tax liabilities of the partnership's investments in portfolio companies pass through to the underlying investors, in proportion to their respective interests in the fund.
If the investee company is in its early developing stage, co-investment with other funds is not common. Other than at the start-up stage, venture capital funds usually invest in portfolio investee companies with other funds.
Most venture capital funds are structured as limited partnerships. In 1999, the Diet of Japan passed the Limited Partnership Act for Investment establishing the limited partnership for investment (Investment LPS). Its limited partners only have limited liability, leaving the general partners with unlimited liability. Therefore, most venture capital funds are structured as an Investment LPS.
Most venture capital funds have a ten-year term. The first half of the term is generally devoted to investing in new investee companies. The second half is taken up by the maintenance of the portfolio with a view to exiting the investments.
The investment policy of Japanese venture capital funds has generally been to invest a relatively small amount (less than JPY100 million on average) in each of many portfolio companies. The historical internal rate of return related to such investments is relatively low.
Partnership interests in venture capital funds are characterised as deemed securities under the Financial Instruments and Exchange Act (FIEA). Therefore, the FIEA applies to venture capital business.
For the promoter to solicit partnership interests in the course of trade, he must obtain a Type II Financial Instruments Business licence. For the manager (who is usually the operating partner of the venture capital fund) to make venture capital investments, he must obtain an Investment Management Business licence.
However, if the business is a specially permitted business for qualified institutional investors and so on, as defined in the FIEA, no licence is required and filing in advance with the office of the Prime Minister is sufficient.
No other licences are generally required to establish and operate a venture capital fund.
Partnership interests in venture capital funds are deemed securities under the FIEA, and are therefore regulated by the FIEA. However, public placement of deemed securities is defined as a solicitation of applications to acquire newly issued securities, that will result in the securities being held by at least 500 people who respond to the solicitation. Therefore, a venture capital fund rarely has to comply with prospectus rules.
The promoter and manager who hold the relevant licences (see Question 9) are called Financial Instruments Business Operators. They must follow various rules on business activities including marketing, as set out in the FIEA.
The relationship between the investors and the fund is principally governed by the fund's partnership agreement. It is very common to include provisions in the partnership agreement that protect investors' interests, including:
Requirements about the qualifications of investee companies.
Prohibition on transactions involving conflicts of interest.
General partner's compensation.
Right to dismiss the general partner for cause.
In addition, the Limited Partnership Act for Investment is compulsory in certain respects. This also safeguards some investors' rights.
Most venture capital investments take the form of shares (equity). Sometimes, venture capital funds receive share options with or without bonds as a result of bridge financing.
Venture capital funds value an investee company from various viewpoints. If the target is a start-up, the unique nature of its intellectual property or business model is the key factor. The size of the relevant market, its competitiveness and opportunities for the target are also very important. The funds also look at the quality of the management team.
In some industries, such as biotechnology, there is a tendency for a professional with an IPO record in other start-up companies to be in the management of the investee company. Venture capital funds value this positively.
Venture capital funds conduct due diligence relating to business, financial and legal matters of potential investee companies. The matters investigated are comprehensive and similar to typical M&A transactions, although the depth of due diligence varies.
A share purchase agreement and a shareholders' agreement are commonly used in a venture capital transaction. A share purchase agreement is sometimes called a share subscription agreement if a fund purchases newly issued shares from the investee company.
The use of shares of different classes is not common in Japan (see Question 17). Venture capital funds tend to seek contractual protections to the extent possible.
Venture capital funds typically receive, in a share purchase agreement, detailed representations and warranties from the investee company or its founder relating to the investee company's:
Legal and regulatory compliance.
In addition, venture capital funds require, in a shareholders' agreement, that the investee company and its founder respect and perform certain detailed negative and positive covenants.
A stock company can issue shares of different classes, including preferred shares (Companies Act) (see Question 18). However, since the use of shares of different classes is still not common in Japan, venture capital funds generally obtain ordinary shares in its portfolio companies.
A stock company can issue shares of different classes (Companies Act) (although this is not common; see Question 17). Class rights may relate to the following:
Distribution of residual assets.
Capacity to exercise the right to vote as a shareholder.
Company approval being required to transfer shares.
Demand by a class of shareholders that the company acquire the shares of that class.
The company being able to acquire shares on the occurrence of certain conditions.
The company being required to acquire all of a certain class of shares by resolution of the shareholders.
Certain matters to be resolved at a shareholders' meeting or board meeting that require, in addition to the resolution, a resolution of a certain class of shareholders.
The directors or company auditors being required to be elected by a certain class of shareholders.
Venture capital funds normally request, and are granted in a shareholders' agreement, board representation rights, when the investment is a relatively large shareholding ratio of the portfolio company. If the investment is only a small shareholding in an investee company, the venture capital fund is generally satisfied with information access rights. These sometimes include the right to have its representative attend board meetings of the investee company as an observer.
Venture capital funds further impose on portfolio companies and its founder contractual obligations not to take certain significant actions in relation to the investee company without the fund's prior consent, including:
Changes to its articles of incorporation.
Reductions of the amount of its capital.
Election and removal of directors.
Changes to the business.
Execution of material agreements.
Remuneration of directors.
Budgets and business plans.
Almost all investee companies are stock companies with articles of incorporation that contain share transfer restrictions, where the transfer of shares is subject to the approval of the board of directors.
In addition, most shareholders' agreements contain rights of first refusal and co-sale that are granted to the venture capital fund. These enable the fund, when a founder seeks to sell its shares to a third party, to buy the shares on the same terms or to sell its shares on the same terms to the third party.
Co-sale rights, otherwise called tag-along rights, are very common in shareholders' agreements. On the other hand, drag-along rights are not as common in Japan.
It is common to include anti-dilution provisions in shareholders' agreements. These grant venture capital funds the right to participate in future financings, so that they will be able to maintain their shareholding ratios.
The board of directors of the investee company must approve the transaction. A resolution of the shareholders is also required to issue new shares. Since the creation of shares of a different class is uncommon in Japan, amendment of the articles of incorporation is necessary for an investee company to be able to issue shares other than ordinary shares. These shareholders' resolutions require a majority of two-thirds of outstanding voting shares.
It is uncommon for the costs of the venture capital investment to be reimbursed by an investee company.
It is commonly understood to be beneficial for the founders to maintain a shareholding in the portfolio company. In most cases, the portfolio company is granted the right to issue share options to the founders and employees, up to 10% of all outstanding shares.
If share options comply with certain requirements, they can be qualified share options with favourable tax treatment. No capital gains in relation to the share option are recognised until the shares obtained through the exercise of the option are sold.
It is common to include a covenant in the shareholders' agreement to oblige the founder to manage the portfolio company so that it will go public in a specified period. Failure to do so, or another breach by the founder of his commitment to the company, could trigger a put option for the venture capital fund on its shares in the investee company, with some practical limits (see Question 27).
In some shareholders' agreements, the venture capital fund is granted a put option on its shares, exercisable in certain circumstances against the founder at a specified price. Failure to go public in a certain period of years may be one of the trigger events of this option. However, it is rare for a venture capital fund to successfully exercise this option, because the founder of an unsuccessful company also usually incurs financial losses.
The secondary market that deals with venture capital funds' shares in portfolio companies that have not yet gone public is not well developed. It is not easy for venture capital funds to dispose of shares of investee companies that have not gone public.
More realistic exits from an unsuccessful company are the sale of the company and the sale of its assets. While venture capital funds can directly recover some of its investments through the sale of the company, the sale of the company's assets involves the additional need to conduct liquidation procedures.
IPOs have been the typical form of exit for venture capital funds. However, since the number of IPOs in Japan has dramatically dropped in the past few years, Japanese venture capital funds are struggling to find alternative forms of exit.
Some are trying to explore IPOs in foreign countries (such as Singapore, Hong Kong and South Korea). However, a sale of the shares is the most available form of exit, including sales resulting from the exercise of tag-along or co-sale rights.
The exit rights are, subject to the parties' negotiations, granted to the venture capital fund in the shareholders' agreement.
Qualified. Japan; New York
Areas of practice. Corporate; M&A; litigation.
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