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In most cases, venture capitalists investing in a Japanese company prefer to structure their investments like a typical Silicon Valley VC financing — using preferred stock and many of the same bells and whistles that afford the venture capitalists a certain degree of control over the portfolio company. VCs who invest in Japan, though, should understand how the Japanese system and Japanese legal requirements differ from those in the U.S. before undertaking such an investment. Quite often, these investors are either represented by U.S. attorneys unfamiliar with the Japanese system or local Japanese counsel unfamiliar with the U.S. system. U.S. attorneys may try to persuade Japanese portfolio companies to execute Silicon Valley-modeled venture capital agreements without a clear understanding as to how such agreements are treated under Japanese law. Local Japanese counsel may be unfamiliar with the various terms and protections a U.S. investor typically obtains in its U.S.-based investments and expects to obtain in its Japan investment. In the first case, the U.S. investor may be surprised to discover that it ended up negotiating for rights that may ultimately be unenforceable in Japan. In the latter case, the U.S. investor may end up with less protection and control over its investment than might otherwise have been possible. The good news is that — with some creative adjustments, careful documentation and a clear understanding of the legal risks involved — several Silicon Valley-type VC techniques can be effectively employed by a U.S. venture capitalist investing in a Japanese company. The typical Silicon Valley VC financing is structured as a purchase of convertible preferred stock. Over the years, many investor protections were added to a preferred stock investment and became standard terms for most VC financings. Convertible preferred stock has been used in Japan for VC financings for the past few years. The use of this type of security is similar in many respects to the use of convertible preferred stock in a U.S.-style VC financing, but with some striking differences. Japan utilizes a civil law legal system, and the statutory scheme that governs most aspects of Japanese corporate law is the Commercial Code of Japan, Law No. 48, March 9, 1899, as amended. Pursuant to the Commercial Code, preferred stock in Japan may have a preference over common stock upon certain liquidation or dissolution events of the company. However, the Commercial Code does not authorize preference payments to be made to shareholders upon a so-called “deemed liquidation” event (e.g., upon the sale of the business or sale of substantially all of the assets of the business). Therefore, in Japanese VC financings, a company and its shareholders will often enter into a separate shareholders’ agreement to set forth, among other matters, the liquidation preferences of the preferred stockholders in the event of a “deemed liquidation.” There are, however, enforceability issues associated with this approach. For one, any party not a signatory to the shareholders’ agreement would obviously not be bound by its terms. Additionally, it has long been held by most Japanese legal scholars and practitioners that if a party to the shareholders’ agreement (e.g., the portfolio company) breached its obligations under such agreement with respect to matters not expressly permitted by the Commercial Code, the non-breaching party’s sole remedy would be to sue for monetary damages pursuant to a breach of contract claim, and would not be entitled to sue for specific performance. Recently, there have been a few legal scholars and practitioners, including professors Kenjiro Egashira and Hideki Kanda of Tokyo University and Kazuhiro Takei of the Japanese law firm Nishimura and Partners, that have argued that breaches of a shareholders’ agreement should be treated the same as a violation of the articles of incorporation of a Japanese company and as such, a shareholder should be able to force the company to abide by its agreements in a court of law. Along with the liquidation preference, it is quite common for a preferred stock to have a priority over the other common stockholders on the payment of dividends. Many U.S.-style venture capital deals also are structured with “cumulative” dividends.” Cumulative dividends are dividends that, if not paid, will accumulate and are added to the amount of a venture capitalist’s liquidation preference. The Commercial Code does allow shares to have differing preferences with respect to the payment of dividends. Similar in many respects to restrictions on paying dividends under the corporate law of most states in the U.S., dividends may only be distributed by a Japanese company to the extent of the balance of a company’s net assets after the subtraction of certain amounts. The Commercial Code also allows for cumulative dividends. Under the Commercial Code, a company may provide in its articles of incorporation for a set dividend on preferred stock that will accumulate yearly until a divided is actually declared. However, the Commercial Code does not allow for unpaid dividends to be paid out upon a liquidation event; therefore, the Commercial Code concept of cumulative dividends may not be helpful to a venture capitalist: If a dividend is never declared, no payment would be made, regardless of how high the value of the accumulated dividends. As a result, as with “deemed liquidation” provisions, provisions that cause unpaid cumulative dividends to be added to the liquidation preference of a preferred shareholder are often built into a shareholders’ agreement, and contain the same enforceability issues discussed above. Holders of convertible preferred stock typically have the right to convert their preferred stock into shares of the company’s common stock. In Japan, both automatic (e.g., forced conversion upon an IPO) and optional (e.g., conversion at the shareholder’s option) conversion provisions may be utilized in a VC financing. Additionally, anti-dilution price protection (an adjustment to the conversion ratio for the benefit of the shareholder if there are subsequent financing rounds in which stock is issued at a price lower than the price such shareholder paid for its stock) and pre-emptive rights (the right for the shareholder to purchase its pro rata share of any subsequent stock issuance to ensure that such shareholder maintains its overall percentage of ownership in the company) also may be employed in a Japanese VC financing. It should be noted that shareholders of a Japanese company are automatically provided with statutory pre-emptive rights if the company’s articles of incorporation provide that the transfer of shares by shareholders requires the approval of the company’s board of directors and the new issuance is not approved by a special resolution of shareholders of the issuing company. (This provision is usually included in the articles of incorporation of most privately held Japanese companies and is designed in part to protect the company from its shares being held by persons not approved by the company, e.g., competitors.) Since statutory pre-emptive rights are not triggered if the new issuance is approved by a special resolution of the shareholders of the issuing company (i.e., 66.66 percent of the shareholders approve the new issuance), pre-emptive rights in Japan are often separately provided to venture capitalists either in the articles of incorporation or by contract. In Japan, a shareholder is provided with certain statutory voting rights pursuant to the Commercial Code. For example, a vote of at least two-thirds of the shares of outstanding stock of a company is required for certain material corporate transactions, including the amendment of a company’s articles of incorporation, the acquisition of the entire business of another company or the sale of all or substantially all of a company’s business. Consequently, this would provide a shareholder who holds more than one-third of the shares of outstanding stock of a company with a veto right over these types of transactions. However, because statutory voting rights are limited and in most cases do not provide a venture capitalist with sufficient protection, usually a venture capitalist doing a deal in Japan would require additional approval rights, either by contract or by amendment to the company’s articles of incorporation. Amendments to the Commercial Code in 2002 now permit Japanese companies to provide special management and voting rights to certain shareholders. Prior to such amendments, the Commercial Code concept of “shareholder equality,” pursuant to which no shareholder generally could have voting rights in excess of what its stock ownership permitted (i.e., one vote per share of stock), made it difficult to allocate additional voting rights to venture capitalists. Pursuant to such amendments, a company may provide in its articles of incorporation that all or part of corporate matters that are required by law, regulation or the articles of incorporation, to be determined by resolution of a shareholders’ meeting or the board or directors shall require, in addition to such resolution, a resolution of a meeting of the shareholders of a specific class of shares (e.g., a class of preferred stock). Consequently, a venture capitalist can now obtain veto/approval rights that may be included in the articles of incorporation of the company, and therefore may be specifically enforced if breached by the portfolio company. Historically in Japan, board nominee rights were not permitted to be included in the articles of incorporation and were usually handled by a separate shareholders’ agreement or voting agreement. The same issues of enforceability as discussed above were therefore present, and the prevailing view among scholars and practitioners in Japan has been that if other shareholders breach their obligation to vote for the venture capitalist’s board nominee, the venture capitalist’s sole recourse would be to sue for monetary damages, pursuant to a breach of contract claim, and would not be entitled to an injunction (and its designee would not be appointed to the board). However, pursuant to the 2002 amendments to the Commercial Code, board nominee rights for holders of a class of securities may be set forth in the articles of incorporation. During the “venture capital boom” in Japan of the late 1990s, many VC deals were consummated in a legal and regulatory environment that could be called anything but friendly. After the burst of the “Internet bubble” in 2000, the Japanese government instituted a variety of sweeping revisions to the Commercial Code with the desired effect of spurring an increase in venture capital investment and entrepreneurialism in Japan. Now, with domestic venture capital activity on the rise, and with many U.S. and other non-Japanese venture capitalists returning to the Japanese market, structuring venture capital deals in Japan from the perspective of a U.S. venture capitalist has once again become a significant endeavor. Venture capitalists experienced with U.S. VC deals should know that with some creative adjustments, careful documentation and a clear understanding of the legal risks involved, the “Silicon Valley model” of venture capital financings can be effectively utilized by any venture capitalist investing in Japan. Randy Laxer is counsel with O’Melveny& Myers in its Tokyo and Silicon Valley offices. He can be reached at [email protected] The author thanks Kohei Yamamoto, a Japanese-licensed attorney at O’Melveny& Myers Gaikoku Jimubengoshi Jimusho Watanabe Kokusai Law Offices, for his assistance with Japanese law issues.Practice Center articlesinform readers on developments in substantive law, practice issues or law firm management. Contact News Editor Candice McFarland with submissions or questions at [email protected]or go to www.therecorder.com/submissions.html.

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