5.Financing
In order for a private company to expand its business, it will typically need to raise funds in some form, depending on the degree of expansion. Fund-raising can be divided broadly into two categories: (i) debt financing, including primarily loans and bonds (shasai); and (ii) equity financing, which basically means increasing the company’s capital through the issuance of new shares. In between those two, there are instruments such as a convertible bond with warrant (the rough equivalent of a convertible note in the U.S.). Especially for start-ups, the repayment obligations associated with debt can hinder the company’s growth, so in general start-ups will more frequently raise funds through the issuance of new equity. For the company, it is necessary to construct a capitalization model that will ensure the company’s ability to expand its business in the future, as well as to actually execute financings based on its capitalization model.
When accepting an investment from a venture capitalist, the investor may demand preferred shares or a convertible bond with warrant instead of common shares, in which case it is necessary to properly construct the terms and conditions of those instruments. In particular, in the case of a convertible bond with warrant, under the Companies Act, you must consider such issues as whether or not a bond administrator is necessary and the regulations on contributions in kind. You also have to make sure to comply with the Financial Instruments and Exchange Act. In addition, the investor will typically require the company to enter into an investment contract and a shareholders agreement, in which case you must make sure that you fully understand the meaning of the terms, and that no unforeseen circumstances will arise later.
AZX has provided support for venture capital financings for many years, and we have been involved in various kinds of financing schemes in the past. Specifically, in addition to providing advice on capitalization structures, we have assisted clients to construct the terms and conditions of preferred shares and convertible bonds with warrants, as well as the procedure to issue such instruments. We have also assisted clients in the drafting, review and negotiation of investment contracts and shareholders agreements.
Q1 (Regulation of Private Placements)
We plan to issue shares to several acquaintances. We’ve heard that the Financial Instruments and Exchange Act (“FIEA”) applies to the issuance of shares in a public company, but may we believe that it is irrelevant for a non-public company?
The FIEA is a law that regulates financial instruments, and its scope is not limited to public companies. In particular, if your company issues shares of capital stock, options/warrants, or convertible bonds with warrants, and such issuance is deemed to be a “public offering of securities” (FIEA, Article 2, Section 3), in principle you are required to submit a registration statement (FIEA, Article 4, Section 1) as well as additional securities reports (FIEA, Article 4, Section 1). So, even before your company becomes a listed company, you need to be careful about the regulations under the FIEA. Since the burden of preparing these disclosure documents is extremely heavy, and in particular the securities reports are a continuing obligation, it would be practically difficult for a private company to satisfy these obligations. Accordingly, it is important to make sure that your activities do not trigger the filing of a registration statement before you become a listed company.
(Posted: January 27, 2012)
Q2 (Investment Contracts)
In entering into an investment contract with a venture capitalist, what kind of points should we be careful about?
When you enter into an investment contract with a venture capitalist, regardless of how much you desire to make the investment, you shouldn’t sign the agreement without properly reviewing its contents. If necessary, you should consult with a lawyer, and negotiate points that need to be negotiated, and then sign. Specifically, you should consider such matters as the following: (1) whether the fundamental terms match your understanding; (2) whether you can satisfy the closing conditions; (3) whether the representations and warranties are appropriate; (4) whether you can accept the corporate governance terms (such as board seats and protective provisions); (5) whether you can accept the stock transfer restrictions; and (6) whether the exit rules (such as redemption rights) are not unreasonable.
(Posted: January 27, 2012)
Q3 (Debt-Equity Swap (DES))
What kind of procedure is a debt-equity swap (DES)?
A DES is a scheme under which a creditor of a company subscribes for new shares, and then, in lieu of paying cash for the shares, the creditor contributes its claim to the company as payment for the shares. The result is as if the creditor’s claim (debt) is exchanged (swapped) for the shares (equity), hence the name.
(Posted: January 27, 2012)
Q4 (Procedure for Foreign Investors – Company)
What kind of special procedures are necessary by the company in the issuance of new shares if a foreigner invests in our company?
If the foreign investor is not resident in Japan, under the Foreign Exchange Law (“FEL”), the company must submit a post-transaction report to the Bank of Japan for the “receipt of payment from a non-resident to Japan” (FEL, Article 55). However, if the amount received is not more than 30,000,000 Japanese yen, no report is required (unless the payment is from certain specified countries). Also, for a discussion of the regulations on the investor in a foreign direct investment into Japan, please see Question 00163.
(Posted: January 27, 2012)
Q5 (Procedure for Foreign Investors – Investor)
What kind of special procedures are necessary by the foreign investor in the issuance of new shares if a foreigner invests in our company?
If the foreign investor is not resident in Japan, the investment is a “inward direct investment” under the Foreign Exchange Law. In the case of a “inward direct investment”, the investor must submit a post-transaction report to the Bank of Japan (unless the investor is a citizen of certain specified countries, in which case a pre-transaction report is required). However, if the ownership percentage of the foreign investor (together with any spouse, affiliate and other parties with a special relationship to the investor) is less than 10%, then no report is required.
(Posted: January 27, 2012)
Q6 (Regulation of Convertible Bonds with Warrant (CB))
If we issue a convertible bond with warrant (CB), we have heard that we need to be careful about the Financial Instruments and Exchange Act, but what exactly does that mean?
If the issuance of a CB is considered a “public offering of marketable securities”, in principle you are required to submit a registration statement (and subsequent securities reports as continuous disclosure), which will be a great burden on the company. So, it is better to plan your CB issuance so that it won’t be considered a “public offering of marketable securities”. In order to do this, you should not make offers to more than 49 persons and entities (within a 6-month period) and you should fulfill the requirements specified below .
If the investors are not qualified institutional investors, (i) you must impose transfer restrictions that prohibit any partial transfers, and affix a legend on the CB certificates or other instruments to let potential transferees to know about the restrictions, or (ii) you must not issue 50 or more units of the CB (subject to the 6-month integration rule for the same type of CB) and you must impose restrictions that prohibit each unit of the CB from being divided into a greater number of units, and you must affix a legend on the CB certificates or other instruments to let potential transferees to know about the restrictions.
(Posted: January 27, 2012)
Q7 (Third Party Valuation for CB)
Typically, a convertible bond with warrant (CB) is a security in which the holder contributes the bond upon the exercise of a warrant to purchase shares. If this is considered a contribution in kind, isn’t a valuation by a third party evaluator required?
Strictly speaking, the contribution of the debt and exercise of the warrant under a CB is a contribution in kind, which would require a valuation by a third party evaluator. However, a CB typically falls within one of the exemptions from the valuation requirement. Specifically, there are certain exemptions from the valuation requirement (Companies Law, Article 284, Section 9):
(1) if the number of shares issued under the exercised warrant does not exceed 1/10 of the total outstanding shares of the company;
(2) if the designated total value of the contributed asset does not exceed 5,000,000 Japanese yen; or
(5) in the case that the contributed asset is a monetary claim (limited to those claims that are due and payable), if the designated value of the monetary claim for purposes of the contribution in kind does not exceed the book value of the liability.
In practice, the company will designate the exercise price for each warrant as not more than 5,000,000 Japanese yen in order to utilize exemption (2) above.
(Posted: January 27, 2012)