Preferred Share Investment Agreements: The Terms Founders Should Treat as Business Decisions

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

In Series A fundraising, it is common for companies to issue preferred shares to institutional investors and venture capital firms. When you hear the term "preferred shares," it may sound like a primarily financial or technical arrangement: shares that take priority over common shares in the distribution of dividends of surplus and residual assets.

However, when you look closely at actual investment agreements and shareholders' agreements, the various conditions attached to preferred shares significantly shape how the company makes decisions after the round. In particular, at companies around the Series A stage, the founders must run the business while simultaneously managing the board of directors, handling shareholders' meetings, and coordinating relationships with key investors.

In my view, an investment agreement involving preferred shares is not merely a document setting out what rights are granted to investors. It is a document that designs the company's "freedom of business judgment": with whom, at what timing, and to what extent the company will be able to make business decisions freely as it runs its business going forward.

What a Preferred Share Investment Agreement Means for Management

The Legal Framework for Class Shares and Freedom of Business Judgment

Under the Companies Act, a stock company may issue two or more classes of shares with different terms regarding dividends of surplus, distribution of residual assets, voting rights at shareholders' meetings, and so on. The preferred shares used in startup fundraising are also designed using this class share system under the Companies Act. When actually issuing them, the company goes through a series of procedures: amending the articles of incorporation, determining the offering terms, obtaining resolutions of the shareholders' meeting and the board of directors, and confirming the registration and consistency with existing agreements.

In Series A practice, however, what founders need to keep in mind goes beyond the abstract legal question of what kinds of class shares can be designed under the Companies Act. What matters is whether the articles of incorporation, the investment agreement, the shareholders' agreement, and the actual operation of the board of directors function together consistently across the company as a whole.

Specifically, the articles of incorporation may set out a liquidation preference for the distribution of residual assets, while the investment agreement sets out the distribution method in a deemed liquidation arising from a sale of the company or a business transfer, and the shareholders' agreement provides for matters requiring investor approval relating to mergers, new share issuances, and the next financing round. The combination of these conditions directly affects the company's exit strategy and future business development.

As a founder, it is advisable not only to check whether "the proposed terms are standard in investment practice," but also to consider them from the perspective of "whether, having accepted these terms, the company can respond flexibly to future business alliances, additional fundraising, and organizational restructuring." At the Series A stage, it is not unusual for the business plan to change flexibly, such as a change in customer base, a major overhaul of the product, or entry into a new business. Viewing the contract terms as a framework for preserving the company's freedom to manage, so that it can respond promptly to such changes in its environment, is a helpful stance.

Sorting the Provisions into Three Groups

When you receive a draft investment agreement, trying to negotiate every provision in detail with equal weight will exhaust both the founders and the person in charge of administration. In Series A negotiations, the parties need to reach agreement within a limited timeframe, and if you try to rewrite every provision to be as favorable to your company as possible, there is a risk that the negotiation itself will stall.

In practice, it helps to approach the contract provisions by dividing them into the following three groups.

First, there are matters that must be put in order accurately because they relate to laws and procedures under the Companies Act. These include the determination of offering terms, amendments to the articles of incorporation, and the procedures for convening and adopting resolutions of the board of directors and shareholders' meetings. Any defects here will require corrective action at the time of future registrations or the next round, so legal must confirm these reliably.

Second, there are matters that are generally accepted as part of investment practice but whose standards should be adjusted to fit the company's actual circumstances. These include periodic information rights, certain matters requiring prior approval, preemptive rights, and restrictions on share transfers. The practical focus is to adjust these to a level that does not impose an excessive burden in light of the company's structure and business plan.

Third, there are matters that should be decided carefully as business decisions, because they may significantly narrow the future options of the company and the founders. These include the distribution ratios in a deemed liquidation, broad veto rights, and non-compete obligations imposed on the founders personally. For this group, it is important not merely to point out whether there is a legal risk, but to estimate concretely what impact accepting the provision would have in the future, so that management can make a decision with full understanding.

Deemed Liquidation Provisions and Future Distribution Design

Different Distribution Paths Depending on the Transaction Structure, and the Procedures Involved

When reviewing the terms of preferred shares, one of the provisions requiring the closest attention is the deemed liquidation provision.

A deemed liquidation is an arrangement under which, although the company does not enter into legal dissolution and liquidation proceedings, certain transactions, such as an M&A or a transfer of control through a transfer of shares above a certain percentage, are "deemed to be a substantive liquidation," and consideration is distributed to preferred shareholders ahead of common shareholders. The scope of covered transactions is not uniformly fixed by law; it is specifically determined by the definitions in the investment agreement.

Who receives the consideration differs depending on the form of the transaction. In an acquisition by share transfer, the shareholders who sell receive the consideration. In a business transfer, the company as seller receives the consideration, so a separate procedure is needed to distribute it to shareholders. Where a dividend of surplus or an acquisition of treasury shares is used, the respective resolution procedures and the restrictions on the distributable amount must be checked. In a reorganization such as a company split, the procedures must be confirmed according to the method used, including the type of consideration, whether cash or shares, and to whom it is delivered. You need to confirm not only the distribution formula in the contract but also whether it can actually be carried out, taking taxation into account.

Types of Liquidation Preference and Maintaining Incentives

In a deemed liquidation, what founders should look at is not limited to the multiple, that is, "how many times the investment amount comes back on a preferred basis." Liquidation preferences mainly come in the following types:

• 1x non-participating: The preferred shareholders first receive a preferential distribution equal to their investment amount (1x), with the remainder divided among the common shareholders only, or alternatively the preferred shareholders convert into common shares and share in the whole pro rata to their shareholding, whichever is more favorable to them
• Participating: The preferred shareholders receive a preferential distribution equal to their investment amount and then also participate, together with the common shareholders, in the distribution of the remaining value pro rata to their shareholding
• Capped participating: Like participating preferred, the distribution is received in two stages, but a cap, such as a certain multiple of the investment amount, is set on the total amount the preferred shareholders receive

In addition to checking these economic terms, it is important to simulate how the comparative calculation against the distribution amount upon conversion into common shares is performed, and how much value would remain in the hands of the common shareholders and founders assuming a realistic sale price.

Suppose the company receives an acquisition offer of a certain size before it has achieved rapid profit growth. Even if, given the business outlook and the founders' wishes, the founders would like to consider the offer positively, if the liquidation preference is designed as a heavy participating preference, a situation may arise in which the investors secure an ample return while the founders and employee shareholders who have worked hard are left with almost nothing. In such a situation, once acquisition talks begin to move forward, a misalignment of incentives between the investors and management may arise, and there is a risk that a friendly sale will fail to progress.

It is a natural judgment for investors who put money in during a high-risk early phase to seek a certain degree of downside protection. What matters is finding a balance that protects investors without undermining management's motivation in future M&A and capital policy. As a business decision, confirm the following points:

• Whether the scope of transactions subject to deemed liquidation is unreasonably broad
• The type of liquidation preference (non-participating, participating, or capped) and the multiple
• The mechanism for the comparative calculation against the case where conversion into common shares is chosen
• An estimate of the distribution to founders, employees, and investors at the expected sale price
• Whether, from the perspective of new investors in the next round, past preferences would become an excessive burden

Deemed liquidation affects not only the company's exit but also its bargaining power in the additional fundraising and business alliance negotiations that come before it. Confirm in advance that the terms do not narrow future options too much.

How Veto Rights and Preemptive Rights Affect Business Operations

Narrowing Prior Approval Matters and Their Relationship with Corporate Decision-Making

Investment agreements and shareholders' agreements contain provisions requiring the prior written consent of the preferred shareholders or key investors for certain actions of the company. These are the so-called veto right provisions. Under the Companies Act, it is also possible to design class shares with veto rights that require a resolution of a class shareholders' meeting on specified matters (Article 108, Paragraph 1, Item 8 of the Companies Act), but in practice, matters requiring a class shareholders' meeting resolution under the articles of incorporation are used in combination with matters requiring prior approval under the investment agreement.

Investors seek prior approval rights in order to control the risk that, after the investment, the company will unilaterally make major changes to its capital structure or take on excessive debt. Items such as new share issuances, large borrowings, reorganizations, and transfers of major businesses tend to be covered.

What founders should be careful about is that if the scope of prior approval matters becomes too broad, the speed of day-to-day business decisions will be significantly impaired. At a startup that has completed its Series A, the frequency of decision-making rises considerably, with aggressive hiring, the execution of marketing initiatives, and the conclusion of business alliances. If these are comprehensively constrained by vague wording such as "significant expenditures," "material contracts," or "transactions outside the ordinary course of business," it becomes difficult for the front line to make prompt decisions.

On the other hand, a stance of excluding investor prior approval altogether is not realistic in the practice of accepting investment. What becomes important, therefore, is making the wording of the provisions concrete and building in exceptions. Possible approaches include setting monetary thresholds for borrowings and expenditures, and excluding expenditures within the annual budget approved by the board of directors. It is also effective to state expressly that contracts entered into in the ordinary course of business are excluded, or to include a provision under which consent is deemed given if no response is received within a certain period after the request for approval.

Note, however, that even if the contract provides that "consent is deemed given if no response is received," this does not legally allow the company to dispense with the resolutions of the shareholders' meeting, board of directors, or class shareholders' meeting required under the Companies Act. In practice, it helps to treat contractual prior consent and statutory corporate decision-making as separate procedures and to build them into the company's internal approval workflow.

Designing Preemptive Rights with the Next Financing in Mind

A preemptive right gives existing investors the opportunity to subscribe for new shares on a priority basis, so that they can maintain their ownership percentage when the company raises capital in the future by issuing new shares or share options. The Companies Act provides for an "allotment to shareholders" system that gives existing shareholders the right to receive an allotment of new shares, but the preemptive rights set out in startup investment agreements are generally designed as rights based on contractual agreement. They are a mechanism for securing the opportunity to make additional investments, and they serve a different role from anti-dilution provisions, which adjust the conversion price of preferred shares and the like under certain conditions such as a down round.

For existing investors, preemptive rights prevent dilution of their ownership and serve as an important foothold for making additional investments in a growing company. For founders, too, the willingness of existing shareholders to continue supporting the company in subsequent rounds is a reassuring factor.

However, if preemptive rights are designed rigidly, they can hinder subsequent financings. For example, when bringing in a new lead investor in a Series B, if that investor wants to acquire at least a certain ownership percentage but all existing investors exercise their preemptive rights in full, coordinating the allocation can become difficult. And if the existing investors include a shareholder who takes time to make decisions, this can delay the schedule of the entire round.

It is therefore important to clarify in advance the scope of issuances excluded from preemptive rights (excluded issuances). Negotiate the scope and number of shares to be excluded for the issuance of stock options and equity compensation, and for the delivery of shares as consideration in M&A. Whether to exclude third-party allotments to strategic capital alliance partners is also a point to consider. These are not automatically excluded; write down the terms agreed with each investor.

Information Rights, Transfer Restrictions, and the Founders' Personal Commitments

Setting Information Obligations Appropriate to the Company's Administrative Capacity

Investment agreements include provisions requiring periodic information to be provided to investors, such as monthly trial balances, annual business plans, and notices of significant litigation or legal violations.

Appropriate information sharing with investors is important for building trust, but if the obligations diverge from the reality of the company's administrative structure, they become a major burden on the team. If a company that does not yet have a dedicated administrative department or CFO is required to provide detailed budget-versus-actual variance analysis close to that of a listed company, or monthly reports in a different format for each investor, the business operations on which it should be focusing may be squeezed.

On the other hand, if the information standards are relaxed too much, it may become harder to receive prompt support and advice from investors when cash flow becomes tight or the business plan is not met.

Practical points to consider include adjusting the granularity and frequency of materials to a level that the company can submit without strain given its current staffing, including a provision that allows the company to limit the scope of information provided where an investor operates a competing business, and ensuring that a minor delay in reporting is not immediately treated as a material breach of contract.

Share Transfer Restrictions, Drag-Along, and a Stable Shareholder Base

Under the Companies Act, shareholders can in principle transfer their shares freely, but non-public startups generally impose transfer restrictions through their articles of incorporation. In addition, investment agreements and shareholders' agreements set out prior consent among shareholders, rights of first refusal, tag-along rights, drag-along provisions, and the like.

What founders should confirm is the balance between the transfer restrictions imposed on themselves and those imposed on the investors. It is common for a founder's share transfers to be restricted, but you also need to understand, with respect to transfers by investors to third parties, whether transfers to competitors or anti-social forces can be restricted, and to what extent succession within a fund or transfers among affiliates are permitted.

A drag-along provision, which allows certain shareholders, when specified requirements are met, to force other shareholders to sell their shares as well, is a useful mechanism for smoothly completing a future M&A. However, this provision is a contractual arrangement that binds the parties who signed the agreement; it does not legally bind shareholders outside the agreement. If you do not confirm in advance the percentage of shareholder approval that triggers it, the minimum sale price, and its interaction with deemed liquidation, there is a risk that the founders will be forced to sell on terms they did not intend, so careful assessment is important.

Founders' Personal Obligations and Their Balance

In Series A agreements, it is common for not only the company but also the founders personally to be parties and to assume significant obligations such as a duty of dedication, non-compete obligations, confidentiality obligations, and the assignment of intellectual property to the company.

For investors, founder obligations are a prerequisite for securing the commitment of the management team that holds the key to the business's success. From the founder's personal perspective, however, they are a heavy promise that directly constrains their private life and career. If the duty of dedication is excessively broad, it may even restrict research and writing activities outside the company. And if the post-departure non-compete period is too long, it may become difficult for the founder to make a fresh start should they ever leave the company.

Especially where there are multiple co-founders, you also need to pay attention to fairness according to each person's degree of involvement. Whether it is appropriate to impose the same obligations on a founder who is fully devoted to the business and a founder whose involvement is only partial, and whether penalties distinguish between unavoidable departure and a bad-faith exit, are important points to confirm for maintaining trust within the team. It is important not to rely on the good relationship at the time of signing, but to anticipate every possibility in the future and determine the scope of the responsibilities each individual will assume. Our support for negotiating each provision of investment agreements is described on our Startup Legal and Fundraising Support page.

Frequently asked questions

What significance does an investment agreement for preferred shares issued by a startup have?

It has significance as a document for designing the company's freedom in management decisions after the financing. This is because the terms attached to preferred shares are not limited to financial arrangements concerning dividends of surplus and the distribution of residual assets, but greatly affect how the company makes decisions after the financing. The combination of the articles of incorporation, the investment agreement and the shareholders' agreement has a direct impact on the company's exit strategy and future business development.

What is a deemed liquidation clause in a preferred share investment agreement?

It is an arrangement that treats a specified transaction, such as M&A, as a substantive liquidation and distributes consideration preferentially to preferred shareholders. Although the company does not enter legal dissolution and liquidation proceedings, a transfer of control through a share transfer or the like is deemed to be a liquidation. Liquidation preferences come in types such as 1x non-participating, participating and capped participating, and it is considered important to run distribution simulations in comparison with conversion into common shares.

If an investment agreement's prior approval clause deems consent to be given when there is no response, can resolutions under the Companies Act be omitted?

The resolutions under the Companies Act themselves cannot legally be omitted. This is because contractual prior consent and decisions by corporate bodies based on law are separate procedures. Even if the contract includes an arrangement deeming consent to be given where there is no response, the resolutions of the shareholders' meeting, the board of directors or the class shareholders' meeting required under the Companies Act cannot be omitted, so this needs to be built into the company's internal approval flow.