Author: | Published: 4 Jan 2001
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Traditionally, at least five factors have worked against a vibrant Silicon Valley-style venture capital market in Japan:

  • Cultural bias against risk capital;
  • A limited number of venture capitalists and incubators active in the market;
  • Absence of angel investors;
  • No clear path to liquidity; and
  • Legal factors.

Despite an abundance of available capital, the Japanese market has historically been unwilling to invest in venture start-ups, owing in large part to a cultural and psychological aversion to risk. The best evidence of this bias can be seen in the overwhelming investment of choice for the typical Japanese family: postal savings accounts, notable for the miniscule interest rates they offer depositors. This distaste for risk has not been limited to Japanese households, however. The venture capital industry in Japan, which has existed in some form for over 20 years, has generally taken a more conservative approach to investing than its counterpart in the US, eschewing the Silicon Valley practice of investing broadly with the expectation that only a few investments will show a return (either as a result of a lucrative IPO or the sale of the company). The traditional Japanese investment fund, typically the venture financing arm of a Japanese financial institution, will conduct extensive due diligence of its investment targets and, once an investment has been identified, pool risk by investing through a syndicate system which might might include up to 15 partners. Moreover, the motivation of these venture capital investments was not necessarily to achieve a liquidity event such as an IPO or sale, but rather to build relationships with growing companies that would be sources of business for the syndicate partners' parents (Japan's large commercial banks) down the road.

In the past few years, a number of developments have significantly changed the Japanese venture capital market. First, there has been a significant flow of foreign venture capital firms and incubators into Japan, as well as growth in the number of domestic venture capital funds and angel investors. On the homefront, companies like Softbank have revolutionized the domestic venture capital industry. Softbank is thought to have been among the first to take a Silicon-Valley approach to venture investing, making numerous investments and hoping that a few big pay days will more than offset the losses incurred from unsuccessful investments. Softbank alone has invested in over 400 start-ups, most of which are internet ventures. On the other end of the venture capital spectrum, grass-roots organizations have begun to sprout in Japan, designed to introduce young entrepreneurs to wealthy individual angel investors. Simultaneously, foreign firms have focused further on Japan, either by recently entering the market (most notably, Soros Fund Management and Credit Suisse Asset Management), or by strengthening existing venture capital activities in the country (including major investment banks such as Warburg Pincus, Goldman Sachs and Patricof & Co). As in the US, the bulk of the money invested by these firms – whether foreign or domestic – will go to new economy start-ups.

The increased availability of both foreign and Japanese venture capital has made it easier for Japanese entrepreneurs with promising ideas to source funding. However, other obstacles have also historically stood in the way of a robust Silicon Valley-style venture capital market in Japan. One such obstacle is the Japanese Commercial Code, which continues to restrict the types of capital structures start-ups can establish, and also places limits on the issuance of stock with preferred features. Companies are also prohibited by the Commercial Code from issuing over 10% of outstanding shares of stock options to employees, which may be insufficient to spread among equity-hungry staff.

In addition, Japan has long suffered from a dearth of exit strategies for those investing risk capital. Until the recent launch of the Mothers and Nasdaq Japan stock exchanges, strict listing rules for the most reputable Japanese stock markets (including the prestigious Tokyo Stock Exchange) required a company to demonstrate, among other things, that it was generating profits before it would be eligible for listing (few of the companies going public in the US or other jurisdictions today could meet such a requirement). Another hurdle is the rule prohibiting a listing company from issuing new shares during the fiscal year in which a listing application is filed. This rule is problematic because it forces holders of preferred shares to convert to common stock, and thereby lose the special rights associated with their preferred shares, by the end of the fiscal year preceding the year of the IPO, often well in advance of an IPO. Finally, cultural and legal factors have often made non-IPO liquidity options, such as trade sales and management and leveraged buyouts, unavailable to venture start-ups, although they have begun to occur.

We will focus below on how the Japanese Commercial Code and exchange listing requirements have evolved over the past few years to help venture investment in Japan.

The commercial code: friend or foe?

Capital structure and related issues

Typically, emerging technology companies in the US begin their existance by issuing a large number of of shares at a low price, with no minimum par value, give the start-up flexibility in several ways. First, it allows the founder to obtain a large number of shares at the outset, which means that more shares can be issued to more employees and advisers as incentive options with less dilutive effect on the founders. The low per-share value results in a low exercise price for options, making it easier for recipients to exercise. Also, the large number of shares and low per-share value enhances the marketability of the shares when the company goes public.

In contrast, Japanese start-ups often issue just two hundred shares of ¥50,000 ($467) par-value stock on formation. Since the Commercial Code limits the number of shares that a company is authorized to issue to four times the number of existing issued and outstanding shares, a start-up with only 200 shares of stock outstanding can issue only 600 shares of stock in the next round of financing. Legal restrictions on the number of shares which can be issued result in a significantly higher average share price in Japan compared with the US. Such high values inhibit the liquidity of the shares, since only investors with large amounts of capital can afford them. It also virtually prohibits the use of the shares for employee incentive options, because i) a single share represents too large an interest in the company to be used realistically as a stock option, and ii) the cost of exercising the options would be too high for most employees to bear.

These problems can be ameliorated by issuing a large number of shares of no-par stock at a low price, a practice which is allowed under the Commercial Code. No-par stock is stock that does not have a preset minimum value, which dictates the minimum issue price, stipulated in the issuing company's articles.

Despite its availability, no-par stock has historically been overlooked in Japan in favour of issuing stock at par value, because companies have resorted to cross-shareholding of the expensive shares, rather than offering the shares for sale on the open market. Moreover, stock options have not been a component of the traditional employee compensation package, so high per-share values have not traditionally been a concern. The boom in technology start-ups in Japan, however, has created a demand for a way to allocate interests in emerging companies to investors and employees efficiently. There are indications that the use of no-par stock among Japanese companies is increasing: this past October, two companies listed on Nasdaq Japan, each with more than 7 million shares outstanding post IPO, and a per-share IPO price of under ¥2,000.

Despite its usefulness, no-par stock carries certain requirements. First, no-par stock must be authorized in the issuing company's articles. If a company has already been formed with 200 shares issued at typical par value (¥50,000), several rounds of issuances, with accompanying board and shareholders' approvals are required in order to issue the desired number of shares because of the four-times issued limit on the number of authorized shares. In addition, if the company wishes to effect a stock split, the paid-in capital of the company would need to be raised to a level high enough to yield a per-share value of at least ¥50,000 per share after the split is completed. Tax considerations will also need to be taken into account.

Equity compensation

The issuance of stock options to employees of start-up companies has long been a common practice in the US because it is believed that giving employees an ownership interest will incentivize them to work towards increasing its value. The issuance of stock options to employees in Japan, on the other hand, has only been allowed under the Commercial Code since 1997.

The Commercial Code allows companies to issue one of two types of stock options (but not simultaneously): treasury stock options or warrant stock options (also called new stock options). Whether a company chooses to adopt a treasury or warrant stock option plan, it may not issue a total number of shares issuable upon exercise of options which exceeds 10% of the company's outstanding shares. Furthermore, a company may not issue stock options to more than 49 of its employees in any six-month period without registering its securities.

Treasury and warrant stock options each have a number of drawbacks which make them impractical for most start-ups. Under either a treasury or warrant stock option plan, a company many not increase the size of its stock option pool in excess of 10% of its issued and outstanding shares, nor may it issue options to consultants or advisors to the company, unless it receives the approval of the Ministry of International Trade and Industry (MITI), in which case the option pool can represent up to 30% of outstanding shares. The process of obtaining MITI approval is time consuming and there is no guarantee that approval will be granted. Treasury stock options are often unacceptable because they require a company to buy back shares using funds available for dividends, which most start-ups do not have. Among the disadvantages of adopting a warrant stock option plan are that i) it must be approved by two-thirds of a company's shareholders and ii) optionees must pay the company the exercise price of the option when they decide to exercise their options (unlike in the US, where it is common for a company to sell the optionee's shares, and pay them the difference between the exercise price and the sale price).

A third method of granting stock options is available in Japan (Shinkabu Hikiuke Kentsuki Shasai) which may be preferable in some ways to the treasury and warrant stock option plans. Under this approach a company grants options through issuance of warrants for the subscription of new shares. The warrants for the purchase of new shares are issued as attachments to debt instruments (bonds, or Shasai). Approximately 30 days later, the company redeems the bonds, buys back the warrants, and then grants the warrants to the participants. One advantage of this type of stock option plan is that it allows a company to issue warrants to third parties. Furthermore, there is no limit on the number of warrants a company can issue under a warrant bond-based plan. There are, however, several major drawbacks to a warrant bond-based option plan which need to be carefully considered before opting for this method of offering incentive options: i) the administrative burden associated with issuing the warrants with bonds is such that it can not be done more than once a year, ii) interest must be paid on the bond until it is redeemed, iii) the warrant price is generally 1% to 2% of the bond amount, iv) the warrants are not eligible for beneficial treatment as a tax-qualified stock option plan, and v) any warrants issued to non-employee, non-director third parties must be exercised before the issuer's IPO.

Preferred stock

Another development which has brought Japan's venture capital market more in line with the US market is increased issuance of preferred stock to strategic investors in venture financings. The market for preferred stock is still developing, however, and its use is still not a foregone conclusion in every financing transaction. Issues which companies and investors should note when structuring preferred financings include the following:

Conversion. Because the rights and preferences of preferred stock are extinguished by law when the preferred is converted to common stock, it is preferable not to convert until the IPO is assured. However, local rules prohibit most stock issuances, including the issuance of common stock upon conversion of preferred, in the fiscal year in which the company lists its shares for an IPO. The effect of this rule is to require conversion of the preferred, and therefore end the preferred stockholders' special rights, by the end of the preceding fiscal year, which is typically well in advance of the actual IPO closing.

One approach which investors have taken – given the rights at stake when the board meets near the end of the preceding fiscal year to consider an IPO for the following year – is to require some objective evidence of the practicability of an IPO (a letter from an investment bank, for example) in addition to a board decision in favour of pursuing the IPO and requiring conversion of the preferred. A more stringent solution is to structure convertibility as solely elective, in effect giving investors a veto right over the IPO decision. In some cases, investors have proposed their common be re-converted back into preferred stock if the company does not complete the anticipated IPO within the proposed time frame. At the time of going to press, however, it remains unclear whether legal affairs bureaus and the Ministry of Justice will accept a separate class of convertible common stock for these purposes.

Protective provisions. Another issue encountered when attempting to implement the Silicon Valley-style preferred rights is the enforceability of voting rights, often called protective provisions, which typically require preferred stockholder approval for enumerated actions, such as the issuance of shares with superior rights, amendments to the articles adversely affecting the preferred holders' rights, the payment of dividends, and a merger or sale of the company. Such approval rights cannot be granted to a single class or series of stock alone, since it would violate the principle of shareholder equality by giving a select group of shareholders the unilateral right to decide certain matters that affect the interests of all stockholders. Accordingly, although approval rights of this nature may be granted to a single group of shareholders as a matter of contract in a shareholders' agreement, the rights may not be ultimately enforceable against the Company.

In fact, under the Commercial Code, only certain rights, such as preemptive rights, dividend and liquidation preferences, and limited conversion and anti-dilution formulae may be included in the preferred terms which must be registered with the ward legal affairs bureau whenever the Company issues preferred stock. More expansive rights provisions must be dealt with contractually, resulting in a weaker basis for enforceability than would be the case if they could be written into the company's articles.

Japan's new markets

Within the last year, Japan has seen the launch of two new significant stock exchanges: the Tokyo Stock Exchange's Mothers on November 11 1999 and Nasdaq Japan on June 19 2000. Both Mothers and Nasdaq Japan were developed to serve the same market in Japan that Nasdaq serves in the US, i.e., venture companies many of which are generating losses, but with strong growth potential. From the venture capitalists' perspective, these two new exchanges offer increased liquidity options for Japanese venture investments, primarily owing to the fact that the listing rules for these two stock markets, as well the maintenance standards which must be kept once a company has listed, are much less stringent than the other reputable exchanges in Japan (such as the Tokyo Stock Exchange).

Although both of these exchanges were designed to be venture friendly, liquidity remains a serious problem for Japanese venture companies. It continues to be the case that most companies which list on exchanges have par values of ¥50,000 per share and relatively few shares outstanding. In addition, the few shares which are publicly available in the markets are often traded in large lots. The end result is that Japan's stock exchanges are still off-limits to all but large institutional investors. By contrast, in the US, well over a majority of households invest in the equity markets, where companies are quick to effect stock splits to keep shares affordable to the individual investor. If Japan is to experience a bull market similar to that in the US, the markets will need to become accessible to the small-time investor, primarily by making stock affordable.


Silicon Valley-style venture capital is now gaining a foothold Japan. First, Japanese start-ups now have the option of issuing no-par stock, which means that more shares can be issued to more employees and advisors as incentive options with less dilutive effect on the founders. Second, it is now allowed, subject to certain limitations, to issue preferred stock to strategic investors. Venture capitalists often insist on preferred stock because it affords them a degree of control over their investment. Third, a Japanese company can now issue stock options to its employees and advisors, thereby ensuring they will be properly incentivized to work towards the growth of the company's value. Finally, the launch of Mothers and Nasdaq Japan stock exchanges – and their more flexible listing requirements – have increased the liquidity of venture investments.

Various interest groups have filed petitions with the Minister of Justice seeking amendments to the Commercial Code in order to make Japan significantly more hospitable to Silicon Valley-style financing terms than it is. Among the items included in the petitions are as follows:

  • Relaxation of restrictions on stock options plans;
  • Abolition of stock split regulations;
  • Lowering the minimum capitalization requirement;
  • Relaxation of restrictions on preferred and convertible stock;
  • Relaxation on restrictions on in-kind contributions;
  • Simplification of incorporation procedures; and
  • Simplification of capital increase procedures.

Other important obstacles to the continued development of Japan's venture capital market include the ability of the Japanese to overcome the continuing cultural and psychological hurdles to investing risk capital and, of course, the overall health of the Japanese economy. Finally, there is a relative dearth of qualified management personnel, particularly financial managers, in the Japanese marketplace as well as the absence of a liquid labour market.

Morrison & Foerster

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