What Is a Distribution Agreement? Practical Issues of Distribution on M&A and Deemed Liquidation Clauses
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
In a Series A financing, in addition to the investment agreement, the shareholders' agreement and the document setting out the terms of the class shares, a document called a "shareholders' distribution agreement relating to acquisition," or simply a "distribution agreement," sometimes appears. These four documents are an example of a structure in which separate documents are prepared for each role. The number of documents is not fixed by law, and the rights attached to shares set out in the articles of incorporation should be considered separately from the contracts between the parties. Compared with the investment agreement and the shareholders' agreement, I feel that the distribution agreement is a document whose place in the overall structure is hard to grasp for founders seeing it for the first time.
A distribution agreement is a contract that sets out how the sale proceeds will be allocated among the shareholders when the company is acquired through M&A. Many people wonder why a separate contract is prepared even though the articles of incorporation already contain a provision on the preferential distribution of residual assets for preferred shares. The reason is structural: the residual asset distribution provisions in the articles of incorporation alone cannot fully cover an exit through M&A.
In this column, I untangle the difference between the preferential distribution of residual assets under the articles of incorporation and the contractual distribution rules, and I set out how a distribution agreement works and the key points founders should check, using numerical examples.
Residual Asset Distribution under the Articles of Incorporation and the Problem in M&A
The preferential distribution of residual assets set out in the articles of incorporation as part of the terms of preferred shares is a rule that assumes the company is dissolved and liquidated. Under the Companies Act, when a stock company is liquidated, the liquidator manages and disposes of the company's assets and, as a rule, distributes to shareholders the assets remaining after its debts are paid. The determination of the distribution of residual assets is governed by Article 504 of the Companies Act, and the restriction on distribution before debts are paid by Article 507 of the same Act. By giving preferred shares priority in this distribution, investors can receive a prescribed distribution ahead of common shareholders, to the extent of the assets available for distribution.
In startup exits, however, M&A such as share transfers and mergers are widely used. In a share transfer, in which the acquirer obtains the issuer's shares, the company continues to exist as a legal entity, and in an absorption-type merger or the like, the company ceases to exist without going through liquidation proceedings.
As a result, the residual asset preferential distribution provisions in the articles of incorporation alone do not determine the rules for allocating sale proceeds among shareholders in M&A. Investors often invest on the understanding that "they will be able to recover their investment preferentially when the company is sold," but a gap arises because the residual asset distribution clause in the articles of incorporation applies only in the limited situation of dissolution and liquidation.
If this gap is left as is, the preferential recovery that the preferred shareholders expected may not be achieved in an M&A. That said, it is not appropriate to interpret that merely stating the words "deemed liquidation" in the articles of incorporation automatically allows the redistribution of proceeds to be enforced even against shareholders who are not parties to the contract. The rights attached to class shares under the Companies Act and an agreement among shareholders on the allocation of proceeds need to be treated as separate matters.
How Deemed Liquidation Works and the Scope of Covered Transactions
Deemed liquidation is a contractual agreement under which an M&A transaction that does not involve the dissolution and liquidation of the company is treated as if the company had been liquidated, and the consideration is allocated among shareholders in the same order and proportions as on liquidation. It serves to supplement, through an agreement among shareholders, the situations that the residual asset distribution under the articles of incorporation does not directly reach.
In practice, a common method is to enter into a standalone distribution agreement and give concrete form to the distribution rules as an agreement among shareholders. The typical framework of a distribution agreement first defines which transactions are "deemed liquidation events," then sets out the order of distribution and the calculation method when such a transaction occurs, and includes provisions restricting transaction structures that circumvent the agreement.
The range of transactions included as deemed liquidation events mainly includes the following.
- Share transfers that transfer control, such as a majority of voting rights
- Mergers in which the company is the disappearing company
- Share exchanges or share transfers in which the company becomes a wholly owned subsidiary
- Transfers of all or a material part of the business
Although these are not liquidations in legal form, they can be occasions for shareholders to recover their investment, in that control of the company or the substance of its business is effectively transferred to a third party. However, if the range of covered transactions is defined too broadly, the agreement may end up applying even to transactions that do not involve any substantive change, such as formal reorganizations within a group or a transition to a holding company structure. Careful design is important, for example including a provision that excludes intra-group reorganizations that do not change the substantive control relationship.
In the case of a business transfer, the company itself receives the sale proceeds. To return the proceeds received by the company to the shareholders, procedures such as dividends of surplus, acquisition of treasury shares, or dissolution and liquidation of the company must be considered. Dividends and acquisitions of treasury shares are subject to the distributable amount restrictions in Article 461 of the Companies Act, liquidation is subject to the rules on payment of debts and distribution of residual assets, and the tax treatment of each must also be confirmed. It should be kept in mind that a contractual agreement on deemed liquidation does not make it possible to circumvent these dividend restrictions and other rules under the Companies Act. The funds actually available for distribution are affected by deductions for transaction costs, repayment of liabilities, taxes, escrow (holding back part of the sale price), earn-outs, and the valuation and timing of receipt of non-cash consideration.
Distribution Calculations Using Numerical Examples and the Non-Participating Option
The distribution calculation in a distribution agreement is often designed in two stages. The first stage is the preferential distribution to preferred shareholders, in which a certain multiple of the investment amount (1x is typical, but higher multiples are sometimes set) is distributed to the preferred shareholders ahead of other shareholders. The second stage allocates the remaining amount after the preferential distribution among all shareholders in proportion to their ownership ratios, treating the preferred shares as if they had been converted into common shares. A design in which preferred shareholders also take part in this second stage is called "participating."
To get a feel for this, let us look at a concrete numerical example. The following figures are hypothetical and for explanation only, and they differ from the figures in any actual deal.
As assumptions, there is a single class of preferred shares, the total amount paid in for the preferred shares is JPY 200 million, the preferential distribution is 1x participating, and the ownership ratio of the preferred shares if converted into common shares is 20% (80% for the common shareholders). It is also assumed that the sale price becomes, as is, the funds available for distribution to all covered shareholders, without taking costs, taxes and the like into account. We compare the case in which this company is sold for (a) JPY 300 million with the case in which it is sold for (b) JPY 1.5 billion.
(a) Sold for JPY 300 million
In the first stage, the preferred shareholders receive JPY 200 million, the same amount as their investment, as a preferential distribution. The remaining amount is JPY 100 million, which is JPY 300 million minus JPY 200 million. In the second stage, when this remaining JPY 100 million is allocated by post-conversion ownership ratio, the preferred shareholders receive JPY 20 million, equivalent to 20%, and the common shareholders receive JPY 80 million, equivalent to 80%. As a result, the preferred shareholders receive a total of JPY 220 million (JPY 200 million + JPY 20 million), and the common shareholders receive JPY 80 million.
(b) Sold for JPY 1.5 billion
Similarly, the preferred shareholders first receive JPY 200 million as a preferential distribution. The remaining amount is JPY 1.3 billion, which is JPY 1.5 billion minus JPY 200 million. When this remaining JPY 1.3 billion is allocated, the preferred shareholders receive JPY 260 million, equivalent to 20%, and the common shareholders receive JPY 1.04 billion, equivalent to 80%. As a result, the preferred shareholders receive a total of JPY 460 million (JPY 200 million + JPY 260 million), and the common shareholders receive JPY 1.04 billion.
In case (a), where the sale price is low, the JPY 200 million preferential distribution takes up most of the consideration, so the common shareholders take home JPY 80 million. There is a large gap compared with JPY 240 million, the amount obtained by allocating the entire sale price at the 80% ownership ratio. In case (b), where the sale price is high, the common shareholders also take home more, but because of the participating design, the preferred shareholders receive JPY 460 million, more than twice their investment. A participating distribution can be described as a design that achieves both securing recovery of the investment at a low sale price and obtaining an additional upside at a high sale price.
In contrast, under a "non-participating" design, the preferred shareholders choose whichever is more advantageous: receiving the preferential distribution (JPY 200 million), or converting into common shares and receiving their pro rata share of the entire consideration (JPY 1.5 billion x 20% = JPY 300 million). Note that in this comparison, 20% is applied to the entire consideration, not to the remaining amount after the preferential distribution. In case (b), choosing the JPY 300 million pro rata share of the entire consideration is more advantageous than the JPY 200 million preferential distribution, so the preferred shareholders would forgo the preferential distribution and choose to receive a distribution as if they had converted into common shares. Whether actual conversion is required, or whether a contractual calculation alone suffices, also follows the terms of the clause.
Where the sale price falls short of the preferential distribution amount, the preferred shareholders also receive a distribution only to the extent of the funds that can be recovered. Where there are multiple classes of preferred shares, there are designs based on ranking structures such as senior or equal ranking (pari passu), under which classes of equal rank share pro rata according to the ratio of their preferential distribution amounts. Before calculating simply by shareholding ratio, check the ranking and allocation method in the contract.
Securing the Agreement of All Shareholders and Coordination with the Drag-Along Clause
Because a distribution agreement is a contract among shareholders, it has no effect that directly binds shareholders who are not parties to it. Even if some shareholders do not participate, the agreement usually remains effective among the shareholders who agreed, but since the design redistributes the consideration received by all shareholders as a whole, it is necessary to obtain the agreement of everyone it is meant to cover. This is because the share transfer proceeds received by non-participants cannot automatically be put toward the redistribution.
You should also confirm participation in the distribution agreement by officers and employees who newly become shareholders by exercising stock options, and by new investors who join in subsequent rounds. It is necessary to put in place procedures that actually bring them into the agreement, such as including clauses in stock acquisition right allotment agreements and investment agreements that obligate them to join the distribution agreement.
When reviewing a distribution agreement, also check the consistency between the trigger requirements of the drag-along clause (the right to compel a sale) in the shareholders' agreement and the distribution rules. A drag-along clause is a mechanism for requiring other shareholders to sell their shares in an M&A that meets certain requirements, while a distribution agreement is a mechanism for allocating the sale proceeds among shareholders. Another approach is to line up individual agreements at the time of the transaction. If the two are linked in advance, the risk of disputes over allocation or participation in the sale arising just before the transaction can be reduced. Note that a drag-along is a contractual right to make a demand, and it differs from a squeeze-out procedure under the Companies Act, which can also sweep in non-parties to the contract.
From the founders' perspective, the focus is on whether the trigger requirements for the drag-along include the consent of the management shareholders, and whether a minimum sale price is set so that the clause cannot be triggered for transactions below a certain sale price. If the design allows the clause to be triggered by a majority of investors alone, founders may be forced to sell on terms that sharply compress their take-home amount in a situation where the sale price is low, as in numerical example (a). In addition, because the terms differ between preferred shares and common shares, it is not necessarily mandatory to apply the same per-share price to all shareholders.
Further, liability for representations and warranties and indemnification required at the time of sale should be shared according to the degree of involvement in management and the size of the consideration received. For shareholders who are not involved in management, it is worth considering whether they can give warranties about the company's business as a whole, and negotiating to narrow the matters warranted and to cap their indemnification liability. It is important to check notice deadlines, due dates, the scope of indemnification and similar points in advance.
The terms of the preferential distribution of residual assets on the articles of incorporation side are covered in Designing Preferred Share Terms: Review Points for Liquidation Preference, Conversion and Down-Round Adjustments. The relationship with the drag-along clause in the shareholders' agreement is discussed in Review Points for Shareholders' Agreements: Prior Consent Matters, Information Rights and Obligations of Management Shareholders. The place of the full set of contracts is explained in What Is Financing through Class Shares (Preferred Shares)? An Overview of Series A Contracts and Procedures, and an overview of the clauses founders should examine as business decisions is set out in Clauses Founders Should Examine as Business Decisions in Preferred Share Investment Agreements.
Modeling Distribution Scenarios and Support from LegalAgent
At LegalAgent, we review the investment agreement, the shareholders' agreement, the terms of the class shares and the distribution agreement as a single set of contractual relationships, and we help model distributions under multiple sale price scenarios. From confirming consistency between the preferential distribution of residual assets in the articles of incorporation and the deemed liquidation rules in the distribution agreement, to designing the order of priority where there are multiple classes of preferred shares, we provide support from the perspective of the issuer and its founders.
Frequently asked questions
What is a deemed liquidation clause?
It is an arrangement under which, if the company is acquired through M&A, the consideration is distributed among the shareholders in the same order of priority as in a liquidation of the company. Because the preferential distribution of residual assets in the articles of incorporation operates only in a liquidation, distribution upon M&A is addressed by this clause.
Who signs the distribution agreement?
It is usually signed between the issuing company and all shareholders (including common shareholders such as the founders). If not all shareholders are parties, the distribution as agreed may not be carried out upon M&A.
How does it relate to a drag-along clause?
A drag-along is a clause that, with the approval of certain shareholders, requires participation in an M&A transaction, and it functions in combination with distribution under deemed liquidation. It is necessary to check whether the triggering conditions of the two are consistent.
Services connected to this topic