[co-authors: Masamichi Sakamoto, Kiyoshi Nakayama, Naoki Matsuo]*
World Law Group member firms recently collaborated on a Global Venture Capital Guide that covers more than 30 jurisdictions on investment approval processes, typical investment sectors and investment structures on Venture Capital deals (and more!).
The guide does not claim to be comprehensive, and laws in this area are quickly evolving. In particular, it does not replace professional and detailed legal advice, as facts and circumstances vary on a case-by-case basis and country-specific regulations may change.
This chapter covers Japan. View the full guide.
- In your jurisdiction, which sectors do venture capital funds typically invest in?
Venture capital (VC) funds in Japan mostly invest in the IT-related sector (52.8% of the total investment amount for FY2018) and in the bio/medical/healthcare sector (19.9% of the same). The computer and related equipment/IT service sector, which comprises 44.9% of the same has received the largest investment from VC. The bio/pharmaceutical sector makes up 13.6% of the same.
- Do venture capital funds require any approvals before investing in your jurisdiction?
1 Overview of restrictions
The following are three types of restrictions on investments by offshore venture capital funds in Japanese companies:
- Prior Notification or Post Reporting requirement under the Foreign Exchange and Foreign Trade Act of Japan (“Foreign Exchange Law”);
- Prior Notification requirement under the Act on Prohibition of Private Monopolization and Maintenance of Fair Trade of Japan (“Antimonopoly Law”); and
- Certain restriction to foreign investments in certain regulated sectors.
2-1 Prior Notification or Post Reporting requirement under the Foreign Exchange Law
If a foreign investor intends to acquire 10% or more of the shares of a target company whose business does not include a Designated Sector, as a general rule, the investor is required to file a report with the Bank of Japan (“BOJ”) after the acquisition.
On the other hand, if a target company’s business operates in a Designated Sector, a foreign investor’s acquisition of one or more unlisted shares of the target company, or 1% or more of the total outstanding listed shares in the target company, will require prior notification to be filed with the BOJ. However, a foreign investor who satisfies certain requirements, such as not assuming an officer position in the target company (“Requirements for Exemption of Prior Notification”), may only be required to file a report after the acquisition. If prior notification is required, a 30-day waiting period is applied as a general rule.
2-2 Certain restrictions to foreign investment in certain regulated sectors
To operate a business in communication, broadcasting, aviation or consigned freight forwarding sectors, a company must seek the approval of competent authorities. If a foreign corporation holds a certain number of voting rights or more in the company or if non-Japanese officers occupy a certain number of officer positions in the company, such approval will not be granted. This may restrict the offshore venture capital funds’ investment in the above sectors.
- Are there any legal limitations to an offshore venture capital fund acquiring control or influencing the business, operations or governance of an investee entity?
As discussed in above 2-1(2), if an offshore venture capital fund is expected to be involved in the target company’s management, the Requirements for Exemption of Prior Notification are generally considered not satisfied. In such a case, the acquisition of one or more unlisted shares in the target company, or 1% or more of the total outstanding listed shares in the target company, by such a fund requires prior notification to be filed with the BOJ.
Additionally, subject to certain exceptions, prior notification must be filed with the BOJ if a foreign investor (i) consents to a proposal to add operations in a Designated Sector to the business purpose of a target company, (ii) consents to a proposal that the investor itself or a related person assume the position of director or statutory auditor of the target company which has been conducting businesses in a Designated Sector, or (iii) presents and consents to a proposal to transfer/abolish businesses in a Designated Sector of a target company.
- Would an investor be required to undertake an antitrust analysis prior to investment? When would such a requirement be triggered?
Yes. Under the Antimonopoly Law, an investor (a member company or group of combined companies whose domestic total sales exceed JPY 20 billion) is required to file prior notification with the Fair Trade Commission (“FTC”) if they intend to acquire shares in a target company (a company whose domestic total sales plus such sales of its subsidiaries exceed JPY 5 billion), and if the ratio of voting rights in the target company held by the group of combined companies is expected to exceed 20% or 50% respectively after the acquisition..
As a general rule, the investor is prohibited from acquiring the shares for 30 days from the day on which the above prior notification is accepted by the FTC.
- What are the preferred structures for investment in venture capital deals? What are the primary drivers for each of these structures?
In Japan, using a stock company or a form of limited partnership (which is so called as “LPS”) to invest in venture capital deals is fairly common. One of the advantages of using an LPS is the ability to limit the liabilities of investors to the amount of the investors’ investment. In addition, an LPS enjoys preferential tax treatment.
For investors it is common to subscribe for a share class providing certain preferences or privileges. In particular, a combination of the following share structures are often used: (i) preferred shares for distribution of surplus, (ii) preferred shares for distribution of residual assets, (iii) shares with put option in which a company is obliged to purchase the shares upon shareholders’ demand, and (iv) shares subject to call in which a company is permitted to compulsorily purchase the shares.
With respect to the preferred shares for distribution of residual assets in (iii) above, in exit stages, there are many cases in which a company is not dissolved or liquidated. Therefore, even in cases of M&A or disposition through share transfer, setting forth a structure granting shareholders preferential rights for distribution of consideration or for distribution of residual assets in a company’s articles of incorporation or shareholders’ agreement (Deemed Liquidation Clause) is fairly common.
Regarding shares with a put option in (iii) above and shares subject to a call option in (iv) above, conversion of such shares into ordinary shares is generally conducted before listing the shares. A company is permitted to compulsorily convert shares that are subject to a call option. However, if the ordinary shares converted to be delivered as consideration include a fractional share, and while such shares are held by shareholders who are unwilling to accept the conversion, court permission is required, which takes considerable effort and time. To avoid this situation, a company can issue the above shares with a put option to shareholders and set forth in a shareholders’ agreement an obligation of shareholders to exercise their put options when the board of directors decides to go public.
- Is there any restriction on rights available to venture capital investors in public companies?
If an investor intends to purchase shares in a listed company outside of a financial instruments exchange market and its shareholding ratio after the purchase is expected to exceed 5% of the total outstanding shares, such purchase is required to be conducted through takeover bid (“TOB”). However, even in such a case, if the investor purchases the shares from 10 shareholders or less within 60 days, the purchase is not subject to the above TOB requirement. Nevertheless, if the investor’s shareholding ratio after the purchase is expected to exceed one-third (1/3) of the total outstanding shares, a formal TOB is still required to give equal selling opportunities to all shareholders.
In addition, listing rules may restrict the execution of an agreement between a venture capital investor and a public company-investee which grants the venture capital investor special rights (e.g., veto rights on important matters or rights to appoint officers).
- What protections are generally available to venture capital investors in your jurisdiction?
Under the Companies Act of Japan, shareholders have claims in the distribution of surplus and residual assets by virtue of their rights to receive economic benefit directly from a company. Shareholders are also granted the right to participate in a company’s management to some extent such as the right to vote, the right to ask questions and make proposals at shareholders’ general meetings and the right to convene shareholders’ general meetings. Moreover, shareholders have the right to supervise and correct acts conducted by directors including various rights to file actions such as (i) the right of action to rescind a resolution of shareholders’ general meeting, (ii) the right of action to invalidate share issuances, (iii) the right to demand injunction against misconduct, and (iv) the right to demand inspection of various documents including board meeting minutes.
To be able to exercise the above rights (e.g., right to make a proposal at a shareholders’ general meeting and right to convene a shareholders’ general meeting), shareholders are required to hold a certain number of voting rights, a certain ratio of voting rights or a certain ratio of shares.
- Is warranty and indemnity insurance common in your jurisdiction? Are there any legal or practical challenges associated with obtaining such insurance?
When compared to Europe and the US, warranty and indemnity insurance is not common in Japan. While warranty and indemnity insurance has recently become popular in M&A transactions conducted in Japan, the same is not true in venture capital investment agreements generally.
- What are common exit mechanisms adopted in venture capital transactions, and what, if any, are the risks or challenges associated with such exits?
There are several exit mechanisms adopted by venture capital companies such as M&A, IPO and liquidation. In Japan, M&A including disposition of shares (62.8% of the total exit cases in FY2018) and IPO (21.1% of the same) are the methods primarily adopted. In particular, selling shares to other companies and secondary funds (29.3% of the same) is the most common, followed by the repurchase of shares by the company owners (23.1% of the same).
The share transfer method is often adopted because of the simple procedure as compared to the other methods. For example, in a share transfer, certain procedures to protect creditors or employees are not required. However, the share transfer method often results in a lower sales price when compared to the sales price of an exit done through an IPO.
The challenges inherent in IPO are as stated in 10) below.
- Do investors typically opt for a public market exit via an IPO? Are there any specific public market challenges that need to be addressed?
In the past, an IPO was the most predominant exit method in Japan. Nowadays, however, because of the negative image associated with M&A, such as hostile acquisitions or forced selling, use of this exit method has waned. Due to the challenges related to an IPO, as stated below, the number of exit cases through M&A has been growing.
An IPO requires time to prepare for and is generally costly. The same is true to maintain a listing. Major shareholders who may be obliged to hold their shares for a certain period of time (e.g., a 90-day or 180-day “lock-up period”) are not permitted to sell their shares or earn capital gains on them before the end of the lock-up period. Furthermore, an IPO is subject to insider trading regulations under the Financial Instruments and Exchange Act of Japan. A system supplementary to the regulations has been established, under which a listed company is entitled to claim a return of capital gains earned by a major shareholder who actually holds 10% or more of the total voting rights if such shareholder earns the gains from short-term trading (i.e., before the end of the lock-up period).
 “Venture White Paper 2019” published by Ippan Shadan Houjin Venture Enterprise Center
 The Japanese government has designated certain sectors that require protection, which include national security, maintenance of public order, safeguard of public safety and smooth functioning of Japanese economy.
 The above “Venture White Paper 2019”