The number of Japan’s corporate venture capital (CVC) funds, which invest corporate funds directly in external startup companies, and amount of their investments have risen markedly in recent years. This is especially true in areas of digital transformation (DX) and climate change.

Membership in the Japan Venture Capital Association has more than quadrupled over the last decade. A recent report attributes this growth to various structural developments. For one thing, independent VCs have really broken out in Japan, with “the mark of a maturing startup ecosystem.”

The virtuous cycle needed for this expansion is clear: More VC investments are fueling greater startup successes and leading to improved VC returns, which attracts more capital and talent. The result? VC is becoming ensconced as an asset class, and that accelerates the positive feedback loop.

INVESTMENT STRUCTURE

There are three key investment structures to consider for CVC funds, and each yields a different type of risk mitigation:

• Direct investment from Japan: Does not require the burden of fund formation, but there is a risk that Japanese investors might be directly involved in disputes in the United States (especially startup-related disputes). There is also the blocker entity, which insulates Japanese investors from US taxation and audit risks.
• Investment through US corporate fund: Although investments through a US corporate fund can reduce the risk of Japanese investors being directly involved in disputes in the United States, the fund is treated as a corporation for US tax purposes. In addition, dividends a US corporate fund receives from its portfolio companies are subject to federal corporate income tax.
• Investment through US LP fund: Limited partnership (LP) fund structures can enable Japanese investors to reduce the risk of being directly involved in disputes in the United States while enjoying tax benefits from pass-through taxation. An LP fund is treated as a partnership for US tax purposes and is not subject to federal corporate income tax on dividends received from its portfolio companies.

FUND FORMATION PROCEDURES

In Japan, there are necessary steps to set up a fund. The first step is the incorporation of a blocker entity, which can insulate Japanese investors from US taxation and audit risks, and further reduces the risk of liability exposure in connection with US investments. Tax-exempt individuals in the United States and some foreign investors have used such instruments when participating in private equity or investing in hedge funds.

The next step is to complete a notification of qualified institutional investor and notification of specially permitted business for qualified institutional investors, etc. in Japan, prior to the execution of a limited partnership agreement and subscription agreement by a Japanese investor.

On the US side, the State of Delaware is the preferred jurisdiction for fund formation. Delaware corporate law reflects the latest US business developments and contains provisions limiting directors’ and officers’ personal liability and extends indemnification, making it easier to attract talented people. The Delaware Court of Chancery specializes in corporate practice and has a high degree of business predictability, thanks to dispute resolution by professional judges and the large number of precedents.

Note that this venue also signals prestige, as the majority of US publicly traded companies and more than 60% of Fortune 500 companies are incorporated in the state. At a practical level, Delaware offers prompter processing by authorities compared to other states. As for privacy concerns, Delaware filings do not require much personal identifying information, thereby mitigating the risk of disclosure liability.

KEY TAKEAWAYS ON FUND FORMATION

Prior to the execution of a limited partnership agreement and subscription agreement by a Japanese investor, it is necessary to complete the notification of qualified institutional investor and notification of specially permitted business for qualified institutional investors, etc. in Japan.

• The State of Delaware is preferred for the formation of fund managers and LP funds in the United States.
• In addition to corporate filings related to fund formation, filings with the Commerce Department’s Bureau of Economic Analysis (BEA) and filings under the US Securities Act also need to be considered.

Learn More

For more details on CVC investment fund issues, please see our full presentation, Corporate Venture Capital Investments in US Startups (Part 1): Fund Formation and Investment Structures (conducted in Japanese). This event is part of our 2023 series designed for Japanese companies and funds developing new business models through investment in US startup companies.

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