What is a Deemed Liquidation Clause in an Investment Agreement?

In investment contracts, there may be a provision called a deemed liquidation clause. There are many factors to consider regarding the deemed liquidation clause, such as when it should be stipulated and what its content should be. Therefore, this article will explain the deemed liquidation clause in investment contracts.

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What is a Deemed Liquidation Clause?

A Deemed Liquidation Clause (みなし清算条項) is a provision that stipulates that in the event of a merger or acquisition (M&A) involving the issuing company, the company is considered to be liquidated, and distributions are made to investors. In investment contracts and the like, if a Deemed Liquidation Clause is stipulated, shareholders who are subject to the application of the Deemed Liquidation Clause can receive preferential distributions, prioritized over other shareholders, from the consideration obtained through the M&A.

Generally, regarding the Deemed Liquidation Clause, it is often stipulated that if preferential rights are recognized for the distribution of residual assets, the consideration obtained through the M&A will be distributed in the same manner as the distribution of residual assets.

Purpose of the Deemed Liquidation Clause

The primary purpose of the deemed liquidation clause is to protect the rights and interests of shareholders such as venture capitalists (VCs) who have acquired shares at a higher price than the founders or those involved from the inception of the company. Even if a venture company is aiming for an IPO, there are many cases where it does not reach the IPO stage, and there are many cases where mergers and acquisitions (M&A) occur, such as being acquired by another company or being absorbed by another company. When an M&A occurs, if the consideration is distributed according to the shareholding ratio, it is conceivable that VCs who have acquired shares at a high acquisition price will suffer a significant loss.

For example, in a company that has issued 10,000 shares, let’s assume that the founders or those involved from the inception of the company have acquired 9,000 shares (90% shareholding ratio) at 10,000 yen per share. In this case, the acquisition price of the shares is 90 million yen.

On the other hand, let’s assume that VCs, etc., have acquired 1,000 shares (10% shareholding ratio) at 100,000 yen per share. In this case, the acquisition price of the shares is 100 million yen. Later, if the venture company grows and there is talk of an M&A with a market capitalization of 500 million yen, from the perspective of the founders or those involved from the inception of the company, if they can receive a distribution according to the shareholding ratio, they can receive a distribution of 450 million yen, and the profit will be 360 million yen, subtracting the acquisition price of the shares, 90 million yen.

On the other hand, for VCs, etc., if they receive a distribution according to the shareholding ratio, they will receive a distribution of 50 million yen, but since the acquisition price of the shares is 100 million yen, they will end up suffering a loss of 50 million yen. As a founder or someone involved from the inception of the company, there is a possibility of executing an M&A even if a loss occurs for VCs, etc., as they can receive a profit of 360 million yen. The main purpose of the deemed liquidation clause is to protect the rights and interests of VCs, etc., who would suffer a loss in the above situation.

On the Effectiveness of Deemed Liquidation Clauses

As previously mentioned, deemed liquidation clauses are typically stipulated in cases where preferential rights are granted for the distribution of residual assets. In such cases, the consideration obtained through M&A is distributed in the same manner as the distribution of residual assets. In the case of such deemed liquidation clauses, the company is deemed to have been liquidated, and the distribution is carried out in the same manner as the distribution of residual assets. This allows the type of shares with preferential shares for residual assets to receive preferential distribution of the consideration obtained through M&A.

If a deemed liquidation clause is not stipulated, shareholders with preferential distribution rights for the distribution of residual assets can receive preferential repayment when the company is dissolved or liquidated. However, in the event of an M&A such as an acquisition or merger, they would not be able to receive preferential distribution.

Thus, the effectiveness of a deemed liquidation clause allows shareholders with preferential distribution rights for the distribution of residual assets to receive preferential distribution even in the event of an M&A such as an acquisition or merger.

About the Scope of Deemed Liquidation Clauses

When stipulating a deemed liquidation clause, it is crucial to clearly define its scope. For instance, even when we broadly refer to M&A, there are various methods to consider, such as acquisition (transfer) of shares, subscription of new shares, share exchange, business transfer, merger, and company split. Therefore, if the scope of the deemed liquidation clause is not clearly defined, it could potentially lead to disputes between the parties involved.

Furthermore, in the case of M&A such as business transfers or company splits, the M&A consideration is distributed to the company, not the shareholders. As a result, it is not possible to stipulate this as a deemed liquidation clause, and it is necessary to separately stipulate a provision that specifies distribution to shareholders.

Triggering Conditions for Deemed Liquidation Clauses

In the above, we explained the targets of the deemed liquidation clause, but it is also necessary to clearly define the triggering conditions for the deemed liquidation clause. For example, it is conceivable to stipulate that the liquidation clause will only be applied if the fair market value exceeds a certain amount in the case of targeted M&A. The triggering conditions need to be thoroughly examined, taking into account factors such as the fair market value, the share acquisition price of shareholders such as VCs, and the shareholding ratio of each shareholder.

Distribution of Consideration through Deemed Liquidation Clauses

As previously mentioned, in the case of deemed liquidation clauses, it is common for the distribution of the consideration obtained through M&A to be stipulated to be distributed in the same manner as the distribution of residual assets, especially when preferential rights are recognized for the distribution of residual assets. Therefore, the distribution of consideration is often the same as the distribution of residual assets.

However, it is not always necessary to stipulate that the distribution of consideration under the deemed liquidation clause should be done in the same manner as the distribution of residual assets. It is also possible to stipulate that the consideration should be distributed in a different manner. In this case, there is also the issue of how to consider the relevant consideration from a tax perspective. Therefore, when distributing the consideration in a different manner from the distribution of residual assets, it is necessary to keep in mind the tax issues and make the necessary stipulations.

Is it necessary to stipulate a deemed liquidation clause in investment contracts or shareholder agreements?

There is ongoing debate about whether a deemed liquidation clause can be stipulated not only in “contracts” such as investment contracts and shareholder agreements, but also in the “articles of incorporation”. Regarding class shares with a deemed liquidation clause, there is a negative view that it should not be stipulated in the articles of incorporation because it does not fall under Article 108 of the Japanese Companies Act, which stipulates the content of class shares.

Furthermore, on page 50 of the “Main Points to Consider in Contracts for Healthy Venture Investment in Japan” published by the Ministry of Economy, Trade and Industry in March 2018 (Heisei 30), it is stated that “Deemed liquidation is set as a contract clause that is voluntarily agreed upon. In other words, unlike preferential dividends and residual property distribution based on the effect of the articles of incorporation, which affect all shareholders, it brings preferential distribution to investors as the effect of the contract.”

Considering this description, it can be said that the Ministry of Economy, Trade and Industry believes that the deemed liquidation clause is stipulated by contract, not by the articles of incorporation.

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Example of a Deemed Liquidation Clause

For example, a deemed liquidation clause may look something like this:

Article ○ (Deemed Liquidation Clause)

The contracting parties agree that the consideration received by each shareholder due to a corporate acquisition will be calculated in the same way as the formula for the distribution of residual assets stipulated in the articles of incorporation.

Summary

We have discussed the deemed liquidation clause in investment contracts. When venture companies negotiate investment contracts with venture capitalists (VCs) and the like, they are often proposed to include a deemed liquidation clause. To receive investment from VCs, venture companies need to meet their demands. However, to avoid future disadvantages, it is necessary to carefully consider the contents of the deemed liquidation clause. Since expert knowledge is required for the consideration of the deemed liquidation clause, it is desirable to seek advice from a lawyer who is an expert in this field.