The number of Japan’s corporate venture capital (CVC) funds, which invest corporate funds directly in external startup companies, and the amount of their investments have risen markedly in recent years. This is especially true in areas of digital transformation and climate change.
Successful Japanese CVC investments into 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 this article based on Morgan Lewis’s Japan Corporate Venture Capital Investment Series, conducted in Japanese, we examine this dynamic market and what investors should be aware of in terms of investments, deal terms, employment, and labor factors, as well as a closer look at the life science industry and intellectual property (IP) considerations.
- Structures and Fund Formation
- Getting the Deal Done: Key Terms
- What You Need to Know About IP for Investments in Life Sciences Companies
- Labor and Employment Considerations
STRUCTURES AND FUND FORMATION
There are three key investment structures to consider for CVC funds, and each yields a different type of risk mitigation:
- Direct investment from Japan: While direct investment does not require the burden of fund formation, there is a risk that Japanese investors might be directly involved in disputes in the United States (especially startup-related disputes). There is also the blocker entity, which insulates Japanese investors from US taxation and audit risks.
- Investment through US corporate fund: Although investments through a US corporate fund can reduce the risk of Japanese investors being directly involved in disputes in the United States, the fund is treated as a corporation for US tax purposes. In addition, dividends a US corporate fund receives from its portfolio companies are subject to federal corporate income tax.
- Investment through US LP fund: Limited partnership (LP) fund structures can enable Japanese investors to reduce the risk of being directly involved in disputes in the United States while enjoying tax benefits from pass-through taxation. An LP fund is treated as a partnership for US tax purposes and is not subject to federal corporate income tax on dividends received from its portfolio companies.
In order to set up a fund, a few steps need to be taken both in Japan and the United States. The following are important to note:
- Prior to the execution of a LP agreement and subscription agreement by a Japanese investor, it is necessary to complete the notification of qualified institutional investor unless the Japanese investor is a statutory qualified institutional investor and notification of specially permitted business for qualified institutional investors, etc. in Japan unless the general partner of the LP can rely on the de minimis exclusion.
- The State of Delaware is preferred for the formation of fund managers and LP funds in the United States.
- In addition to corporate filings related to fund formation, filings with the US Department of Commerce’s Bureau of Economic Analysis (BEA) and filings under the US Securities Act also need to be considered.
Learn More
In our recent Japan Corporate Venture Capital Investment Series presentation, Corporate Venture Capital Investments in US Startups (Part 1): Fund Formation and Investment Structures (conducted in Japanese) we discussed these topics in further detail.
Media Module - Datasource Item: CVC Investments in US Startups Part 1
GETTING THE DEAL DONE: KEY TERMS
Below, we take a closer look at key 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
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 the Committee on Foreign Investment in the United States (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 four to five months (90-day review period, plus one to two months of preparation prior to formal application) to complete a CFIUS filing, so it is important to consider this early, as it significantly impacts the schedule of the investment.
Some Challenges
There are some cultural points for Japanese companies to consider when looking to invest in the United States. For instance, 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.
Learn More
In our recent Japan Corporate Venture Capital Investment Series presentation, Corporate Venture Capital Investments in US Startups (Part 2): Getting the Deal Done: Key Terms and Considerations (conducted in Japanese), we provide further detail on the considerations in investment transactions by CVC investors.
Media Module - Datasource Item: CVC Investments in US Startups Part 2
WHAT YOU NEED TO KNOW ABOUT IP FOR INVESTMENTS IN LIFE SCIENCES COMPANIES
Japanese CVC investments in the life sciences industry provide investors entry into a market by supporting the development of innovative products and services. However, these innovations, and thus the companies behind them, derive their value from their exclusivity, so it is important to investigate how well protected they are from competitors before moving forward with a transaction.
There are several steps CVC investors can take during IP due diligence, including the following:
- Perform “patent landscaping”: Search and review third-party patents to identify crowded areas and troublesome IP. This search should include a freedom-to-operate (FTO) review of third-party patents and published applications to determine whether a product launch risks infringement. During the review, an investor might explore if the company targeted for investment has analyzed and prepared a legal opinion for noninfringement or invalidity positions.
- Check the quality of the patent portfolio: Assess matters such as whether an invention is patentable and whether, in the course of seeking a patent, the correct procedures were followed and enough information was provided to achieve a successful outcome. Keep in mind that good patents can withstand a US Patent and Trademark Office invalidity proceeding. The quantity of patent claims also matters since there is possibly a higher chance of surviving invalidity proceedings if there are more claims.
- Determine what is owned or licensed: Ask whether assignment documents are properly prepared, signed, and recorded or if employment agreements extend rights to an employee. If IP is licensed, check whether it is for exclusive or nonexclusive rights, what territory is covered, and whether it comes with rights to enforce, direct patent prosecution, or sublicense.
- Protect trade secrets: Identifying and labeling a trade secret can protect commercially valuable information from being shared outside of a business. Trade secret efforts should be proactive—for example, by labeling materials as “confidential.” Keep in mind that overuse of the “confidential” label can limit its effectiveness.
- Review third-party agreements: There are various types of third-party agreements that can be made while developing a product or service, including license, research, nondisclosure, joint research, consulting, and master transfer agreements. Regardless of what kind of arrangement is utilized, check what information was given to the third party and how information was recorded or protected.
Risks of Inadequate Due Diligence
Ventures without IP rights are a risk and become the cause for disputes over who is allowed to use or profit from a particular product or service. Given these stakes, taking time to identify and assess potential risks and benefits, along with developing strategies for any such risks, is important for potential venture investors.
Due Diligence Tips
- An FTO search is required to ensure that a potential investment target can use its invention and is not at risk of patent infringement.
- A patent attorney with litigation experience should evaluate the quality of the patent portfolio.
- Make sure to clarify IP ownership or the right to use, that trade secrets are kept confidential, and that all third-party agreements are reviewed.
Learn More
In our recent Japan Corporate Venture Capital Investment Series presentation, CVC Investments in the Life Sciences Industry: Key IP Issues and Conducting IP Due Diligence (conducted in Japanese), we look at these topics in further detail.
Media Module - Datasource Item: CVC Investments in the Life Sciences Industry
LABOR AND EMPLOYMENT CONSIDERATIONS
For Japanese CVC investors, involvement with US startups come with a host of labor and employment issues to consider.
Points on Due Diligence
- Perform thorough due diligence to identify the risks of a startup founder or key employees leaving. In startups, founders and executives play integral roles in the technical and managerial success of the startup. Losing those key figures after an investment could prove disastrous. Employees who leave the company to work for a competitor or take confidential information or technology rights on departure could also hurt the investment.
- Make sure to identify these risks early on and take steps to reduce the likelihood of these situations, including securing technology rights and improving employee engagement.
- Other employee retention measures include appropriate closing conditions in investment agreements, incentive and stay bonuses, and noncompete and nonsolicit covenants.
- Investigate the employment terms and conditions for key employees. Review whether important executives and employees have stock-based compensation or other items that could cause a change in the post-investment ownership interest and whether there are any payments triggered by resignations, potential changes in employment conditions or other financial expenditures. In addition, be aware of pending or potential legal disputes involving trade secrets, patent rights, or discriminatory treatment.
- Understand employment contract provisions. Employment contract provisions dealing with confidential information, invention assignment, or noncompete or nonsolicit agreements may be held differently from state to state and from common understanding in Japan.
- Get familiar with startup compensation arrangements. Equity compensation plans are common at startups and typically include restricted shares, stock options, restricted share units, and/or performance share units. Each has its own features and conditions.
Noncompete Provisions
If considering the use of noncompete provisions in contracts, which bar an employee from engaging in a competing business or signing on with a competitor after retirement, it should be noted that they do not necessarily carry the same validity in the United States as they do in Japan, and their applicability can vary from state to state. Furthermore, a proposed rule from the US Federal Trade Commission could ban use of these clauses.
Key Takeaways for Startup Investment
- Correctly identify the executives and employees who are essential to the conduct of the business at the time of due diligence and confirm the policy for dealing with them.
- Perform careful due diligence, including agreements with executives and employees, to understand potential legal disputes regarding employment.
- Incorporate provisions in investment contracts to prevent, as much as possible, the turnover of executives and employees who are indispensable to the execution of the business.
- Keep in mind it is becoming harder to enforce post-retirement noncompete covenants in agreements with individual executives and employees.
- Involve the legal, human resources, and business departments to carry out due diligence and analyze post-closing policies.
Learn More
In our recent Japan Corporate Venture Capital Investment Series presentation, we discussed the Key Labor/Employment Issues when Investing in US Startups (conducted in Japanese) in further detail.
Media Module - Datasource Item: Key Labor Employment Issues when Investing in US Startups
CONCLUSION
As Japanese CVC funds continue to develop new business models through investment in US startup companies, it is important to consider these key tools, insights, and fundamentals to assist in navigating this complex and exciting investment landscape.