What are the Equity Clauses in Investment Contracts?

Various clauses are stipulated in the content of an investment contract, and there may be clauses related to shares.

From the investor’s perspective, clauses related to shares, which are accepted as consideration for investment, are important in the investment contract. From the company’s perspective, it is also an important clause that needs to be clearly stipulated, considering the relationship of the management team’s shareholding ratio and preventing the outflow of shares to the outside. Therefore, this article will explain the clauses related to shares in the investment contract.

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Provisions Regarding Shares in Investment Agreements

In investment agreements, the following provisions regarding shares can be considered:

1. Provisions regarding the preferential subscription of newly issued shares, etc.
2. Provisions regarding preferential purchase rights and pre-emptive rights
3. Provisions regarding joint sale rights and transfer participation rights
4. Provisions regarding the transfer of shares
5. Provisions regarding drag-along rights

Provisions on the Preferential Subscription of Newly Issued Shares

For Venture Capitalists (VCs) and similar entities, preferentially subscribing to newly issued shares can help maintain their shareholding ratio.

By maintaining their shareholding ratio, VCs can exercise their voting rights as shareholders and maintain control. In addition, they can earn returns proportional to their shareholding ratio during stock listings or M&A, making the maintenance of their shareholding ratio a crucial matter for VCs.

Therefore, investment contracts may include provisions that allow VCs to preferentially subscribe to new shares issued by venture startups. Even with such provisions, it is generally not expected that venture companies will face significant risks.

However, when setting these provisions, the following two points should be carefully considered:

Issuance of Stock Options

Stock options are rights that allow company executives, employees, and investors to purchase shares of a corporation at a certain exercise price. Venture companies often use stock options to attract and retain talented individuals. Therefore, it is in the company’s best interest to use stock options to secure top talent. As such, it is advisable to exclude stock options from the provisions regarding preferential subscription. If not specifically stipulated, stock options could fall under the scope of these provisions, potentially hindering the company’s ability to use them to attract talent.

Period for Exercising Preferential Subscription Rights

If the period for exercising preferential subscription rights is not specified, VCs may delay exercising their rights, which could hinder the company’s financing progress. To avoid such situations, it is advisable to specify the period for exercising preferential subscription rights in the investment contract.

Provisions on Preemptive Purchase Rights and Right of First Refusal

What are Preemptive Purchase Rights and Right of First Refusal?

The provisions on the preferential subscription of newly issued shares, which we explained above, are clauses that grant the right to preferentially subscribe when the “company” issues new shares. On the other hand, preemptive purchase rights and right of first refusal refer to the right to allow those who have these rights to preferentially purchase the shares that have become the subject of transfer when a specific shareholder transfers their own shares.

Purpose of Provisions on Preemptive Purchase Rights and Right of First Refusal

The main purposes of preemptive purchase rights and right of first refusal are as follows:

1. The purpose of increasing one’s own shareholding ratio by purchasing shares
2. The purpose of preventing the transfer of shares to third parties who are not favorable to the company

Can Preemptive Purchase Rights and Right of First Refusal be Granted to Managers?

The cases of purchase due to the exercise of preemptive purchase rights and right of first refusal can be summarized as follows:

• When the manager transfers and the manager purchases
• When the manager transfers and the investor purchases
• When the investor transfers and the manager purchases
• When the investor transfers and the investor purchases

In the case where an investor transfers shares, there are many cases where it does not matter whether the manager or the investor purchases, as long as the shares can be sold. Also, from the manager’s perspective, there are many cases where they would prefer to purchase the shares themselves rather than having them purchased by unfavorable third parties. Therefore, there is a certain rationality in the manager preferentially purchasing when the investor transfers shares.

Therefore, there are many cases where preemptive purchase rights and right of first refusal are granted to managers. Also, in order to achieve the above-mentioned two purposes, it is often necessary to purchase all, not part, of the shares, so it is often the case that all, not part, of the shares are purchased.

And when transferring multiple shares, it is common practice for those who have exercised their preemptive purchase rights and right of first refusal to proportionally purchase the shares when there are multiple such persons.

Provisions on Joint Sale Rights and Transfer Participation Rights

What are Joint Sale Rights and Transfer Participation Rights?

Joint sale rights and transfer participation rights refer to the right that allows other shareholders to jointly sell their shares when a specific shareholder intends to sell theirs. In other words, it is a right that allows shareholders to secure an opportunity to sell their own shares.

Purpose of Provisions on Joint Sale Rights and Transfer Participation Rights

The main purpose of provisions on joint sale rights and transfer participation rights is to prevent a situation where only specific shareholders sell their shares and profit from it, by sharing the opportunity to sell shares among all shareholders. This is particularly important for minority shareholders, as they may miss the opportunity to sell their shares if a majority shareholder sells their shares and the parent company or corporate structure changes unexpectedly. As a result, they may lose the opportunity to profit from an exit.

Therefore, provisions on joint sale rights and transfer participation rights can be particularly important for minority shareholders.

Can Joint Sale Rights and Transfer Participation Rights be Granted to Managers?

The cases of participation in sales due to the exercise of joint sale rights and transfer participation rights can be summarized as follows:

• When a manager transfers shares and the manager participates
• When a manager transfers shares and an investor participates
• When an investor transfers shares and the manager participates
• When an investor transfers shares and another investor participates

We have explained that there is a certain rationality in granting preferential purchase rights and pre-emptive rights to managers, and there are many cases where they are granted to managers.

However, it is generally not common to grant joint sale rights and transfer participation rights to managers. For investors such as VCs, there is a necessity and rationality to secure an opportunity to transfer at a certain time by granting joint sale rights and transfer participation rights.

On the other hand, for managers, unlike investors such as VCs, the main purpose is not to invest in the company, but to manage the company. Therefore, for managers, unlike investors such as VCs, there is no necessity or rationality to grant joint sale rights and transfer participation rights and secure an opportunity to transfer at a certain time, and it is generally not common to grant joint sale rights and transfer participation rights.

However, in cases where it is planned from the beginning that the manager will transfer shares, joint sale rights and transfer participation rights may be granted exceptionally.

Points to Note When Stipulating Provisions on Joint Sale Rights and Transfer Participation Rights

For joint sale rights and transfer participation rights, it is important to clearly define how to determine the number of shares that can be transferred, and how to handle the situation when a person who wishes to purchase shares changes the number of shares they wish to purchase.

Also, joint sale rights and transfer participation rights may be stipulated simultaneously with preferential purchase rights and pre-emptive rights in the content of the investment contract. Therefore, when they are stipulated simultaneously, it is necessary to consider how to adjust the relationship between the two.

Provisions Regarding the Transfer of Shares

In investment contracts, it is common to make some sort of agreement regarding the transfer of shares in order to balance the interests between venture companies and venture capitalists (VCs). For instance, there may be a clause stipulating that the approval of VCs is required when the management transfers shares. On the other hand, it may be explicitly stated that VCs can freely transfer their shares. This is because it is recognized that there is a need and rationality for VCs to secure opportunities to transfer shares at certain times.

However, if VCs are allowed to freely transfer their shares to undesirable parties for the company, it could potentially harm the company. Therefore, it is conceivable to negotiate provisions that, while generally allowing VCs to freely transfer their shares, require the company’s approval for the transfer of shares to specific individuals, thereby imposing some restrictions on the transfer.

Provisions Regarding the Drag-Along Right

The Drag-Along Right, also known as the compulsory sale right, is defined as “the right that allows investors to force M&A or exit involving the management team and other shareholders under certain conditions” (Tetsuya Isozaki, “Equity Finance for Startups,” page 139). For more information about the Drag-Along Right, please refer to the article below.

Conclusion

We have explained the clauses related to shares in investment contracts. The clauses concerning shares can affect the shareholding ratio and the return at the time of Exit, making them important for both the company and investors such as VCs. Therefore, it is necessary to clearly define these in the investment contract.

However, considering the clauses related to shares in investment contracts requires specialized knowledge. Therefore, it is advisable to have a contract drafted by a specialist lawyer or to seek advice from a lawyer.