Issuance and Contents of Preferred Shares in Venture Investment Contracts

When an investor invests in a company, shares are issued by the company to the investor in accordance with the amount of money invested. Although we generally refer to these as “shares”, under the Japanese Companies Act, it is permissible to issue shares with different contents, and there are various types of shares that can be issued at the time of an investment contract. If you do not understand these various types of shares, there is a risk that as a company, you may issue shares that are extremely disadvantageous to your own company, and as an investor, you may only be able to receive shares that do not match your investment. Therefore, in this article, we will first explain about common shares, and then explain about the types of shares that are often issued when an investment contract is concluded.

Types of Shares
As a rule, all shares have the same content. A type of share is a share that differs from other shares in certain respects (Japanese Companies Act Article 108, Paragraph 1). In order to issue such shares, it is necessary to stipulate it in the articles of incorporation (Japanese Companies Act Article 108, Paragraphs 2 and 3, Company Rule 20).

Kazuyuki Takahashi et al., “Small Dictionary of Law” p.632 (Yuhikaku, 5th edition, 2016)

Types of Class Shares

The Japanese Companies Act stipulates the following about class shares:

• Provisions regarding the distribution of surplus funds (Japanese Companies Act Article 108, Paragraph 1, Item 1)
• Provisions regarding the distribution of residual assets (Japanese Companies Act Article 108, Paragraph 1, Item 2)
• Provisions regarding the exercise of voting rights at the general shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 1, Item 3)
• Provisions regarding the transfer of shares (Japanese Companies Act Article 108, Paragraph 1, Item 4)
• Provisions regarding the shareholder’s right to request the company to acquire its shares (Japanese Companies Act Article 108, Paragraph 1, Item 5)
• Provisions regarding the company’s right to acquire its shares from shareholders when certain events occur (Japanese Companies Act Article 108, Paragraph 1, Item 6)
• Provisions regarding the company’s right to acquire all of its shares by resolution of the general shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 1, Item 7)
• Provisions regarding the necessity of a resolution at the class shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 1, Item 8)
• Provisions regarding the appointment of directors and auditors at the class shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 1, Item 9)

Provisions on Surplus Dividends and Distribution of Residual Assets

Shares with Different Provisions on Surplus Dividends and Distribution of Residual Assets

Firstly, shares may be issued with provisions that allow for the receipt of surplus dividends and distribution of residual assets ahead of other types of shares. Such class shares, which take precedence over other shares in terms of surplus dividends and distribution of residual assets, are referred to as “preferred shares”.

Next, shares may be issued with provisions that allow for the receipt of surplus dividends and distribution of residual assets after other types of shares. Such class shares, which are subordinate to other shares in terms of surplus dividends and distribution of residual assets, are referred to as “subordinate shares”.

Standard shares without any special treatment are referred to as “common shares”.

There are also shares that have advantageous provisions for either surplus dividends or distribution of residual assets, but disadvantageous provisions for the other. Such shares, which have mixed provisions, are referred to as “mixed shares”.

Issuance Procedures for Shares with Different Provisions on Surplus Dividends and Distribution of Residual Assets

To issue shares with different provisions on surplus dividends and distribution of residual assets, the following procedures must be followed:

For shares with different provisions on surplus dividends, the following items must be stipulated in the articles of incorporation:

• The method for determining the value of the dividend assets to be distributed to the shareholders of the said class (Japanese Companies Act Article 108, Paragraph 2, Item 1)
• The conditions for distributing surplus dividends and other handling of surplus dividends (Japanese Companies Act Article 108, Paragraph 2, Item 1)
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

For shares with different provisions on the distribution of residual assets, the following items must be stipulated in the articles of incorporation:

• The method for determining the value of the residual assets to be distributed to the shareholders of the said class (Japanese Companies Act Article 108, Paragraph 2, Item 2)
• The type of the said residual assets and other handling of the distribution of residual assets (Japanese Companies Act Article 108, Paragraph 2, Item 2)
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

Provisions on Shares with Restricted Voting Rights

What are Shares with Restricted Voting Rights?

Shares with restricted voting rights are shares that have restrictions on the exercise of voting rights at the general shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 1, Item 3). If the exercise of voting rights is not permitted for certain matters, the range of involvement that investors can have in the management of the company becomes narrower. However, on the other hand, there may be advantageous provisions regarding surplus dividends and distribution of residual assets.

Issuance Procedures for Shares with Restricted Voting Rights

To issue shares with restricted voting rights, the following items must be stipulated in the articles of incorporation:

• Matters on which voting rights can be exercised at the general shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 2, Item 3(i))
• When conditions for the exercise of voting rights are set for the said class of shares, those conditions (Japanese Companies Act Article 108, Paragraph 2, Item 3(ii))
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

Provisions on Shares with Transfer Restrictions

What are Shares with Transfer Restrictions?

Shares with transfer restrictions are shares for which the company has stipulated that the company’s approval is required when transferring shares. By issuing shares with transfer restrictions, the company can prevent shareholders from freely transferring their shares to third parties, and can prevent undesirable individuals from becoming shareholders.

Issuance Procedures for Shares with Transfer Restrictions

To issue shares with transfer restrictions, the following items must be stipulated in the articles of incorporation:

• The requirement that the company’s approval is needed to acquire the said shares by transfer (Japanese Companies Act Article 108, Paragraph 2, Item 4, and the same Act Article 107, Paragraph 2, Item 1(i))
• When it is stipulated that the company is deemed to have given approval under Article 136 or Paragraph 1 of Article 137 in certain cases, that fact and the said certain cases (Japanese Companies Act Article 108, Paragraph 2, Item 4, and the same Act Article 107, Paragraph 2, Item 1(ii))
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

Provisions for Shares with Acquisition Request Rights and Shares with Acquisition Clauses

Shares with Acquisition Request Rights

What are Shares with Acquisition Request Rights and Shares with Acquisition Clauses?

Firstly, shares with acquisition request rights are shares that allow shareholders to request the company to acquire these shares. Secondly, shares with acquisition clauses are shares that allow the company to acquire shares from shareholders when certain conditions are met. Both types of shares have the commonality that the company is expected to acquire the shares, but they differ in whether the initiative is taken by the shares or the company.

Issuance Procedures for Shares with Acquisition Request Rights and Shares with Acquisition Clauses

Firstly, to issue shares with acquisition request rights, the following items must be stipulated in the articles of incorporation:

• The fact that shareholders can request the company to acquire the shares they hold (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(i))
• When the company issues bonds (excluding those with new share subscription rights) to the shareholder in exchange for acquiring one share, the type of bonds (referring to the type stipulated in Article 681, Item 1, the same shall apply hereinafter in this section) and the total amount of each bond per type or its calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(ro))
• When the company issues new share subscription rights (excluding those attached to bonds with new share subscription rights) to the shareholder in exchange for acquiring one share, the content and number of the new share subscription rights or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(ha))
• When the company issues bonds with new share subscription rights to the shareholder in exchange for acquiring one share, the matters stipulated in ro regarding the bonds with new share subscription rights and the matters stipulated in ha regarding the new share subscription rights attached to the bonds with new share subscription rights (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(ni))
• When the company provides property other than shares, bonds, and new share subscription rights (hereinafter the same) to the shareholder in exchange for acquiring one share, the content and number or amount of the property or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(ho))
• The period during which shareholders can request the company to acquire the shares (Japanese Companies Act Article 108, Paragraph 2, Item 5(i), Article 107, Paragraph 2, Item 2(he))
• When the company provides other shares to the shareholder in exchange for acquiring one share of the said type, the type and number of the other shares or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 5(ro))
• The total number of shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Column)

Next, to issue shares with acquisition clauses, the following items must be stipulated in the articles of incorporation:

• The fact that the company will acquire its shares on the day when certain conditions are met and those conditions (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(i))
• When the day determined separately by the company is considered as the condition in i, that fact (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(ro))
• When the company acquires part of the shares on the day when the condition in i occurs, that fact and the method of determining the part of the shares to be acquired (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(ha))
• When the company issues bonds (excluding those with new share subscription rights) to the shareholder in exchange for acquiring one share, the type of bonds and the total amount of each bond per type or its calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(ni))
• When the company issues new share subscription rights (excluding those attached to bonds with new share subscription rights) to the shareholder in exchange for acquiring one share, the content and number of the new share subscription rights or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(ho))
• When the company issues bonds with new share subscription rights to the shareholder in exchange for acquiring one share, the matters stipulated in ni regarding the bonds with new share subscription rights and the matters stipulated in ho regarding the new share subscription rights attached to the bonds with new share subscription rights (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(he))
• When the company provides property other than shares, bonds, and new share subscription rights to the shareholder in exchange for acquiring one share, the content and number or amount of the property or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 6(i), Article 107, Paragraph 2, Item 3(to))
• When the company provides other shares to the shareholder in exchange for acquiring one share of the said type, the type and number of the other shares or their calculation method (Japanese Companies Act Article 108, Paragraph 2, Item 6(ro))
• The total number of shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Column)

Definition of Class Shares with All Acquisition Clause

What are Class Shares with All Acquisition Clause

Class shares with an all acquisition clause are a type of share that allows a company to forcibly acquire all shares through a resolution at a general shareholders’ meeting. The initial concept of class shares with an all acquisition clause was to replace all shareholders by extinguishing all shares and issuing new shares, except in rehabilitation or reorganization procedures. However, in reality, these shares are often used as a means to fully subsidiary after the first stage of a public tender offer in realizing a management buyout (MBO).

Issuance Procedure of Class Shares with All Acquisition Clause

In order to issue class shares with an all acquisition clause, the following items must be stipulated in the articles of incorporation:

• When the acquisition consideration is the company’s shares, the type and number of shares for each type or the calculation method thereof (Japanese Companies Act Article 108, Paragraph 2, Item 7(i), Article 171, Paragraph 1, Item 1(i))
• When the acquisition consideration is the company’s bonds (excluding those with new share subscription rights), the type and total amount of each bond for each type or the calculation method thereof (Japanese Companies Act Article 108, Paragraph 2, Item 7(i), Article 171, Paragraph 1, Item 1(ii))
• When the acquisition consideration is the company’s new share subscription rights (excluding those attached to bonds with new share subscription rights), the content and number of such new share subscription rights or the calculation method thereof (Japanese Companies Act Article 108, Paragraph 2, Item 7(i), Article 171, Paragraph 1, Item 1(iii))
• When the acquisition consideration is the company’s bonds with new share subscription rights, the matters stipulated in (ii) regarding the bonds with new share subscription rights and the matters stipulated in (iii) regarding the new share subscription rights attached to the bonds with new share subscription rights (Japanese Companies Act Article 108, Paragraph 2, Item 7(i), Article 171, Paragraph 1, Item 1(iv))
• When the acquisition consideration is property other than the company’s shares, the content and number or amount of such property or the calculation method thereof (Japanese Companies Act Article 108, Paragraph 2, Item 7(i), Article 171, Paragraph 1, Item 1(v))
• When stipulating the conditions under which a resolution can be made at the general shareholders’ meeting, those conditions (Japanese Companies Act Article 108, Paragraph 2, Item 7(ii))
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

Definition of Veto Rights

What are Shares with Veto Rights?

Shares with veto rights are a type of share that requires the resolution of a class shareholders’ meeting, composed of shareholders of that type of share, for matters to be resolved at a general shareholders’ meeting. In order for a resolution of the general shareholders’ meeting to be treated as having been made, a resolution of the class shareholders’ meeting is also necessary. Therefore, if the class shareholders refuse to pass a resolution, the resolution of the general shareholders’ meeting will not be accepted.

Procedures for Issuing Shares with Veto Rights

In order to issue shares with veto rights, the following items must be stipulated in the articles of incorporation:

• Matters requiring the resolution of the class shareholders’ meeting (Japanese Companies Act Article 108, Paragraph 2, Item 8(i))
• When stipulating conditions requiring the resolution of the class shareholders’ meeting, those conditions (Japanese Companies Act Article 108, Paragraph 2, Item 8(ii))
• The total number of shares of the type that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

Provisions for the Appointment of Directors or Auditors at Class Shareholders’ Meetings

What are the Different Types of Shares Regarding the Appointment of Directors or Auditors at Class Shareholders’ Meetings?

Different types of shares regarding the appointment of directors or auditors at class shareholders’ meetings refer to class shares that include the appointment of directors or auditors at class shareholders’ meetings composed of the class shareholders of such class shares.

Issuance Procedures for Different Types of Shares Regarding the Appointment of Directors or Auditors at Class Shareholders’ Meetings

In order to issue shares with veto rights, the following items must be stipulated in the articles of incorporation:

• The appointment of directors or auditors at class shareholders’ meetings composed of such class shareholders, and the number of directors or auditors to be appointed (Japanese Companies Act Article 108, Paragraph 2, Item 9 (i))
• When some or all of the directors or auditors who can be appointed by the provisions of (i) are to be jointly appointed with other class shareholders, the type of shares held by such other class shareholders and the number of directors or auditors to be jointly appointed (Japanese Companies Act Article 108, Paragraph 2, Item 9 (ii))
• If there are conditions for changing the matters listed in (i) or (ii), those conditions and the matters listed in (i) or (ii) after the change when those conditions are met (Japanese Companies Act Article 108, Paragraph 2, Item 9 (iii))
• In addition to the items listed from (i) to (iii), matters stipulated by the Ministry of Justice Ordinance (Japanese Companies Act Article 108, Paragraph 2, Item 9 (iv))
• The total number of class shares that can be issued (Japanese Companies Act Article 108, Paragraph 2, Proviso)

The Significance of Class Shares

The issuance of class shares has been permitted since the enactment of the Japanese Commercial Code in Meiji 32 (1899). However, at that time, it was only recognized for the right to claim surplus dividends and the right to claim distribution of residual assets, and the significance of class shares was considered to be mainly for diversifying fundraising methods. Since the amendment of the Japanese Commercial Code in Heisei 13 (2001) November, class shares have also taken on the personality of a means of adjusting rights related to company control among shareholders.

Issuance of Class Shares at the Time of Investment Contract Conclusion

As mentioned above, there are many types of class shares. Among these, the following types of shares become particularly important when concluding an investment contract. Let’s explain these types of shares in detail.

• Shares with different provisions for residual property distribution
• Shares with acquisition request rights
• Shares with acquisition clauses

Shares with Different Provisions for Residual Property Distribution

As a feature of class shares, if there are preferential distribution rights for residual property distribution, investors who hold such class shares can receive the distribution of residual property prior to shareholders who hold common shares. This allows investors to reduce their investment risk, making it easier to invest in venture companies and the like.

When stipulating provisions regarding shares with different provisions for residual property distribution in the articles of incorporation, for example, the following provisions can be considered.

Article ○ (Distribution of Residual Property)
When the Company distributes residual property (regardless of its type, the same shall apply hereinafter), it shall pay to the shareholders (hereinafter referred to as “Class A Preferred Shareholders”) or the registered share pledgees (hereinafter referred to as “Class A Preferred Registered Share Pledgees”) of Class A Preferred Shares, prior to the shareholders (hereinafter referred to as “Common Shareholders”) or the registered share pledgees (hereinafter referred to as “Common Registered Share Pledgees”) of common shares listed or recorded in the final shareholder register, an amount equivalent to the standard distribution amount per Class A Preferred Share (hereinafter referred to as “Class A Preferred Residual Property Distribution Amount”). The standard distribution amount shall be the amount obtained by multiplying 1 by 100,000 yen (however, it shall be appropriately adjusted in the event of a stock split, free allotment of shares, consolidation of shares or any other similar event with respect to Class A Preferred Shares). In addition, the Company shall distribute residual property equal to the amount of residual property distributed per common share to the Class A Preferred Shareholders or Class A Preferred Registered Share Pledgees for each Class A Preferred Share.

Shares with Acquisition Request Rights

Shares with acquisition request rights may also be issued as class shares to reduce the investment risk of investors, similar to shares with different provisions for residual property distribution. Specifically, as an investor, if you want to let go of your shares for some reason, you can recover some of your invested capital by requesting the company to buy back the shares. Also, even if a conflict arises between the company and the investor, the investor can sell the shares by requesting the company to buy them back.

When stipulating provisions regarding shares with acquisition request rights in the investment contract, for example, the following provisions can be considered.

Article 10 (Purchase of the Shares by the Issuing Company)

The investor may request the issuing company to purchase the shares held by the investor (hereinafter referred to as the “Shares Subject to Purchase”) or transfer them to a third party designated by the issuing company and approved by the investor, in the event of any of the following circumstances. If the investor requests the issuing company to purchase the Shares Subject to Purchase, the issuing company shall pay the purchase price to the investor within [30] days from the date of receipt of the request from the investor.
(1) If the issuing company or the managing shareholder violates the provisions of this contract and does not cure the violation within [30] days from the request of the investor.
(2) If the representations and warranties of the issuing company or the managing shareholder set forth in Article 5 are not true or are inaccurate in any material respect.

The purchase or transfer price per share of the Shares Subject to Purchase under the preceding paragraph shall be the highest amount among the following amounts.
(1) The issuance price per share stated in the new share issuance procedure stated in the appendix (however, if there is any change in the shares of the issuing company due to a split, consolidation or other changes, it shall be appropriately adjusted.)
(2) The net asset value per share based on the book value net assets on the most recent audited balance sheet of the issuing company
(3) If there is a case of new share issuance or share transfer by the issuing company prior to the request under the preceding paragraph, the most recent new share issuance price per share or the transfer price per share in the transfer case (however, if there is any change in the shares of the issuing company due to a split, consolidation or other changes, it shall be appropriately adjusted)
(4) The market price per share of the issuing company’s shares as appraised by a third party appointed by the investor
(5) The amount per share calculated in accordance with the similar industry standard value stipulated in the Basic Notice on Inheritance Tax Property Valuation

If the investor makes a request to the issuing company based on paragraph 1, the issuing company and the managing shareholder shall carry out all necessary procedures for the purchase or transfer (including the procedure for changing the name of the shares in the issuing company, but not limited to this).

General Incorporated Association Computer Software Association, “Investment Contract Seed Round (No Competition Avoidance Obligation)”, https://www.csaj.jp/documents/activity/project/startup/Contractsample_3-1.pdf, (September 10, 2019)

Shares with Acquisition Clauses

When a venture company is on a growth trajectory, it may consider going public through an Initial Public Offering (IPO). If a company has issued different classes of shares, it can make it challenging for general investors to evaluate the company’s stock situation. Therefore, it’s common practice to convert these specialized shares into regular common shares before going public. If the specialized shares aren’t structured with buy-back provisions, the company can encounter difficulties in acquiring these shares from shareholders, hampering a smooth conversion into common shares and potentially affecting the IPO process.

To address this, companies often issue a class of shares with buy-back provisions to ensure a smooth acquisition of shares from their shareholders.

Summary: Consult Lawyers in Case of Issuing Class Shares or Investment in Ventures to Receive Specialized Assistance

In conclusion, we have explained about common stocks in general and the issuance of common stocks in investment scenarios. As a company, it is necessary to issue the type of stocks that investors would want to invest in for fundraising purposes. On the other hand, as an investor, it is necessary to ensure that you are receiving the issuance of worthwhile common stocks. The type of stocks to be issued in an investment contract requires consideration from a professional perspective. As explained in this article, there are various types and combinations of common stocks, and without sufficient legal knowledge, it can be difficult to determine what type of common stocks should be issued. Also, issuance must be done in accordance with the procedures stipulated in the Japanese Companies Act, so please be sure to consult with a lawyer who is an expert in this field.