J-KISS Conversion (Exercise) Procedures: A Practical Guide to Avoid Scrambling at Series A

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

With J-KISS, consultations about conversion tend to be far more hectic than those about issuance. It is common for the question "By the way, how do we handle the existing J-KISS?" to come up just as the Series A term sheet has been settled and negotiations on the preferred share agreements are entering the final stage. The conversion procedure is documentation work that runs in parallel with the Series A closing. Separately from negotiating the investment agreement, you need to plan and work through a sequence of steps: resolutions of the shareholders' meeting and other bodies, obtaining consent forms, exercise notices, and registration.

At the time a J-KISS is issued, the contract is thin and the procedure looks simple. In the matters I have handled, however, conversion took more work than issuance. Here, I explain what actually needs to be done at the conversion stage, following the order of the procedure.

The mechanics of J-KISS itself are covered in What Is J-KISS? Structure, Capital Policy and Points for Founders to Check, and the terms to check before issuance are covered in Checklist Before Raising Funds with J-KISS: Capital Policy Points Founders Should Check. Please refer to those as well.

Note that the content of J-KISS templates varies depending on the version and on individual modifications. Here, I explain the practical process with reference to Post Cap J-KISS v2.01 published by Coral Capital. For an actual conversion, it is important to check each point individually against the agreement and terms of issue you have on hand, the company's articles of incorporation, and the terms of the Series A.

Contractual Conversion Routes and Advance Preparation

Before planning the specific steps of a conversion, there is information you will want to gather in advance. This includes confirming the conversion route set out in your agreement and terms of issue (exercise by the investor or acquisition by the company); the breakdown of the fully diluted share count needed to fix the conversion price; the point of contact for every J-KISS investor and a realistic schedule for collecting documents; whether a class shareholders' meeting is required if class shares have already been issued; and an advance check, from registration and tax perspectives, of the amount by which stated capital will increase as a result of the conversion.

Under the structure of the template, there are broadly two routes by which the stock acquisition rights become shares.

The first is exercise by the investor. The investor submits an exercise notice to the company and pays JPY 1 per stock acquisition right, and receives a number of shares equal to the total issue price divided by the conversion price. Because payment of, for example, JPY 1 million per right was already completed at issuance, the design keeps the payment at exercise to a nominal JPY 1 per right.

The second is acquisition by the company. The template contains an acquisition clause under which, if the company decides to carry out a qualified financing (the next equity financing), the body designated by the company resolves on an acquisition date, and on that date the company acquires all unexercised stock acquisition rights and delivers shares in exchange. Under this acquisition route, the company is to notify investors at least two weeks before the acquisition date, and where a fraction of less than one share arises in the shares to be delivered, the structure provides for adjustment in cash in accordance with Article 234 of the Companies Act.

Whichever route is chosen, the number of shares to be delivered is calculated as "total issue price / conversion price." In the basic form of the template, the conversion price is the lower of the price after applying the discount and the price based on the valuation cap. Rounding up where the price contains a fraction of less than JPY 1 is also handled according to the terms of issue. The approach to this calculation is as explained in the c27 article, and the practical work of conversion starts precisely with finalizing this calculation.

Finalizing the Conversion Price and Number of Shares

The starting point of the conversion procedure is finalizing the calculation. Until the conversion price is fixed, you cannot determine the number of shares to be delivered, the total number of authorized shares that must be provided for in the articles of incorporation, or the content of the registration application.

The first thing to settle in the calculation is the fully diluted share count. In addition to issued common shares, class shares and existing stock options, you check one by one, in line with the template's definitions, how much of any unissued option pool reserved under a shareholders' agreement or the like should be included, and whether treasury shares and treasury stock acquisition rights held by the company itself have been properly excluded. In the template I referred to, any option pool newly increased in connection with the next financing is excluded, so it is treated separately from the existing unissued pool. Because a difference in this breakdown can change the conversion price and the number of shares, the calculations for each series are cross-checked.

For companies that have issued J-KISS in multiple rounds, the calculation takes even more steps. Where J-KISS converting on a cap basis and J-KISS converting on a discount basis coexist, the post-conversion shares of the portion converting on a discount basis must be reflected in the denominator and the calculation redone, so the figures are not fixed in a single pass. In addition, where each series has a different cap, multiple conversion prices will be calculated, one per series.

Under the investor-exercise route, fractions of less than one share are rounded down and no cash adjustment is made. If you finalize the table of share numbers first, including the treatment of each investor's fractions, the subsequent document preparation goes smoothly.

I recommend that you do not keep the calculation results within the company, but prepare them as materials that can show the investors the basis of the calculation. If you can clearly present the basis for calculating the conversion price and the breakdown of the fully diluted share count, the investors' review proceeds faster and collecting the exercise notices also goes more smoothly.

Exercise Practice via an Amendment of the Terms

A common stumbling block in practice is the design of the shares into which the J-KISS converts. It may look as if formally applying the template's clauses is enough, but there are many situations that require advance arrangements.

One point to note is that the shares into which the J-KISS converts are not necessarily the same as the shares newly issued in the Series A. If the issue price of the class shares issued in the next equity financing is the same as the conversion price, those class shares are delivered as they are. However, in a typical financing where a valuation cap or discount applies, the J-KISS conversion price is lower than the per-share price paid by the Series A investors. In such a case, the template adopts a design that delivers a different class of shares in which the per-share residual asset liquidation preference and the acquisition price for conversion into common shares are adjusted to the conversion price.

Specifically, in contrast to the "Class A Preferred Shares" subscribed for by the Series A investors, a separate class such as "Class A1 Preferred Shares" is newly created for the J-KISS conversion. Rights such as voting rights are kept almost identical to Class A, while the per-share residual asset liquidation preference and the acquisition price for conversion into common shares are set to match the J-KISS conversion price rather than the issue price of Class A. Without this arrangement, a J-KISS investor who acquired shares at a conversion price of JPY 10,000 would receive the same liquidation preference of JPY 40,000 per share as a Series A investor who subscribed at JPY 40,000 per share, creating an imbalance that does not correspond to the amount invested. In this example where the conversion prices differ, creating a separate class is the approach consistent with the template's terms. That is why unfamiliar share classes appear in the articles amendment proposal at the shareholders' meeting at the time of conversion.

In practice, therefore, a commonly used approach is to tidy up the terms of the stock acquisition rights themselves before the rights are exercised. One method is to carry out an "amendment" that reflects the conversion price fixed by the calculation in the terms of issue as a specific fixed figure, specifies the newly created Class A1 Preferred Shares as the shares to be delivered, and strips out exercise conditions and acquisition clauses that are no longer needed, and then to have each investor exercise. The amended terms of issue become a simple document of a few pages, covering the class of shares, the fixed conversion price, the exercise price of JPY 1 per right, transfer restrictions, provisions on recording stated capital, and so on.

This amendment method is generally carried out by obtaining consent forms from all of the holders of the relevant stock acquisition rights in addition to a resolution of the shareholders' meeting. The full text of the amended terms of issue is attached to the consent form as an exhibit to make the agreed content clear. The amendment route is not the only option, but if you choose this procedure in practice, it becomes difficult to proceed if even one investor cannot be reached or does not consent, so it is important to confirm in advance whether all investors will move in step.

Resolutions and Registration Carried Out on the Same Day as the Series A

The conversion is carried out as part of the series of Series A procedures. In a structure we put together in an actual matter, resolutions were adopted at a single extraordinary shareholders' meeting, with conditions chained across the agenda items.

First comes approval of the execution of the Series A investment agreement, shareholders' agreement and related agreements. Where the founder serving as representative director is a party to an agreement, you check whether its content constitutes a conflict-of-interest transaction under Article 356 of the Companies Act. If it does, approval is obtained from the shareholders' meeting in a company without a board of directors, or from the board of directors in a company with one (Article 365 of the Companies Act). Merely being a party who signs the same agreement does not, by itself, uniformly create a conflict of interest. Next, the articles of incorporation are amended, including the addition of the terms of the class shares and a change in the total number of authorized shares. Then, the issuance of the Series A preferred shares as offered shares (using the total-subscription agreement method) is resolved, conditional on the articles amendment taking effect. Finally, the amendment of the J-KISS is resolved, conditional on the articles amendment taking effect and on consent forms being obtained from all J-KISS holders. Where J-KISS has been issued in multiple rounds, a separate amendment proposal is put forward for each series.

In addition, you prepare the consent of all shareholders where the convocation procedure is omitted, proxies, and, for a company without a board of directors, a written decision of the directors (or, for a company with a board, board minutes). In a company that has already issued class shares, a separate resolution of a class shareholders' meeting may be required for the articles amendment or the offering terms, and the more classes there are, the more copies of written resolutions are needed.

Once the resolutions and consent forms are in place, exercise notices are collected from the investors. The exercise notice states the number of stock acquisition rights being exercised, the exercise date, the payment amount (JPY 1 x number of rights), and the number of shares to be received (number of rights x issue price / conversion price, rounded down to the nearest whole share). Even though the amount is small, JPY 1 x number of rights, actual payment is legally required, and evidence of receipt of funds is also used in the registration application.

Going through it this way, you can see that the conversion procedure alone produces a full set of documents, including minutes and consent forms. Because these are prepared in parallel with the Series A contract negotiations, it is important to work backward from the closing date and allocate early who will affix their seal to which document and when.

In the registration procedure, the Series A capital increase and the exercise of the J-KISS are treated on paper as separate items of change. The composition of documents we prepared in an actual matter was roughly as follows.

• Minutes of the shareholders' meeting, certificate of execution of the total-subscription agreement, and list of shareholders
• Payment certificates (prepared separately for the Series A capital increase and for the J-KISS exercise)
• Certificates regarding the recording of the amount of stated capital (for the Series A capital increase, plus one for each J-KISS series)
• Power of attorney for registration, registration application and its exhibit, and evidence of receipt of funds

What is easily overlooked in practice is making the basis of the calculation verifiable for each J-KISS series. Where the issue price or the number of rights exercised differs by series, the breakdown is clearly separated; preparing separate certificates for each series, however, is a device to make the calculation breakdown easier to read, to be distinguished from a statutory obligation.

And the registration will not necessarily go through smoothly on the first application. A capital increase registration involving conversion contains many registration items, and we have in fact been asked by the Legal Affairs Bureau to make corrections. If you have set a schedule that assumes completion of registration right after the Series A closing (such as a deadline for submitting the certificate of registered matters to investors), I recommend building in enough slack to allow for possible corrections.

Impact on Stated Capital and Related Issues to Check

One issue that tends to be overlooked at the conversion stage is the impact on stated capital.

When a J-KISS is exercised, the maximum amount of increase in stated capital and related items is calculated in accordance with Article 17 of the Ordinance on Company Accounting, from the book value of the stock acquisition rights at the time of exercise and the amount paid at exercise, among other things. The book value is not always equal to the amount paid at issuance, and the calculation also differs where there is a disposal of treasury shares or expenses to be deducted. Under the exercise route of the published template, one half of that maximum amount is recorded as stated capital (rounded up to the nearest yen), and the remainder as capital reserve. The route in which the company acquires the rights in exchange for shares is subject to a separate calculation rule under Article 18 of the same Ordinance. For example, if J-KISS with a total issue price of JPY 60 million is exercised, the book value at exercise remains JPY 60 million, all of it is satisfied by issuing new shares, and there are no expenses to deduct, the calculation adds JPY 1 x number of rights exercised to that amount. Leaving out the JPY 1 payments for a rough estimate, stated capital and capital reserve each increase by roughly JPY 30 million. Combined with the Series A capital increase itself, stated capital after closing can reach a level well above what was anticipated beforehand.

Because the level of stated capital may affect tax treatment and some licensing requirements, I think it is advisable to check in advance the amount of stated capital after both the conversion and the capital increase and, where necessary, to consider how to respond together with a tax accountant or other advisers. There really are companies that panic after closing, saying "We never expected our stated capital to increase this much."

In addition, once exercise is complete, the register of stock acquisition rights and the shareholder register must be updated promptly. J-KISS investment agreements usually provide that the investor is to be entered in the shareholder register promptly after conversion and that a certificate of the matters stated in the shareholder register is to be delivered to the investor. Where there are individual investors, there is also the issue that eligibility for the angel investor tax incentive is determined by reference to the exercise date of the stock acquisition rights, so please also carry out the tax checks discussed in the c36 article regarding the timing of conversion and the supporting documents.

You also need to pay attention to related issues that must be dealt with before the conversion.

Where a J-KISS has been transferred by the original investor, or a transfer is planned before conversion, the transfer procedures must be completed before entering the conversion procedure. Because the J-KISS terms of issue include a transfer restriction, a series of steps comes first: in addition to the transfer agreement between the parties, a request to the company for approval of the transfer, a resolution of approval by the company and notice of the decision, and the change of name in the register of stock acquisition rights. If there is a discrepancy as to who is treated as the holder of the stock acquisition rights for the procedure, the validity of the consent or exercise could be disputed.

If a certain period set out in the terms of issue looks likely to pass before the Series A, an amendment agreement revisiting the terms may be considered. The 18-month period in the published template is not a deadline upon whose passing the stock acquisition rights automatically lapse or are necessarily converted into shares. You check the exercise conditions available after the period passes separately from the end of the exercise period. The approach to the conversion deadline is as set out in the c36 article. In addition, where an M&A transaction comes before conversion, the published template provides, for certain change-of-control transactions and the like, a route for conversion into common shares by exercise before the acquisition and a route for acquiring the unexercised portion for cash equal to twice the issue price. A cash acquisition is not automatic; the procedure depends on the nature of the transaction and the route chosen (see the c27 article).

Frequently asked questions

When and how is J-KISS converted into shares?

There are two routes for conversion into shares: exercise by the investor and acquisition by the company. In exercise by the investor, the investor submits an exercise notice and pays JPY 1 per stock acquisition right. In acquisition by the company, after a qualified financing is decided, the company resolves on an acquisition date, notifies investors at least two weeks before the acquisition date, and then acquires all of the unexercised stock acquisition rights and delivers shares.

How is the number of shares delivered on J-KISS conversion calculated?

The number of shares delivered is calculated by dividing the total issue price by the conversion price. The conversion price is the lower of the price after applying the discount and the price based on the valuation cap. In this calculation, the fully diluted share count must be fixed first. Under exercise by the investor, fractions of less than one share are rounded down and no cash adjustment is made. Fractions of less than JPY 1 are handled in accordance with the terms of issue.

How does the J-KISS conversion procedure relate to the Series A closing?

The conversion procedure is documentary work carried out in parallel with the closing of the Series A preferred share issuance, and the resolutions and registration are also carried out on the same day. This is because, until the conversion price is fixed, the number of shares to be delivered, the total number of authorized shares to be provided for in the articles of incorporation, and the contents of the registration application cannot be determined. Preparing materials that can show the basis of the calculation makes the investors' review and the collection of exercise notices go smoothly.