Explaining the Conversion Claim Clause in Investment Contracts for Startups

An “investment contract” is a contract that a company enters into with investors when receiving investment. An investment contract includes various details, such as the quantity and price of shares, payment conditions, and more.

In order to prevent the dilution of preferred shares held by investors, it is important to properly establish a “conversion request clause” in this investment contract.

In this article, we will explain in detail what kind of rights are given to preferred shareholders in a startup’s investment contract through the “conversion request right”, and what should be stipulated in the “conversion request clause”.

What is the “Conversion” from Preferred Shares to Common Shares?

In the types of shares, shares that have preferential rights regarding specific matters are called “preferred shares”. The right of a shareholder (preferred shareholder) who holds these preferred shares to request the issuing company to convert the preferred shares into common shares is called the “conversion right”.

Under the Japanese Companies Act, it is permitted to issue types of shares that shareholders can request the company to acquire (Article 108, Paragraph 1, Item 5 of the Japanese Companies Act). As consideration for the company acquiring these shares, it can provide money, bonds, new share options, common shares, and other types of shares. The right of a company to acquire preferred shares and provide common shares to the shareholder as consideration (in other words, to “convert” preferred shares into common shares) is distinguished from the “acquisition right” and is called the “conversion right”.

If you want to know more about the “types of shares” stipulated in venture investment contracts, please see the detailed article below in conjunction with this article.

Related article: Issuance and Contents of Preferred Shares in Venture Investment Contracts

When is the conversion right exercised?

When the conversion right is exercised, the shareholder in question will lose various rights attached to the preferred shares. Therefore, it is generally not expected that preferred shareholders will exercise their conversion rights themselves. However, there are limited cases where it may be exercised, as follows:

When a startup goes public (IPO)

In Japan, shares that are publicly listed or over-the-counter registered are usually ‘common shares’. Therefore, when a startup goes public, it is necessary to convert ‘preferred shares’ into ‘common shares’ in advance.

When a startup is acquired

When a startup is struggling with management and is acquired, the buyer may request the elimination of preferred shares, and ask the preferred shareholders to exercise their conversion rights. However, in the case of a successful startup being acquired, the share price should be high, so there is a possibility that preferred shareholders can capture more upside by converting to common shares.

Adjustment Method for Conversion Price in Conversion Request Clause

The ratio at which preferred shares are converted into common shares is called the “conversion ratio”. The conversion ratio at the time of issuance of preferred shares is usually set at 1:1, but if a stock split or free allocation of common shares is implemented afterwards, the total number of common shares increases and the value per share decreases (stock dilution). In this case, a conversion request clause to adjust the conversion ratio is necessary to prevent the loss of benefits for preferred shareholders.

For example, if Series B preferred shares are issued at a price lower than the paid-in amount of already issued Series A preferred shares (※), a clause to adjust the conversion price is set to prevent dilution.
(※) This type of fundraising is commonly referred to as a “down round”.

There are mainly two types of methods to adjust the conversion price to prevent dilution: the “Full Ratchet Method” and the “Weighted Average Method”.

Full Ratchet Method

The Full Ratchet Adjustment, which is advantageous for investors, is a method of adjusting the conversion price in a down round to the same amount as the effective price of the newly issued preferred shares.

For example, if the initial conversion price of Series A preferred shares is set at 1,000 yen and the effective price of Series B preferred shares is set at 500 yen, the new conversion price will be 500 yen, and Series A preferred shareholders will be able to convert into twice as many common shares.

Weighted Average Method

The most commonly used method is the Weighted Average Adjustment, and the new conversion price can be calculated using the following formula:

New Conversion Price = Old Conversion Price × [{Number of shares already issued + (Number of new effective shares × Issue price) ÷ Old Conversion Price} ÷ (Number of shares already issued + Number of new shares issued)]

Furthermore, the definition of “number of shares already issued” in the above formula divides it into ① Broad-Based Method and ② Narrow-Based Method.

Broad-Based Method

In the Broad-Based Method, the total number of the following shares is adopted as the “number of shares already issued”, so the adjustment range is small.

• Issued common shares
• Common shares obtained by converting preferred shares
• Potential shares such as stock options (new share reservation rights) and convertible bond with reservation rights

Narrow-Based Method

In the Narrow-Based Method, the aforementioned “potential shares” are not included in the “number of shares already issued”, so the adjustment range is larger and is considered advantageous for preferred shareholders. In the Narrow-Based Method, there may also be cases where only the number of issued common shares is considered as the “number of shares already issued”.

Let’s take a look at the difference in conversion prices between the Broad-Based Method and the Narrow-Based Method when a startup that has issued three types of shares issues new Series B preferred shares.

• Common shares: 10,000 shares
• Series A preferred shares: 3,000 shares (@100,000 yen = Old Conversion Price)
• Stock options: 2,000 shares
• Scheduled to be issued Series B preferred shares: 4,000 shares (@50,000 yen = Issue price)

[Calculating the conversion price with the Broad-Based Method]

New Conversion Price = 100,000 yen × [{(10,000 + 3,000 + 2,000) + (4,000 × 50,000 yen) ÷ 100,000 yen} ÷ {(10,000 + 3,000 + 2,000) + 4,000}] = 89,474 yen
(※ Fractions less than 1 yen are rounded to the nearest whole number)

[Calculating the conversion price with the Narrow-Based Method]

New Conversion Price = 100,000 yen × [{(10,000 + 3,000) + (4,000 × 50,000 yen) ÷ 100,000 yen} ÷ {(10,000 + 3,000) + 4,000}] = 88,235 yen

As a result of the calculation, in the above case, it can be seen that the Narrow-Based Method is advantageous for Series A preferred shareholders as they can acquire common shares for 1,239 yen cheaper.

When No Adjustment of Conversion Price is Made

While it is common in investment contracts to stipulate the adjustment of the conversion price, there are exceptions where no adjustment of the conversion price is made. These include the following cases:

When Preferred Shareholders Agree

Similar to the case where the conversion right is exercised, when a new investor makes a rescue investment in a company with poor performance, existing preferred shareholders may be asked not to adjust the conversion price.

To accommodate such cases, it is common to stipulate that no adjustment of the conversion price will be made if certain preferred shareholders agree.

When Issuing Stock Options

The amount of stock options that can be issued without prior approval from investors is commonly referred to as a “stock option pool”. It is often stipulated in investment contracts that no adjustment of the conversion price will be made when issuing stock options along with the stock option pool.

This is because investors understand that issuing stock options will dilute the shares when they agree to the stock option pool.

Pay to Play Clause

Another case where no adjustment of the conversion price is made is due to the “Pay to Play” clause. This clause, mainly used in down-round investments, imposes certain penalties on preferred shareholders who do not subscribe to new shares.

Examples of penalties include:

• No adjustment of the conversion price for the preferred shareholder in question
• No adjustment of the conversion price for the preferred shareholder in question in the future
• Forcing the preferred shares held by the preferred shareholder in question to convert to common shares

Summary: On the Conversion Request Clause in Investment Contracts

The conversion request clause stipulated in startup investment contracts primarily governs matters such as preventing the dilution of preferred shares in a down round. However, it also includes important content such as the method of adjusting the conversion ratio and exception provisions.

When stipulating a conversion request clause in an investment contract, it is necessary to consider not only the interests of the investor but also those of the company when drafting the contract. Therefore, we recommend consulting with a lawyer who has extensive knowledge and experience in advance.

If you want to know more about the “clause on shares” stipulated in investment contracts, please refer to the following article in addition to this one.

Related article: What is the Share Purchase Clause in Investment Contracts?

Introduction to Our Firm’s Measures

Monolith Law Office is a legal office with high expertise in both IT, particularly the internet, and law. The creation of contracts is necessary for investment agreements. Our firm handles the creation and review of contracts for various cases, from companies listed on the Tokyo Stock Exchange Prime Market to venture startups. If you have any concerns about contracts, please refer to the article below.

Contract Drafting and Review