Japanese Corporate Venture Capital Investments in US Startups: Part Two

Successful Japanese corporate venture capital (CVC) investments into US startups tend to be entered into with a long-term view and as a partnership with the target company. When taking a strategic decision to invest, capital gains are an important aspect, but it is also vital to see the investment as a positive business collaboration. In Part One of this series, we explored investment structures and fund formation factors in these collaborations. Here we take a closer look at key terminology and deal terms relating to governance, exit strategies, and national security, as well as best practices to navigate potential challenges.

Governance

• Right to appoint directors vs. observer rights: It is worth noting that those with observer rights in board meetings do not have voting rights. However, considering the risk of personal liability as a director, investors may prefer observer rights to the right to appoint directors. Investors often request disclosure of the documents presented at the issuing company’s board meeting, even if they do not have the right to appoint directors or observer rights.
• Voting rights: When preferred stockholders exercise their voting rights together with common stockholders, the number of voting rights is calculated based on the number of shares if the preferred shares were to be converted into common stocks (fully diluted). In addition, class voting requirements may be imposed by law and the certificate of incorporations.
• Protective provisions: From the viewpoint of the issuing company and its founder, protective provisions would constrain the management of the company, and items to be included in protective provisions are heavily negotiated.
• Information rights: These are an investor’s right to receive information from the issuing company regarding its financial conditions and business operations. They include the right to visit and inspect the issuing company as well as the right to speak with its management team.

Exit Strategy

• Liquidation preference: Upon dissolution or liquidation of the issuing company, the residual assets of the company will first be distributed to preferred stockholders up to the amount of their investments, then the remaining amount will be distributed on a pro rata basis to common stockholders (or all stockholders including common stockholders).
• Redemption rights: Redemption by the issuing company may be restricted under applicable law, and it is important for investors to also consider another strategy as an alternative to redemption rights.

Committee on Foreign Investment in the United States (CFIUS)

The Foreign Investment Risk Review Modernization Act (FIRRMA), passed in 2018, allows not only acquisition of control of a US company by non-US investors, but also investments in “critical technology,” “critical infrastructure,” and “sensitive personal data” to be subject to review by CFIUS.

FIRRMA added mandatory filing requirements for certain investments involving critical technology and foreign government-related persons. Even where there is not a mandatory filing requirement, there are many cases where a joint voluntary notice is filed in practice in order to avoid the risk that CFIUS will negate the transaction after the closing.

Consideration should be given to mandatory filing requirements, and whether a joint voluntary notice or declaration should be filed. It usually takes at least 4-5 months (90-day review period, plus 1-2 months of preparation prior to formal application) to complete a CFIUS filing, so it is important to consider this in the very early stage as it significantly impacts the schedule of the investment.

Some Challenges

Culturally there are considerations for Japanese companies when looking to invest in the United States. Comparatively there may a tendency for more detailed documentation, which can lack speed and confidentiality in decision-making. Often friendly relationships are sought over tough contract negotiations. Furthermore, there have been examples where an organization may have one of the best technologies in the world but is reluctant to enforce its rights. Many organizations often take a risk-averse approach and attempt to avoid litigation.

Top Tips

• Carry out extensive internal coordination and external marketing.
• Conduct meticulous contract drafting and robust contract negotiation.
• Consider Silicon Valley–style equity incentives and contingency fees.
• Prepare for litigation, which can often be an unavoidable cost.
• Seek assistance from advisors with sufficient experience in the US CVC market.

Learn More

If you are interested in Corporate Venture Capital Investments in US Startups (Part 2): Getting the Deal Done: Key Terms and Considerations, as part of our Japan Corporate Venture Capital Investment Series, we invite you to subscribe to Morgan Lewis publications to receive updates on trends, legal developments, and other relevant areas.