Capital Financing Using Class Shares ②

Fundraising with Preferred Stock②

In principle, in Japanese Kabushiki-Kaisha (a stock company), the term “preferred share” refers to a class of shares that has priority over “common share” in terms of (i) dividends of surplus, (ii) distribution of residual assets, or (iii) voting rights at shareholders’ meetings.

In most cases, when a venture company intends to raise funds by using class shares, either (i) or (ii), or both, have priority over common shares.

Right of Distribution of Residual Assets

Residual Preferred Share is the most major and important class of preferred share. Shareholders who have the right of preferred distribution of residual assets have priority over the common share in the event of liquidation of the company.

Sample case:

(1) At the time of incorporation: The founder issues 80 shares of common shares for 800,000 yen (10,000 yen per share).

(2) A few years later: The company’s value becomes 800 million yen and Investor A invests 200 million yen (10 million yen per share) and issues 20 shares.

(3) A few more years later: Sell the company.

Assuming that Investor A received the 20 shares of common shares, the same class as the founder, the distribution ratio of the sale price would be divided between the founder and investor’s equity interest. Therefore, the distribution amount that Investor A would receive would be as follows:

As shown in above, Investor A cannot collect the invested amount until the sale price would reach 1 billion yen, while the founder gains in any cases. In most cases, the investment contract requires the prior approval of investors when selling the business, etc. Therefore, there might be an issue that the investors would not approve the selling of the business even though it would be a good deal.

Residual Preferred Shares are used to eliminate such inequity among the investors.

Participating Preferred Shares

In the case of a participation right of priority distribution of the residual assets, the investor first receives a distribution of the residual assets equal to one time the amount invested (although it is possible to double or triple the amount, it is not often the case), and then receives the remaining residual assets in proportion to investor’s share of the residual assets.

As shown in the above, in each case, the investor will receive a return on his principal and a certain amount of profit. New investors who subscribe to higher valuations are given priority over early investors. Such scheme of shares make easier for investors to invest even at higher valuations.

Non-participating Preferred Shares

In the case of a non-participating right of priority distribution of the residual assets, after investors receive a distribution of residual property equal to one time the principal investment amount (it can be two or three times, but this is not often the case), they are not entitled to any subsequent distribution of residual property.

In the U.S., non-participating preferred shares are widely used, but in Japan, more than 90% of all residual assets are distributed as participating preferred shares.

Disadvantages of Participating Preferred Shares

In Japanese Kabushiki-Kaisha, all class shares are usually converted into common shares at the time of listing in consideration of the principle of equality of shareholders. Meaning the amount of return for investors will be reduced when the company goes public, compared with them continued holding their shares are class shares.

Therefore, at the late stage of a company’s IPO, non-participating preferred shares are sometimes chosen to keep the company’s value at a low level while making an investment to earn a higher return when the company goes public. Non-participating preferred shares are said as it would give less incentive for investors because they do not generate profits for investors unless the corporate value increases to a certain level (in the case of the example below, the recovery amount is flat at 200 million yen to 1 billion yen).

On the other hand, considering that preferred shareholders must also convert to common shares when the company is listed, it can be said that there are certain advantages in setting a non-participating structure from the perspective that the founder and investors can aim to be listed with a common interest.

MK @ 11/03/2022