MK @ Legal Biz Leaf Fundraising with Preferred Stock③
The Liquidation Preference is specifically stipulated in the Articles of Incorporation as follows.
*This is just an example. Please be advised to consult with a specialist (attorney at law, judicial scrivener, etc.) for the specific wording accustomed to your company’s situation.
Article X (Liquidation Preference)
In the event that the Company distributes residual assets, the Company shall pay to shareholders holding Class A Preferred Shares (hereinafter called the “Class A Preferred Shareholders”) or to the registered pledgees of Class A Preferred Shares (hereinafter called the “Class A Registered Pledgees”) 1000 yen per share of Class A Preferred Shares (hereinafter called the “Class A Preferred Distribution Amount”) in preference to the shareholders holding Common Shares (hereinafter called the “Common Shareholders”) or to the registered pledgees of Common Shares (hereinafter called the ” Common Registered Pledgees”).
The text makes it sound confusing but let say if a Class A Preferred Shareholder invests 1,000 yen (1 share), the Class A Preferred Shareholder will receive 1,000 yen first at the time of liquidation (*). By stipulating in this way, opportunities for investors’ capital recovery can be secured.
Also, the common shareholders (the founders) may be motivated to make more profit than the Class A preferred shareholders have invested.
*When we talk about distribution of residual assets, you may imagine a situation such as when a company is dissolved, but when the company is dissolved, the preferred shares will not be utilized, as there will be almost no profit left after payment to creditors. The class preferred shares are rather used in a situation where a business is sold through M&A, etc. and the profits from such sale are distributed.
“Class A Preferred Pledgees”
In Japan, pledges can be placed on shares, so almost all class shares have a reference to such pledgee. However, as investors, who invest tens to hundreds of millions of yen, are not usually expected to pledge their shares, the pledgee does not actually appear in the distribution process.
“Class A Preferred Distribution Amount”
The “1,000 yen” in the provision above referred to the original paid-in amount per Class A Preferred Share. In other words, it stipulates the right to receive a distribution of 1 times of the original invested amount. In Japan, a specific amount will be stated in the Articles of Incorporation and corporate registry for ease of understanding. Thus, in most cases, the amount is written as “2,000 yen” for doubling, or “3,000 yen” for tripling.
Full-Participating Distribution
Article X
2 If there are still residual assets after the distribution pursuant to the preceding paragraph, the Company shall make a distribution to Common Shareholders and Common Registered Pledgees, as well as to Class A Preferred Shareholders and Class A Registered Pledgees. In such case, in addition to the distribution amount in the preceding paragraph, the Company shall distribute to each Class A Preferred Shareholders or Class A Registered Pledgees the residual assets equal to the amount obtained by multiplying the residual assets to be distributed per share of Class A Preferred Shares by the Class A Acquisition Ratio set forth in Article XX.
As a continuation of the above example, if the company is sold for 2,000 yen, the Class A preferred shareholders will be distributed 1,000 yen (1 share) first. Then, the remaining 1,000 yen will be distributed to Class A Preferred Shareholders and to the Common Shareholders in proportion to their shareholdings.
In Japan, there are many venture companies that fail in the early stages of their operations, and they may not be able to fetch a large price when the companies are sold. Therefore, it is easier to reach an agreement with investors by issuing preferred shares on a “full-participation basis”, especially in the early stage.
“Class A Acquisition Ratio”
The acquisition ratio is the number of shares of common shares to be delivered in exchange for one share of class A preferred share at the time of listing. Normally, the ratio is (1:1), so one share of common share is delivered for each share of Class A preferred share.
The acquisition ratio is usually specified in the terms of the put option where stipulates conversion to common share, so in most cases, would not be stated in detail the liquidation preference paragraph.
Stock Split, Reverse Stock Split, and Low-Cost Issuance of Shares
The percentage of voting rights of preferred shares and common shares must always fluctuate in the same manner. Thus, “If one share of common share is split into two shares (a share split), the preferred share will be split in the same proportion” and conversely, “If two shares of common shares are consolidated into one share (a consolidation split), the preferred stock will also be consolidated at the same ratio” are almost always stipulated in the Articles of Incorporation.
*Share split: A procedure whereby shares are simply split without any additional investment, etc. It is used, for example, to increase the flowability of shares by reducing the price per share.
*Consolidation split: A simple consolidation of shares without reducing the amount of investment. For example, it is used to reduce the number of voting rights held by shareholders at a shareholders’ meeting.
The standard formula for Share split/ Consolidation:
Adjusted distribution amount = distribution amount before adjustment*(1/Ratio of split or consolidation)
Example: 2-for-1 split is made in the common share and Class A preferred share.
Adjusted distribution amount =1,000 yen*(1/2)
As a result, after the share split, the distribution amount for the Class A preferred share will be 500 yen per share (1,000 yen for two shares), meaning that the actual distribution amount will remain the same as before the split.
Example: Two shares of common shares and Class A preferred shares are consolidated into 1 share.
Adjusted distribution amount = 1,000 yen*(1/(1/2))
As a result, the Class A preferred distribution amount after the consolidation will be 2,000 yen per share (0.5 shares for 1,000 yen), meaning that the actual distribution amount will remain the same as before the consolidation.
The standard formula for share issues for existing shareholders :
There are some share issues in which existing shareholders are given the right to allot shares. In such cases, the following adjustment formula is used because the shares may be issued without consideration or at a lower price. (This is rarely done because it would reduce the value of the shares).
Distribution amount after adjustment =(Number of Class A Preferred Shares * Distribution amount before adjustment + Number of newly issued Class A Preferred Shares * Amount to be paid in) / (Number of issued Class A Preferred Shares + Number of newly issued Class A Preferred Shares)
Example: A free allotment of 1 share per existing share of common share and Class A preferred shares are made.
Distribution amount after adjustment =(1*1,000 +1*0)/ (1+1)
As a result, the Class A preferred distribution amount after the gratis allotment will be 500 yen per share (1,000 yen for two shares), meaning that the actual distribution amount will be the same as before the gratis allotment.
MK @ 11/05/2022
