In September 2023, Josys Inc, a Japanese software as a serviceand device management platform, closed a series B funding round of USD93 million. This news was widely covered by tech media outlets in and outside Japan and came as a surprise to the investor community, given the large amount raised at an early stage in a globally difficult funding environment. According to a report compiled by STARTUP DB, the total amount raised by start-ups in Japan in 2023 was estimated to be JPY903.7 billion, a 28% decrease compared to the same period in the previous year. Compared to the United States, where funding amounts have roughly halved from their peak periods, the decrease in Japan is smaller. It can be said that Japan now has one of the best funding environments for start-ups.

Despite a recent overall reduction in investment volume in start-ups, the Japanese government, under the Kishida administration, has continued to actively support the start-up ecosystem. The administration’s commitment is evident in its five-year plan to nurture start-ups, aiming to stimulate innovation and economic growth. This policy framework is set against the backdrop of Japan’s unique monetary policy maintaining an interest rate of (almost) 0%, which contrasts with the tightening monetary policies observed in other major economies.

As for funding practice, in should be noted that the use of venture debt has been gradually increasing in the last 12 months.

Digital Transformation

The technology that accelerates the digital transformation of businesses and organisations, such as AI and software services, continues to attract significant VC interest in Japan. Japanese companies’ needs for the acceleration of growth achieved by the digital shift have intensified as a result of the recent COVID-19 pandemic.

Sustainability

With global and national focuses on sustainability, technologies categorised as “climate tech” and “green tech” have continued to draw VC investment. Japan’s commitment to carbon neutrality by 2050 and the promotion of green technologies align with this trend.

Life Sciences and Healthcare

The life sciences sector, including biotech and pharmaceuticals, has been a strong area of focus for VC investment globally. Japan, with its strong foundation in research and an aging population, presents a significant market and innovation landscape for start-ups in these fields.

Formation of Venture Capital Funds in Japan

In Japan, venture capital funds (“VC Funds”) are typically structured as investment limited partnerships (toshi jigyo yugen sekinin kumiai)under the Limited Partnership Act for Investment. Forming an investment limited partnership is preferable because it allows the leveraging of an exemption for specially permitted businesses for qualified institutional investors (SPBQIIs) under the Financial Instruments and Exchange Act from certain registration requirements.

Structure of VC Funds

VC Funds consist of general partners (GPs), who manage and operate the fund, and limited partners (LPs), who invest in the fund. The fund is established through the execution of a limited partnership agreement (LPA) between GPs and LPs. Typically, to avoid personal liability, partners/principals form a limited liability partnership (yugen sekinin jigyo kumiai) (LLP) and designate this LLP as the GP of the VC Fund.

Overview of the LPA

In Japan, to foster appropriate development of start-up investments, the government (Ministry of Economy, Trade and Industry) published a model LPA in 2010. This model serves as a foundation for efficient negotiation and investment consideration between GPs and LPs, making it the market standard for LPAs in Japan. Key terms that typically become points of discussion include:

• management fee (generally 2%, see 2.2 Fund Economics);
• carried interest (generally 20%, see 2.2 Fund Economics);
• fund size;
• capital calls;
• key person clause (usually designates significant individuals in fund management and operation);
• term (generally ten years, with possible extensions of one to two years by agreement);
• reinvestment/recycling;
• advisory committee (generally consists of representatives from LPs contributing a certain amount); and
• no-fault divorce clauses

Management Fee

Partners and principals, as GPs of a VC Fund, receive management fees in accordance with the LPA. Typically, the management fee is calculated as an annual rate (generally 2%) of the total committed capital. For instance, the model LPA calculates the management fee during the commitment period based on the annual rate of the total committed capital, and after the commitment period based on the annual rate of the total drawn-down capital. Generally, the rate after the commitment period is set lower than during the commitment period, reflecting the reduction in management costs.

Carried Interest

Partners and principals, as GPs of a VC Fund, earn carried interest based on the LPA. Typically, carried interest is calculated at a certain rate (generally 20%) of the VC Fund’s returns that exceed the total committed capital.

Depending on the distribution (waterfall) method, returns may either be distributed on a deal-by-deal basis between LPs and GPs, or the original contributions plus a certain percentage of preferred returns may first be distributed before distributing any returns to the GP (all-contributions-plus-preferred-return-back-first model).

GP’s Commitment

It is common for partners and principals, as GPs of a VC Fund, to make their own investments in the fund pursuant to the LPA. The purpose is to incentivise the GP to improve investment performance. Additionally, the model LPA proposes clauses obliging the GP to ensure that their contribution amounts to a certain percentage (for example, 1%) of the total LP contributions.

Key Term: Governance

In VC Funds, the GP has sole discretion over investments. However, to appropriately address potential conflicts of interest and other issues, establishing an LP Advisory Committee (LPAC) is considered a market standard. The LPAC provides appropriate advice to the GP based on the LPA.

Key Term: Transparency

The LPA includes provisions mandating the GP to provide information related to the VC Fund’s finances, risk management, fund operations, portfolio, and transactions.

Regulation of VC Funds

When establishing a VC Fund and raising funds from LPs, it is generally required to register and maintain a Type II Financial Instruments Business and Investment Management Business under the Financial Instruments and Exchange Act. To fulfil these registration and maintenance requirements, strict criteria related to organisation and capitalisation must be met. To take advantage of statutory exemptions from the registration requirements, many VC Funds opt to submit a notification for the SPBQIIs (see 2.1 Fund Structure). It is important to note that foreign VC Funds raising capital from Japanese LP investors and managing those funds are subject to similar regulations, even if the management decisions are made offshore.

Special Business Activities for Qualified Institutional Investors

To submit a notification for the SPBQIIs, the fund must primarily consist of:

• one or more qualified institutional investors (commonly known as professional investors such as securities firms, investment limited partnerships, individuals or corporations with securities exceeding JPY1 billion who submitted appropriate notification); and
• no more than 49 specified investors for special business activities (commonly known as semi-professional investors such as the Japanese national government, local governments, the Bank of Japan, listed companies, corporations with capital or net assets of JPY50 million or more, foreign corporations, individuals who have securities accounts for more than one year and are expected to have investment-type financial assets exceeding JPY100 million and corporations expected to have such assets).

However, if a VC Fund meets the following criteria, individuals with significant investment decision-making capacity – such as officers and former officers of listed companies, and officers, employees, consultants engaged in financial business for more than a year, and having engaged in such within the last five years – may also be included as specified investors for special business activities where the following conditions are complied with:

• the fund’s investment in non-listed company shares or share options exceeds 80%;
• in principle, the fund does not borrow funds or guarantee obligations;
• in principle, the investors may not redeem the fund interest at the investor’s request;
• the LPA specifies certain matters such as reporting to the investors regarding assets under management;
• a document stating that the above requirements are met is provided to the LPs; and
• within three months after submitting the notification for SPBQIIs, a copy of the LPA must be submitted to the Financial Bureau.

Regulations of VC Fund Management and Operation Companies

Typically, the personnel who manage and operate VC Funds are employees of a separate company, which, depending on the type of involvement in the VC Fund, must be registered as an investment advisory business or investment management business under the Financial Instruments and Exchange Act.

Public-Private Funds

In Japan, the amount of funding raised by start-ups has been steadily increasing. A significant factor contributing to this growth is the increase in independent VC Funds, which has been facilitated by LP investments from public-private funds (ie, government-backed VC Funds), as well as direct investments in start-ups by these public-private funds.

A notable example of a public-private fund in Japan is the Japan Investment Corporation (JIC). Under the JIC umbrella, JIC Venture Growth Investments (JIC VGI) established a VC fund in 2020 targeting growth-stage start-ups, with a fund size of JPY120 billion. In 2023, JIC VGI formed another VC Fund with a size of JPY200 billion, aimed at investing in growth-stage start-ups as well as early-stage start-ups in the deep tech and life sciences sectors.

Exit Activities

In Japan, since 2013, there has been a rapid increase in the establishment of VC Funds with a ten-year term, resulting in many VC Funds reaching maturity after 2023. Thus, a characteristic of activities of funds in Japan in recent years has been the invigoration of exit activities by VC Funds, including those not limited to M&A and IPO, but also a second sale. This trend underscores the proactive approach taken by VC Funds towards realising returns on their investments.

Generally, investors analyse a target company from various perspectives during the due diligence, including business, legal, financial, and tax aspects. This analysis encompasses the company’s operational status, revenue prospects, and business risks.

Investments in start-ups are typically minority investments. Moreover, start-ups develop at a rapid pace and the short timeframe from the formulation to the completion of fundraising plans is very short. Consequently, human resources in start-ups available for due diligence are limited, necessitating that due diligence be conducted swiftly and with a focused scope.

Typically, the following items are particularly scrutinised during legal due diligence:

• contracts with shareholders (eg, past investment agreements and shareholders’ agreements);
• material contracts with customers and others;
• intellectual property rights;
• government licences and permits;
• compliance with laws and regulations; and
• litigation, disputes and other contingent liabilities.

It is noteworthy that compared to VC investors, Japanese business corporations and VC Funds formed and operated for such business corporations (CVCs) tend to conduct thorough due diligence, even for early-stage investments. This is because, in addition to capital gains, Japanese business corporations and CVCs aim for business synergies with start-ups through business collaborations and alliances, necessitating the verification of such synergies.

Overview of a Fundraising Round

When fundraising involves a new investor as the lead investor, the timeline from the commencement of due diligence by the lead investor to the execution of the investment often spans one to two months. However, the process may take more time in the case of an auction process (bidding procedure) involving multiple potential lead investors. The process typically unfolds as follows:

• negotiation of the term sheet;
• execution of a non-disclosure agreement (NDA);
• due diligence;
• contract negotiations between the start-up and the lead investor;
• contract negotiations between the start-up, current shareholders (existing investors), and follow-on investors;
• signing and
• closing.

Interest Alignment Among Parties in a Fundraising Round

Negotiations of the key investment terms with the start-up are principally handled by the lead investor. Follow-on investors typically invest based on the terms agreed upon between the lead investor and the start-up. In many cases, follow-on investors only have a limited opportunity to negotiate the terms.

In relation to existing shareholders, the “shareholders’ agreement” and “distribution agreement” (see 3.4 Documentation), which involve both new investors and existing shareholders as contracting parties, are re-negotiated and executed among all relevant parties. The content of these agreements is usually based on the terms agreed upon in the previous fundraising round. The new lead investor, likely to become the largest shareholder among the investors, tends to demand the most preferential rights, while seeking to reduce the rights of existing investors (such as rights to appoint directors or veto rights). Start-ups may adopt a stance to maintain the rights of existing investors as much as possible, especially in the early stages. However, as the company progresses to later stages and the number of shareholders increases, it becomes common for start-ups to negotiate with existing investors to streamline and reduce their rights, given that having fewer shareholders with governance rights enables more agile management.

Common Shares and Preferred Shares

After the establishment of a start-up, investments during the seed stage (by angel investors or seed accelerators, for example) often involve common shares. On the other hand, when VC Funds invest, preferred shares are commonly used, as they offer advantages to both the VC Funds and the founders.

Under the Companies Act of Japan, corporations are permitted to issue different classes of shares with varying rights, such as layers of preference in dividend or distribution upon liquidation. Class shares that have priority over common shares in certain respects (eg, dividend payments or distribution of assets upon liquidation) are generally referred to as “preferred shares”.

In addition to priority in dividend payments and distribution of assets upon liquidation, a stock corporation can create different class-share structures in connection with the points listed below under its articles of incorporation. Additional rights beyond those stipulated by law can be created as shareholder contractual rights under the relevant agreements.

• Voting rights – voting or non-voting (preferred shares of start-ups generally have voting rights).
• Transfer restrictions – provisions that prohibit the transfer of preferred shares without the company’s consent (approval from the shareholders’ meeting or the board of directors), which is standard for (non-listed) start-up shares.
• Shareholder put option (share conversion right) – provisions allowing shareholders to request the conversion of preferred shares into (in most cases) common shares.
• Company call option (compulsory share conversion) – provisions allowing the company to request the conversion of preferred shares into (in most cases) common shares.
• Veto rights – matters that require a resolution at a meeting of a specific class of shareholders (eg, a meeting of series A preferred shareholders).
• The right to appoint board members.

Preferred shares of start-ups commonly contain transfer restrictions, a shareholder put option, and company call options. A company call option is a particularly common provision for preferred shares in Japan as the lead underwriter will demand the conversion of all preferred shares into common shares when a start-up applies for its IPO. Conversely, veto rights and the right to appoint board members are less typically included in the preferred shares’ terms.

Alternative Investment Methods

Convertible bonds and convertible equity are also used as investment methods especially in the seed stage, when quick, low-cost fundraising is required.

Convertible bonds

These are debt instruments that can be converted into preferred shares issued in a future fundraising round. Convertible bonds are often introduced during the seed stage, where business plan validation and company valuation are challenging for investors, or as bridge financing between fundraising rounds. In both cases, given the uncertainty as to the valuation and the future growth of the start-up, investors would be subject to relatively higher risk. A discount rate or valuation cap is occasionally set to allow investors to acquire preferred shares in the future round more advantageously than investors participating in such round. Recently, venture debt has increasingly been used as an alternative financing method for start-ups.

Convertible equity

These are warrants (stock acquisition rights under the Companies Act) that can be converted into preferred shares issued in a future fundraising round (similar to financial instruments such as SAFE or KISS notes in the United States). Similar to convertible bonds, convertible equity allows for the deferral of company valuation to a future financing round. Further, convertible equity is often preferred particularly because it is not classified as debt on the balance sheet of the issuer company.

Contracts Related to Start-Up Investments

Generally, in fundraising rounds where a VC Fund makes an investment, the following three contracts are considered the main agreements:

• Investment agreement – a contract that primarily stipulates the conditions for purchasing newly issued shares of the company (eg, matters related to the class and terms of the shares and the issuance, representations and warranties, pre-closing covenants by the founders (managing shareholders) and the issuer company, and conditions precedent).
• Shareholders’ agreement – a contract that provides for rights and obligations of shareholders in connection with the company’s governance and the operations of the company (eg, information rights, governance rights such as board seats and board observer rights, veto rights over certain material decisions made by the company), as well as rules on the transfer of shares of the company (eg, restrictions on transfer).
• Distribution agreement – a shareholders’ agreement which specifically governs the rules of distribution of proceeds received by shareholders of the company in the event of a “deemed liquidation” (such as a change of control in the event of a merger or acquisition) as per the liquidation preference clause under the articles of incorporation of the company.

The parties to each contract are typically as follows:

• Investment agreement – the company, founders (managing shareholders) and new investors (although there is a growing trend to exclude the founders from the contracting parties, so that they do not bear any personal liabilities relating to, for instance, a breach of the company’s representations and warranties).
• Shareholders’ agreement – the company, founders (managing shareholders), major existing shareholders and new investors.
• Distribution agreement – the company and all shareholders, including founders (managing shareholders).

While it is challenging to make a comparison with the National Venture Capital Association’s model legal documents for start-up investment in the United States, generally speaking, the investment agreement corresponds to the terms contained in the stock purchase agreement, and the shareholders’ agreement includes the terms of the voting agreement, right of first refusal and co-sale agreement and investor’s rights agreement.

However, the distribution agreement is considered unique to Japanese start-up documentation practice. In Japan, it is customary to agree on a “deemed liquidation” mechanism for distributing the proceeds among shareholders in the event of a change in control transaction, according to the rules (or waterfall) of the liquidation preference under the articles of incorporation of the company. Under this mechanism, the proceeds from the sale are distributed first to the preferred shareholders to recover the amount of liquidation preference. Afterwards, in many cases, any residual amount would then be shared between preferred shareholders and common shareholders on a pro-rata basis. To fully enforce the “deemed liquidation” mechanism against all the shareholders of the company, it is desirable for all the shareholders, including common shareholders such as angel investors and employee shareholders, to become parties to the distribution agreement. This is why the distribution agreement is typically executed separately from the shareholders’ agreement to which not every shareholder becomes a party.

“Model Documents” Developing in Japanese Start-Up Market

Although various organisations and law firms have published their own model documents for start-up investments, there are currently no model documents used across the Japanese market. The Ministry of Economy, Trade and Industry (METI) and the Japan Fair Trade Commission published guidelines in March 2022 on major issues and provisions in contracts for start-up investments: the “Guidelines on Business Collaboration with Start-Ups and Investment in Start-Ups” (the “Start-Up Investment Guidelines”). These guidelines provide certain “ideal” practical guidance on start-up investments, trying to achieve an optimal balance between interests of investors and start-ups (eg, the appropriate investor approach to a shareholders’ put option). The guideline is widely read by the start-up community.

When the investor is a business corporation or CVC provider aiming for business collaboration or co-development of products with the start-up, it has become increasingly common for such non-financial investors to execute a separate side letter with the start-up, detailing the terms of the business alliance or co-development of products.

Liquidation Preference

Preferred shares issued to VC investors typically have a mechanism that allows for the prioritised recovery of, typically 100% (or more) of their original investment amount in the event of a liquidation of the company. It is common in Japan to structure the liquidation preference in such a way that the preferred shares issued in later rounds have priority over those issued in earlier rounds (or the preferred shares issued in later rounds are at least given the same priority as the most prioritised preferred shares of the earlier rounds).

Anti-dilution Provisions

As mentioned in 3.3 Investment Structures, preferred shares issued by start-ups typically include the investors’ right to request the conversion of preferred shares into common shares (shareholder put option) as well as the right for the start-up to compulsorily convert preferred shares into common shares (company call option). The conversion price of preferred shares into common shares is initially set to be equal to the original issue price of the preferred shares, resulting in a 1:1 conversion ratio between the common shares and the respective preferred shares. In the event that the company has to implement a “down round,” where fundraising occurs at a lower issue price than the original issue price of the preferred shares, anti-dilution provisions kick in to adjust the number of common shares issued upon conversion of the preferred shares upwards (ie, the economic effect on the preferred shareholders is equivalent to receiving newly issued common shares without making an additional investment).

Under the anti-dilution mechanism, possible adjustment methods include the full ratchet method and the weighted average method (broad-based and narrow-based). In practice, the broad-based weighted average is most commonly used in the market, whereas the full ratchet can be considered rare.

Veto Rights and Pre-emption Rights

In a shareholders’ agreement, consent rights (veto rights) of shareholders holding a certain percentage of shares (commonly defined as “major shareholders” in practice) are provided for certain material decision-making of the company, which typically includes new fundraising. Furthermore, it is common for a shareholders’ agreement to include pre-emption rights of existing shareholders, which entitle such shareholders to participate in a new financing round of the company to acquire newly issued shares in proportion to their shareholding ratio.

It should be noted that “pay to play” provisions (which provide that certain rights of the existing shareholders, including pre-emption rights, can be forcibly amended or extinguished if such shareholders do not participate in a down round) are not common in the Japanese market.

Founders of a start-up often remain as the sole shareholders for a certain period of time after the start-up’s establishment. Angel investors, who do not directly involve themselves in the management of start-ups, also become holders of common shares along with the founders. In this earlier stage of the company, when no strict outside investor oversight is necessary, the governance structure of the company is usually as simple as it can be – just a few directors (who are, at the same time, officers) managing the company, without establishing a formal board of directors as a permanent company body.

As the company grows and begins to accept investments from VC investors, typically from around the series A fundraising, the company generally establishes a formal board of directors with a company auditor to monitor the directors, as per the requirements under the Companies Act. In the Japanese market, this governance structure typically remains up until the governance changes required in anticipation of an IPO.

Investor Involvement in Governance

Investors require certain involvement in the governance of a start-up in the shareholders’ agreement. For instance, “hands-on” VC investors usually require, and actively exercise, the right to appoint directors. Furthermore, it is common for “major shareholders” holding more than a certain percentage of shares to have other governance rights such as consent rights (veto rights), and/or prior-consultation rights, in connection with certain material decision-making of the company (eg, issuance of shares, organisational restructuring, M&A or liquidation).

Even follow-on investors, if they are to purchase more than a certain percentage of shares, may be able to negotiate for the right to appoint observers to the board meetings (and other management meetings essential to the operation and management) of the company.

Additionally, it is common for the shareholders’ agreement to provide for information rights of all shareholders to receive certain financial and non-financial information of the company both on a regular and as-needed basis, as well as the right to receive prior notice upon occurrence of a material event affecting the company (eg, commencement of litigation).

Representations and Warranties

It is common for an investment agreement to include representations and warranties of the company, though their scope and level of detail may vary depending on the stage of the start-up company.

For early-stage start-ups, basic representations and warranties (such as due incorporation and good standing of the company, due authority to execute the investment agreement, and non-violation of any laws and articles in relation to the performance of the investment agreement), as well as limited-scope representations and warranties related to the company (such as the number and class of shares already issued) are usually stipulated.

For start-ups in the middle stage and beyond, the scope and level of detail of representations and warranties related to the company’s business would usually expand. For example, the following items are commonly included:

• material contracts;
• intellectual property rights;
• governmental licences and permits;
• compliance with laws and regulations;
• labour/employment;
• tax; and
• litigation, disputes and other contingent liabilities.

As start-ups reach later stages, full-scoped, more detailed representations and warranties are observed in the Japanese market. Traditionally, both the company and the founders (managing shareholders) have been required to make representations and warranties, the breach of which will lead to joint and several liability. However, there is a growing trend in the Japanese start-up community toward shielding the founders (managing shareholders) from incurring personal liability under the fundraising documentation, which may end up bankrupting them personally together with the company, if things go wrong.

Pre-closing Covenants

Investment agreements also stipulate pre-closing covenants that the company (and the founders in some cases) must comply with from signing to closing. These provisions are designed to ensure that the company is operated in a proper manner during the interim period, preventing any reduction in the company’s value. Typical items include:

• implementing all necessary procedures required for the share issuance (such as obtaining necessary shareholders’ approval);
• operating the business and managing assets with the care of a prudent manager only within an ordinary course of business of the company;
• not to undertake certain material actions (eg, disposal of material assets) without the investor’s prior consent; and
• taking actions to remedy certain issues identified during due diligence

Indemnity

In standard investment agreements, investors are entitled to claim indemnity arising from a breach of representations and warranties or contractual obligations. However, as start-ups are usually in desperate need of cash to conduct their business activities, such as hiring and R&D, and therefore do not normally keep excess cash at hand, it would not be feasible for the investors to fully recover the claimed amount from the company. Even if the investor could recover the full amount, it may not be an optimal solution as the result could be to shorten the runway of the company.

Due largely to the limited usability of an indemnity as discussed above, investment agreements used to require that both the company and the founders (managing shareholders) be held liable on a “joint and several” basis with respect to a breach of representations and warranties and contractual obligations, allowing investors to claim indemnity from the founders (managing shareholders) as well. Furthermore, in cases of a material breach, investment agreements used to entitle investors to exercise share redemption rights to demand the buyback of shares they purchased (ie, investor’s put option exercisable upon a material breach). However, the Start-Up Investment Guidelines mentioned in 3.4 Documentation pointed out that investor’s put option against the founders (managing shareholders) is an undesirable practice that should be rectified. Since then, there has been an observable decrease in the use of investor’s put options against the founders (managing shareholders) exercisable upon a material breach.

In Japan, subsidy programmes that directly provide various benefits by the Japanese government to Japanese start-ups are well-developed. Recently, the Japanese government is promoting investments in start-ups through the tax incentives mentioned in 4.2 Tax Treatment and government investments in VC Funds outlined in 4.3 Government Endorsement.

Taxation (General)

Income earned from stock investments is typically processed either through dividend taxation or capital gains taxation.

Angel Tax System

To encourage angel investors to reinvest the cash earned from start-up investments, if they invest in start-ups that are in the pre-seed or seed stage, they can, under certain conditions, deduct the amount of their investment amounts from their stock transfer profits for that year.

Open Innovation Promotion Tax System

The government has adopted the following special system called the Open Innovation Promotion Tax System applicable only to business corporations and CVC providers with the aim of encouraging them to invest in start-ups in Japan:

• when acquiring newly issued shares of a start-up, under certain conditions, up to 25% of the share acquisition price can be deducted as an expense;
• when acquiring a majority control of a start-up (ie, acquiring more than 50% of shares), under certain conditions, up to 25% of the share acquisition price can be deducted as an expense.

The Japanese government has established equity investment frameworks for start-ups through government-related entities as follows:

• direct investments in start-ups by the JIC, which is 96% funded by the Ministry of Finance, with a fund size of JPY120 billion;
• investments in VC Funds by the Organisation for Small & Medium Enterprises and Regional Innovation, JAPAN (“SME Support JAPAN”), with an investment track record of approximately JPY600 billion from 1999 to March 2023; and
• investments in research and development-oriented start-ups by the New Energy and Industrial Technology Development Organisation (NEDO), which has allocated a budget of JPY100 billion for supporting deep tech start-ups as part of its initiative.

Founders: Subscription of Common Shares

Each founder of a Japanese start-up subscribes ordinary shares at the time of incorporation, having an interest that encourages him or her to continue working for the company until an exit through an IPO or M&A.

Directors and Employees: Granting of Stock Options

Most Japanese start-ups grant stock options to their directors, officers and key employees as an incentive compensation to secure their long-term commitment.

Other Measures to Seek Long-Term Commitment

In addition, when VC Funds invest in Japanese start-up companies, the VC Funds may request them to incorporate non-compete obligations in the agreements as well as clauses that are intended to prevent the resignation of the founders and key persons.

Founders

For founders, ordinary shares and stock options are typically used as incentives for their long-term commitment. If multiple founders incorporate a Japanese start-up company, it has become common for the co-founders to enter into a founders’ shareholders’ agreement. Typically, this agreement makes sure that ordinary shares (and stock options) held by a leaving founder shareholder will be transferred to the remaining founder shareholders upon leaving, except for the already vested portion of common shares held by the leaving founder.

Directors, Officers and Employees

For directors, officers and employees, stock options are typically used as incentives for their long-term commitment. The conditions of stock option exercise commonly stipulate that the grantee must be a director, an officer or an employee at the time of the exercise and that the stock options cannot be exercised until either the company goes public or a change of control (deemed liquidation) of the company occurs. It is typical to set a vesting schedule, or cliff, as condition for the stock option exercise, whereby the number of exercisable stock options would increase according to the length of period of service for the company.

Overview

In principle, stock options are not taxed at the time they are granted, while at the time of exercise, income tax is applied to the amount by which the fair market value of the shares at the time of exercise exceeds the exercise price. Additionally, at the time of share sale, capital gains tax is applied to the amount by which the sale price of the shares exceeds their fair market value at the time of exercise.

Stock options that meet certain requirements (tax-qualified stock options) are not taxed at the time of exercise, and taxation is deferred until the time of share sale. At the time of share sale, capital gains tax is applied to the amount by which the sale price of the shares exceeds the exercise price.

Requirements for Tax-Qualified Stock Options

The major requirements for tax-qualified stock options are as follows:

• Grantees:
1. directors, officers, employees of the issuing company or its subsidiaries;
2. certain heirs of the above (excluding major shareholders and their spouses, relatives, and other related parties) – auditors are not included; or
3. certain highly skilled external professionals.
• Issue price: free of charge.
• Exercise period: from two years to ten years after the resolution to grant stock options (for unlisted companies established less than five years ago, up to the day after 15 years).
• Exercise price: not less than the fair market value of the shares at the time of the contract (the recent tax reforms clarified that the issuing company may calculate the fair market value of the shares by dividing the net asset value by the number of outstanding shares; in such calculation, the company may deduct from the net asset value the amount of preferential distribution upon liquidation with regard to the existing preferred shares and, as a result, it has become clear that start-up companies can issue tax-qualified stock options while keeping the exercise price low, regardless of the stage of the company).
• Exercise limit: the total exercise price must be less than YPY12 million (JPY24 or 36 million if certain conditions are met), annually.
• Transfer restrictions: prohibition of transfer to third parties.
• Custody agreement: a trust agreement regarding the management of shares acquired through the exercise of stock options must be concluded between the issuing company and a securities company, etc, and the shares must be subject to trust management after acquisition; however, if shares with transfer restrictions are acquired through the exercise of stock options, the issuing company does not need to satisfy such requirement and it may manage such shares by itself.

In recent years, there have been significant tax reforms aimed at relaxing the requirements for tax-qualified stock options.

Stock Option Pool

If a private company (ie, a company whose shares are subject to transfer restrictions under the articles of incorporation) issues stock options, a resolution at the shareholders’ meeting is required and the shareholder resolution may set a maximum number of options to be issued and delegate the issuance within that limit to the board of directors. Nonetheless, the determination of the exercise price and exercisable period for the stock options cannot be delegated to the board of directors. Further, any delegation to the board is limited to the issuance of stock options within one year from the date of the shareholders’ resolution.

In practice, the issuance of stock options often becomes subject to consent rights held by certain major shareholders under the shareholders’ agreement. That said, it is common for a start-up company to create a stock option pool (generally, 10–15%) approved by the requisite shareholders, where the issuance of stock options within such pool does not require another shareholder consent at the time of issuance.

Investors’ rights relating to a sale at the time of an IPO (such as piggy-back registration rights) are not commonly provided in the investment agreement or shareholders’ agreement. For an investment made at a time close to an IPO, the investor may be required, by Tokyo Stock Exchange (TSE) regulations and/or at the request of underwriters, to agree on a lock-up period during which the investor is precluded from selling the purchased shares.

Regarding an exit through M&A, the distribution agreement (or shareholders’ agreement) commonly includes a drag-along right exercisable by a (super)majority of shareholders, which enables a co-ordinated smooth sale of the company. The mandatory exit events (deemed liquidation events) typically include a change of control of the company (eg, more than 50% of the shares in the company are sold to a third party).

As discussed in 3.4 Documentation, the distribution agreement provides for a waterfall payment among shareholders with respect to the proceeds from the sale, as per the liquidation preference under the company’s articles of incorporation.

Share transfers by investors are subject to two types of restrictions: restrictions under the articles of incorporation of the company and restrictions under the investment-related agreements such as the shareholders’ agreement. Firstly, the articles of incorporation typically require that any transfer of shares be approved by either the shareholders’ meeting or the board of directors of the company. Secondly, investment-related agreements prevent investors from freely transferring their shareholding, unless otherwise permitted under the rules provided in the agreement (eg, subject to rights of first refusal or tag-along rights exercisable by other shareholders).

In the context of Japanese start-ups, it is noteworthy that the main scenario for exit is through IPOs, with exits through M&A being less common. According to a report published by the METI, 68% of exits of Japanese start-up companies in 2019 were through IPOs. This is attributed to several factors including the M&A market for targeting Japanese start-ups being in a growth phase, a strong inclination towards IPOs among entrepreneurs, and the ease of listing on Japanese stock exchanges.

The timeline from founding a start-up to IPO varies among companies, but on average, it is said to take about seven to eight years.

While listing on foreign markets is not unheard of, typically, IPOs occur on the TSE, involving both the issuance of new shares and the sale of existing shares.

Traditionally, there has been no established secondary market for shares of start-up companies in Japan. Thus, shareholders of start-ups needed to find buyers on their own or through introductions by the company or its founders.

However, in order to increase the liquidity of start-up shares, the Japan Securities Dealers Association has implemented a number of legal amendments and rule changes since 2022. These led to the launch of a Private Trading System (PTS) in July 2023, which, however, is accessible only to specific investors for now.

When a start-up in Japan solicits for its shares, it must pay attention to the disclosure regulations under the Financial Instruments and Exchange Act (FIEA).

Specifically, if a company offers securities to potential investors, it could be subject to public-offering disclosure obligations, including filing of a securities registration statement via the Electronic Disclosure for Investors’ NETwork system (EDINET). The securities registration statement must include securities information as well as corporate information (including financial statements, audit report, details of the business and risks associated with the business). Therefore, a start-up wishing to offer securities without making public disclosure would opt for private placements satisfying certain requirements:

• the number of offerees (not “placees”) in Japan is fewer than 50 (small number placement);
• offerees are limited to qualified institutional investors (QIIs) as designated under the FIEA (QII limited placement); or
• offerees are limited to professional investors as designated under the FIEA (professional investors limited placement).

When a foreign VC Fund acquires shares in a Japanese company, it needs to comply with the foreign direct investment (FDI) regulations under the Foreign Exchange and Foreign Trade Act of Japan (FEFTA). The regulations are comprised of pre-closing notification obligations and post-closing reporting obligations, depending on the type of business conducted by the company or the nationality of the foreign VC Fund.

Under the FEFTA, an FDI investment into the category of “sensitive” businesses may not be executed for the 30 days following the filing of the prior notification (the “prohibition period”). That said, if the transaction is considered to cause no harm to national security, the period can be shortened to two weeks. If, however, the transaction poses national security concerns, the prohibition period may be legally extended for up to five months. In practice, if the review process is not completed within the prohibition period, the foreign investor is required by the government to withdraw the notification and resubmit it once the review is completed (clearance will be issued promptly after resubmission).

The authors are not aware of any instance where a foreign VC Fund abandoned a planned investment in a Japanese start-up due to a failure to clear FDI approvals. Further, there is no observable trend for foreign VC Funds foregoing investments in Japanese start-ups due to strict enforcement of the FDI regulations under the FEFTA.