Term Sheet for Third-Party Allotment in Investment Contract

When venture companies seek funding from third parties such as venture capital (VC), it is common for new shares to be allocated to investors such as VCs through a third-party allotment. When conducting a third-party allotment, a wide range of matters need to be stipulated in the investment agreement, so it is common to create a term sheet during the contract negotiation phase. In this article, we explain what items should be included in the term sheet of the investment agreement, which become the points of contract negotiation.

What is an Investment Contract?

When a company receives investment from a third party like a VC, it is necessary to establish a contract that stipulates the investment conditions. In this case, the parties involved in the contract are the company receiving the investment, the existing shareholders such as the founders, and the new investors like the VC.

The act of entering into an investment agreement is not a procedure required by the Company Act. However, if a company does not enter into such an agreement, it may not be able to prove that the money received from VCs is for investment purposes, which can potentially lead to problems later on. If the company cannot demonstrate that the money is for investment purposes, there is a risk that the VC may later retract its capital contribution. Therefore, it is especially important for companies receiving investment to properly enter into an investment agreement.

Types of Investment Contract

While it is not impossible to draft a single contract for the investments received, usually multiple contracts are entered into, depending on the content of the agreement. The most important documents when entering into a contract with an investor are the investment contract and the shareholder agreement.

The investment contract is a contract entered into between the company receiving the investment and the new investor, such as a VC. It stipulates clauses related to the content of the shares to be invested, and the financial and business conditions of the investee company that form the basis for the investment decision.

On the other hand, the shareholder agreement involves a contract that includes existing shareholders, such as the founders of the company. In many instances, these existing shareholders, who often include the founders, hold more than half of the company’s shares that are receiving the investment. This means they maintain a significant stake and influence within the company.
Under the Company Act, shareholders who own more than half of the shareholding ratio can generally make decisions about basic matters of company management on their own. Many investors like VCs often invest with the intention of being involved in management, but to achieve this, it is necessary to contractually bind existing shareholders who maintain a majority shareholding ratio.

Third-party Allotment in Investment Contracts

When Venture Capital firms (VCs) and similar entities invest in companies through the purchase of shares, the recipient company typically issues new shares specifically for these investors. This procedure is known as a third-party allotment. It’s a method of issuing shares defined in corporate law where a company grants a specific third party the right to underwrite newly issued shares. This allows investors like VCs to purchase these shares. When raising funds from VCs or similar investors by issuing shares via a third-party allotment, there are numerous matters that need to be settled during the negotiation stage, including the terms of the investment.

The Term Sheet in Investment Contracts

The Significance of a Term Sheet

When a company issues new shares to raise funds from investors like VCs through a third-party allotment, an investment contract is formed. Given the complexity and length of such contracts, and the need to negotiate intricate rights and responsibilities among several parties, it’s common to first create a term sheet. This is essentially a summary of the primary contract conditions, set out in a table format, and it forms the basis for subsequent contract negotiations.

Items on a Term Sheet

While the items listed in a term sheet for investment contracts and shareholder agreements can vary by the deal.

• Details about the contractual parties
• Summary of the fundraising (type of shares to be issued, total possible and existing shares, number of shares to be issued, issue price, total subscription money, subscription conditions, capital, subscription deadline, and use of funds)
• Matters related to the type of shares (preferred dividends, residual asset distribution priority, call options, redemption clauses, voting rights, share splits, etc.)
• Information related to the shares (representations and warranties, priority subscription rights for investors, treatment in the event of a breach, termination of the agreement, etc.)
• The operation of the company (use of funds, listing obligations, director or observer appointments, prior approvals or notices to investors, information disclosures to investors, duties of devotion by founding shareholders, etc.)

Items Regarding Different Classes of Shares

When a company issues different classes of shares as part of receiving investments from VCs and the like, relevant clauses will be included in the term sheet. Different classes of shares are those that have different rights and are often used when receiving investments from VCs.

For example, there are different classes of shares that establish different provisions for surplus dividends or residual asset distributions, or shares that provide veto rights on certain shareholder meeting resolutions. VCs and similar investors often expect to have some level of involvement in the management of the company after their investment, which is why shares with these types of provisions are often issued.

When issuing different classes of shares, their details are included in the term sheet. For instance, a section entitled “Priority in Residual Asset Distribution” could read:

¥X per share (X% of the subscription amount per share), which is preferred to common shares and [same or preferred] to X Class Preferred shares, and is [participating or non-participating]

Considerations Regarding Shares

In regards to the shares being issued at the time of investment, the following points should be considered:

• Provisions on the preferential subscription of newly issued shares
• Provisions on preemptive rights and rights of first refusal
• Provisions on share buyback
• Provisions on joint sales rights and transfer participation rights
• Provisions on the transfer of shares
• Provisions on drag-along rights
• Deemed liquidation clauses

The provision on preferential subscription allows the investor to have the right to preferentially subscribe to newly issued shares, maintaining their own shareholding ratio. The preferential subscription right may be described on the term sheet as follows:

When the issuing company issues shares, the investor can preferentially subscribe in accordance with their shareholding ratio. However, this excludes the issuance of stock options equivalent to ◯% of the total issued shares.

Furthermore, the share buyback clause allows investors such as VC to demand the company or officers to buy back the shares they hold in case certain conditions are met. The conditions for triggering a buyback request and the method of calculating the buyback price are important points for this clause, which may be described on the term sheet as follows:

1. The investor may request the issuing company and founding shareholders to buy back the shares held by the investor in the event of any of the following: 　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　・In case of significant violation of Articles ◯, ◯, and ◯ of this contract 　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　・When it becomes apparent that the matters warranted are not true or accurate, and the content is　significant
2. The price for buying back the investor’s shares due to the buyback request above shall be an amount calculated by the method agreed upon by the investor, the issuing company, and the founding shareholders.

Moreover, drag-along rights refer to clauses that allow investors such as VCs to enforce M&A or EXIT under their leadership. From the standpoint of the investor, the drag-along right can be effective for investment recovery, and some investors may require such conditions.

Deemed liquidation clauses are those that treat the invested company as liquidated when it is acquired after the VC’s investment, and distribute property to the VC and other investors. Especially when investing from the startup phase, there are many cases where the company is acquired through M&A without going public. Therefore, without a deemed liquidation clause, there is a possibility that the investment cannot be recovered.

Items Concerning Company Operations

Several items pertaining to the operation of a company are typically stipulated in the term sheet of an investment contract. These include:

• Clauses related to the obligation to strive for a public listing (IPO)
• Clauses related to the use of funds
• Clauses related to the assignment of directors and observers
• Representations and warranties clauses
• Clauses regarding notification of significant matters and prior approval by investors
• Clauses related to post-notification to investors
• Clauses concerning dedication to management

A director dispatch clause, for instance, is a stipulation that allows investors such as venture capitalists (VCs) to appoint their employees or affiliates as directors in the companies they invest in. It’s common for VCs to seek some level of involvement in the management of the companies they invest in for the purpose of recouping their investment. By dispatching an employee as a director, VCs can keep abreast of the internal affairs of the company in real-time and somewhat control the decision-making process by expressing opinions at board meetings. This matter regarding director nomination is described on the term sheet as follows:

A shareholder owning X% or more/X shares or more of the issued preferred shares has the right to nominate one director.

Furthermore, representation and warranty clauses are included in the investment contract primarily to ensure that financial conditions and matters related to company management are appropriately stated or as previously declared. The details of what is represented and warranted are also stipulated on the term sheet.

A clause concerning dedication to management can impose restrictions to prevent officers from leaving for external opportunities after the investment. The term sheet may list the following stipulations:

1. Directors should not resign or refuse re-election without the approval of the investor.
2. Prohibition of concurrent jobs and concurrent appointments without prior approval from the investor.
3. Obligation to refrain from competitive business during the term and for a certain period after leaving.

Also, investors such as VCs generally intend to recoup their investments through the public listing (IPO) of the investee companies, so a clause requiring the investee companies to strive for a public listing may be provided. In this case, the term sheet would read:

1. The issuing company and the founding shareholders shall make efforts to list on the securities exchange by the end of a certain year and month.
2. The issuing company and the founding shareholders shall cooperate when the investor has to sell the shares of the issuing company due to the expiration of the term or other reasons.

Conclusion: The Term Sheet of an Investment Contract via Third-Party Allotment is Crucial for Subsequent Company Management

As we’ve discussed, when receiving investment through a third-party allotment, numerous items need to be decided. These items, decided at this stage, are critical for subsequent company management, so each one should be carefully considered during the term sheet phase. Many items presuppose knowledge of company law, which might be difficult to understand. Therefore, when negotiating a contract to receive investment from a third party like a VC, it’s advisable to consult a lawyer with extensive experience in startup financing.