Designing the Terms of Preferred Shares: Liquidation Preference, Conversion and Down-Round Adjustment
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
In fundraising using class shares, such as a Series A round, it is customary for the investor side to present, together with the investment agreement and the shareholders' agreement, a draft schedule to the articles of incorporation titled "Terms of Class Shares." This document is not merely an attachment to the investment agreement; it is approved at the shareholders' meeting as a proposal to amend the articles of incorporation, and it leads to the registration of matters such as the terms of the shares to be issued.
A contract, as a rule, binds only the parties who agreed to it, but the terms of class shares set out in the articles of incorporation have effect against everyone who becomes a shareholder of the company. Investors who join in the next round are bound by these provisions of the articles, and they extend as they are to third parties who acquire the shares. When reviewing a draft of the terms of class shares, it is therefore essential to look not only at the relationship with the investor in front of you but also at the ripple effects on the company's capital policy as a whole in the future.
When the issuing company or the founders read this draft, it is lined with unfamiliar technical terms, such as the liquidation preference, conversion into common shares, down-round adjustment and call provisions on listing, and they will often be unsure how far to negotiate. Here, I look at the legal position of the main provisions contained in the schedule to the articles of incorporation and the practical points to check. The overall picture of fundraising and the division of roles among the agreements are covered in What Is Fundraising Through Class Shares (Preferred Shares)? An Overview of Series A Agreements and Procedures.
Key Items to Check in Designing Class Shares
Before going into the details of each provision, here is the framework you should check first in the overall design of the schedule to the articles of incorporation.
- The multiple and the participating or non-participating classification in the liquidation preference
- The order of distribution and the basis for pro rata calculation among multiple classes of preferred shares
- The weighted average method in down-round adjustment (broad-based or narrow-based) and the scope of exclusions
- The call provision for common shares on listing and the conditions for the timing of conversion
- The scope of exclusion in the articles of incorporation of resolutions of class shareholders' meetings under Article 322 of the Companies Act
Freedom to Set Class Share Terms in the Articles and the Effect of Registration
The terms of class shares are set out in the articles of incorporation under Article 108 of the Companies Act. When issuing preferred shares, the company sets the total number of authorized shares of each class and incorporates into its articles the specific rights it adopts, such as the distribution of residual assets, voting rights at shareholders' meetings, put options and call provisions. There is no obligation to include every right that could be provided for in the articles; rights are selected according to the agreed rights design.
When the investment agreement is concluded, a proposal to amend the articles of incorporation setting out these matters is submitted to the shareholders' meeting, and the approved terms are registered. The draft sent by the investors is therefore both a subject of contract negotiation and a schedule to the proposal to amend the articles of incorporation.
This is the major difference between what is agreed in a shareholders' agreement and the terms of class shares. Obligations imposed under a shareholders' agreement remain contractual claims between the parties, whereas the terms of class shares are set out in the articles of incorporation and registered. Shareholders who acquire shares of that class in the future also become shareholders on the premise of the rights set out. Even when new investors come in at subsequent rounds, the terms are built on the existing provisions of the articles, so proceed with your review conscious that the initial design forms the foundation of the capital policy that follows.
Multiples and Participation Methods in the Liquidation Preference
One of the provisions in the terms of class shares with the greatest economic impact is the liquidation preference. This is a mechanism under which, when the company is dissolved and its residual assets are distributed, preferred shareholders can receive a preset preferential distribution amount ahead of common shareholders.
These residual assets are the assets remaining after taxes and public charges and payments to creditors have been completed. If sufficient residual assets do not exist, even preferred shareholders cannot receive the full distribution, so even where the multiple for the preferential distribution amount is set at 1x, it is different from a provision guaranteeing repayment of the invested principal.
The preferential distribution amount is calculated by multiplying the amount paid in per preferred share by a prescribed multiple. In Japanese startup practice, 1x is often used as the standard level, and a multiple exceeding 1x is a term favorable to investors, so first check whether it stays at 1x.
The classification as participating or non-participating is also a major issue. Participating preferred shares are designed so that, after preferred shareholders first receive the preferential distribution amount, if residual assets still remain, they can also share in the distribution of the remaining assets together with common shareholders. Non-participating preferred shares, by contrast, are designed so that no additional distribution is received after the preferential distribution amount; there are designs in which the holder chooses between receiving the preferential distribution amount, converting into common shares and receiving a distribution, or the amount resulting from a deemed conversion provided for in the agreement. Which method can actually be used is confirmed from the articles of incorporation and the distribution agreement. The holder does not receive both the preferential distribution amount and a distribution as a common shareholder.
METI's "Key Points to Note in Contracts for Sound Venture Investment in Japan (Expanded Edition)" (September 2025) also reports a tendency for 1x participating preferred shares to be common in domestic practice. However, it also proposes reviewing the practice of treating participation as a given and considering the adoption of non-participating preferred shares or capped participating preferred shares, which set an upper limit on the distribution amount, depending on the expected enterprise value at exit and the level of valuation. Whether the shares are participating or not is a matter decided through negotiation between the parties, and it is a factor that also affects the investment terms of subsequent rounds.
Where different classes of preferred shares exist after several rounds, also check the order of priority and the method of pro rata allocation among the classes. For example, a design that ranks new and old classes equally and, where residual assets are insufficient, allocates pro rata according to the ratio of each class's preferential distribution amount makes it easier to maintain fairness among investors. The mechanism for extending the concept of the preferential distribution not only to the liquidation of the company but also to the distribution of sale proceeds in an M&A transaction is covered in What Is a Distribution Agreement? The Practice of Distribution and Deemed Liquidation Clauses in M&A.
Put Options and the Formula for Down-Round Adjustment
Preferred shares generally carry a right, exercisable at the preferred shareholder's request, to require the company to acquire them in exchange for common shares (a put option, Articles 166 and 167 of the Companies Act). However, it is not uniformly the case that the request can be made at any time without conditions; the period and conditions for making a request follow the provisions of the articles of incorporation, so check the provisions on the exercise period.
The conversion ratio is calculated by dividing the amount paid in for the preferred shares by the acquisition price set out in the articles of incorporation. In many cases it is initially set at 1:1, meaning one common share is delivered for each preferred share, but this is the result of the base amount for the acquisition consideration and the acquisition price being set at the same amount.
This acquisition price may be reduced through down-round adjustment. This is a mechanism under which, if new shares or similar securities are issued at a price below the acquisition price of the preferred shares, the acquisition price of the existing preferred shares is reduced in accordance with the provision. For stock acquisition rights and similar securities, rather than comparing only the issue price of the rights themselves, the price to be compared as prescribed in the provision is calculated using the number of underlying shares and the exercise price. When the acquisition price is reduced, the number of shares delivered on conversion into common shares increases, and the dilution of existing investors' holdings is mitigated.
Adjustment methods include the full ratchet method, which reduces the acquisition price all at once to the new issue price, and the weighted average method, which factors in the number of issued shares and the issue price in the calculation. The weighted average method is a design that gives more consideration to the issuing company than the full ratchet method. Within the weighted average method, there is the broad-based approach, which widely includes potential shares in the base number of shares included in both the numerator and denominator of the formula, and the narrow-based approach, which limits the scope of shares counted. Other conditions being equal, the broad-based approach, which takes a wider base number of shares, results in a more gradual reduction of the acquisition price and is favorable to the issuing company and common shareholders. The narrow-based approach works in favor of investors, but examples of it being proposed are seen in practice. Avoid accepting it unconditionally, and consider it in light of its impact on your company's capital policy.
Down-round adjustment generally includes practical exceptions. Typical examples are an exemption from application where a certain percentage of preferred shareholders (such as the majority investors) consent, and an exclusion where potential shares such as stock options remain within a certain percentage (such as 10% of the fully diluted number of shares). For example, even when issuing stock options with an exercise price of JPY 1, check whether the issuance falls within the exclusion conditions. These exceptions are conditions set in the individual articles of incorporation or agreements. Check, in line with the provision, whether the exclusion refers to potential shares already issued or also includes an unissued pool, and as of what time the number of issued shares used as the base is measured.
Call Provisions on Listing and Practical Procedural Coordination
The terms of class shares frequently include a call provision under which, on the listing of the shares, the company acquires the preferred shares and delivers common shares as consideration (Article 108, Paragraph 1, Item 6 and Paragraph 2, Item 6 of the Companies Act). It is a provision for consolidating all issued preferred shares into common shares at the time of listing.
In conventional practice, conversion into common shares was often carried out around the time of the listing application, but conversion at that time is not a uniform obligation under the law or the Tokyo Stock Exchange's listing examination. As also indicated in METI's September 2025 expanded edition, the method of converting on the listing date itself is permitted under the listing examination and disclosure rules.
However, if a design that converts on the listing date is adopted, close coordination is required with the lead managing underwriter, the stock exchange, the Local Finance Bureau, the Japan Securities Depository Center (JASDEC) and the shareholder registry administrator regarding the conditions for the occurrence of the acquisition event under the articles of incorporation, the timing of the board of directors' resolution, and the statements in disclosure documents on the timing of conversion and dilution risk. In particular, the practical possibility that the new record in JASDEC accounts will be made after the listing date must also be taken into account. In addition, if the listing is cancelled, the procedure for reverting to preferred shares does not take effect automatically, so prior arrangements and resolution procedures are necessary.
Accordingly, rather than assuming that the call provision on listing is a standard provision with little practical benefit in contesting its content, it is important to consider its terms, including flexibility in the timing of conversion and the procedures if the listing is cancelled.
Resolution Requirements for Class Shareholders' Meetings and a Negotiating Perspective
Once class shares are issued, under Article 322, Paragraph 1 of the Companies Act and other provisions, a resolution of a class shareholders' meeting is required when the company takes certain actions that are likely to cause detriment to the shareholders of a particular class. However, to maintain agile decision-making, a design is widely used in practice in which the articles of incorporation provide that a resolution of a class shareholders' meeting is not required (Article 322, Paragraph 2 of the Companies Act), and the confirmation of investors' wishes is consolidated into the matters requiring prior approval under the shareholders' agreement. The design of matters requiring prior approval in a shareholders' agreement is covered in detail in Review Points for Shareholders' Agreements: Matters Requiring Prior Approval, Information Rights and the Obligations of Managing Shareholders.
However, under Article 322, Paragraph 3 of the Companies Act, for amendments to the articles of incorporation relating to the addition of a class of shares, changes to the terms of shares, or increases in the total number of authorized shares or the total number of authorized shares of a class (excluding those relating to the number of shares constituting one unit), the resolution of a class shareholders' meeting cannot be excluded even by a provision of the articles as long as there is a likelihood of detriment and there are class shareholders with voting rights. There are also constraints under other mechanisms, such as the class shareholders' meeting for the issuance of shares for subscription (Article 199, Paragraph 4 of the Companies Act). Understand that even if the wording of the articles states that "a class shareholders' meeting is not required," not every resolution can be omitted.
When considering each provision, check first whether the multiple of the liquidation preference exceeds 1x and whether the shares are participating or non-participating, since these have a large economic impact. As for the method of down-round adjustment, if a narrow-based approach is proposed, there is room to negotiate a change to a broad-based approach. Also check whether the exclusion for stock options matches your future hiring plans. The meaning of the provisions as business decisions is also discussed in Provisions Founders Should Review as Business Decisions in Preferred Share Investment Agreements.
At LegalAgent, we advise on the "Terms of Class Shares" schedule to the articles of incorporation not only by checking each provision, but also by looking ahead to the impact on future rounds and on the capital policy as a whole. We also provide support on issues that require discussion with investors, such as the design of the distribution multiple and the method of down-round adjustment.
Frequently asked questions
What is the difference between participating and non-participating liquidation preferences?
Non-participating is a design in which the holder chooses between receiving the preferential distribution or receiving a distribution ranking equally with common shares, while participating is a design in which the holder receives the preferential distribution and then also shares in the distribution of the remainder. Participating terms are favorable to investors, and the share going to founders and common shareholders is correspondingly smaller.
What is down-round adjustment (an anti-dilution provision)?
It is a provision that, where the company raises additional funds at a lower valuation than in the previous round, adjusts the conversion price of existing preferred shareholders to mitigate dilution. There are adjustment methods such as the broad-based weighted average, and the choice of method significantly changes the impact on founders.
What happens to preferred shares at the time of listing?
In Japan, preferred shares are normally converted into common shares before listing, and the acquisition provisions and conversion procedures for this are set out in advance in the terms of the class shares.
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