Convertible Notes vs. J-KISS: Repayment Obligations, Maturity and Conversion Terms

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

Picture a seed-stage financing in which the founders think, "A convertible note or a J-KISS, either is fine. We just need the money in the bank as soon as possible." This is precisely the moment to pause and confirm a fundamental distinction: is the contract on the table an issuance of "share options" (shinkabu yoyakuken), or is it "borrowed money (a loan)" under a monetary loan agreement? If you sign without being clear on this premise, the burden the company bears will differ greatly if the next round slips behind the original plan.

A convertible note is a debt-type financing instrument that anticipates a future conversion into shares. Its legal structure and governing law vary widely, including loan-type and bond-type structures, but this article focuses mainly on the loan type, structured as a monetary loan agreement. Whether there is a maturity date, how interest is set, and how repayment and share conversion interact must be confirmed against the specific provisions of the contract. J-KISS, by contrast, is a mechanism for issuing share options with a call provision (shutoku joko tsuki shinkabu yoyakuken) for consideration. Its legal vehicle is a share option, and under Japanese GAAP it is recorded in the net assets section of the balance sheet as "share options." This differs from treatment in which the amount is included in shareholders' equity or stated capital before conversion. When choosing between the two, it is important to look comprehensively not only at how quickly the funds arrive, but also at repayment risk, conversion terms, the impact on the next round, protection of investors' rights, and tax and accounting treatment.

I have already explained the basic framework of J-KISS and the terms founders should check in What Is J-KISS? Structure, Capital Policy and Points for Founders to Check and A Checklist Before Raising Funds with J-KISS. Building on those articles, this piece digs into the practical differences between the two instruments from the perspective of a comparison with convertible notes.

Legal Vehicle and Repayment Burden: Loan Type vs. Share Option Type

The convertible note is an instrument that has been widely used in U.S. seed investing. The investor lends money to the issuer, and the parties agree that the loan will convert into shares when a future equity financing by venture capital or others (a qualified financing) is carried out. When the loan-agreement type is used in Japanese practice, the funds received are treated as a liability, and conversion into shares in the future requires separate procedures under the Companies Act, such as an issuance of new shares.

When considering the loan type, it is essential to check whether the lender's lending is conducted "as a business" and whether it meets the exemption requirements under the Money Lending Business Act (Articles 2 and 3 of the Money Lending Business Act and Article 1-2 of its Enforcement Order). A loan does not uniformly require registration as a money lender, but neither can one say that registration is automatically unnecessary simply because the purpose is investment. Note also that convertible bonds with share options (tenkan shasaigata shinkabu yoyakuken tsuki shasai) are a different system under the Companies Act; their issuance and any change in their terms require consideration of the statutory procedures for bonds and share options.

Meanwhile, in the United States, Y Combinator published the SAFE in 2013. According to Coral Capital's official explanation, J-KISS was released in April 2016 as an instrument for Japan based on the 2014 KISS, and its 2.0 revision in 2022 incorporated the design philosophy of the SAFE. Under the Japanese legal system, it uses share options with a call provision under the Companies Act. The terms and conditions of Post Cap J-KISS 2.01, which is now widely used, provide that the amount of money to be paid upon exercise is JPY 1 per share option (this differs from a provision of JPY 1 per share). The number of shares to be delivered is calculated using the aggregate issue price and the conversion price, and the rules for rounding fractions and for notice procedures are distinguished between exercise by the investor and exercise of the call provision by the company.

convertible note, SAFE, KISS and J-KISS are all financing instruments that anticipate a future conversion into shares, but they differ fundamentally depending on whether the legal vehicle is a loan/bond type or a share option type. Their accounting treatment also differs: under Japanese GAAP, the loan type is classified as a "liability," while the share option type is recorded in the "net assets section." For convertible bonds with share options, both the separation method, which accounts for the bond component and the share option component separately, and the single-instrument method, which accounts for them together, are permitted (ASBJ Guidance No. 17 (Japanese), paragraphs 4 and 18), so it cannot be uniformly explained that the full amount is a liability. In addition, even when funds are raised by borrowing, assets such as cash increase by the same amount, so borrowing does not in itself reduce net assets and directly lead to insolvency on a balance-sheet basis. What matters is to estimate in advance the future interest burden and the cash outflow associated with subsequent operating losses.

This difference in legal vehicle translates directly into the burdens specific to debt: maturity, interest and repayment claims. Loan-type instruments commonly provide for a maturity date and interest, although in practice there are also designs that are interest-free or that convert automatically into shares at maturity. Whether the investor can demand cash repayment if the next financing does not happen, or whether conversion into shares or extension of maturity takes priority, depends on the individual contract. If the company adopts a design in which a repayment obligation remains, it should build payments of principal and interest into its cash-flow plan, and it must also check whether there are conditions under which it could lose the benefit of time, for example through a breach of financial covenants, and be forced to repay in a lump sum before maturity.

In contrast, the official J-KISS template contains no interest provision, and it is not designed so that the investor can immediately demand return of the principal when the conversion deadline set in the terms and conditions arrives. The Post Cap 2.01 template calls the date 18 months after the allotment date the "conversion deadline," but this term does not refer to a maturity date on which the share options automatically lapse or a repayment obligation arises. It marks a procedural milestone: after the conversion deadline passes, conversion into common shares can be exercised with the approval of investors holding a majority of the aggregate issue price.

That said, a risk of cash outflow remains even with J-KISS. If a change-of-control transaction (such as an M&A deal) occurs before conversion into shares, the template includes a provision under which the company delivers money equal to twice the issue price as consideration for acquiring the share options. This is legally different in nature from repaying borrowings as agreed, but if the cash call provision applies upon a change of control, a substantial amount of money will flow out from the company to the investors. However, investors also have the option of converting into common shares in accordance with the terms and then participating in the sale process of the M&A deal, so not every M&A transaction necessarily results in the company paying twice the amount in cash. It is premature to think that "J-KISS is not debt, so there is no repayment risk at all." The appropriate understanding is that, while J-KISS avoids the periodic repayment claims specific to debt, it carries a different cash outflow risk: monetary consideration under the call provision upon an acquisition.

Negotiating Conversion Terms for the Next Round

For both convertible notes and J-KISS, when determining the future conversion price, you need to check how the qualified financing threshold, the discount rate, the valuation cap and the fully diluted share count are combined. Some loan-type contracts have no cap or similar terms. I explain the specific calculation steps and the sequence of registration and document preparation when actually carrying out the conversion procedure in a Series A in The J-KISS Conversion (Exercise) Procedure. Here, I focus on what terms should be negotiated before carrying out the financing.

The first element to negotiate is the qualified financing threshold. If the threshold is set too low, even a small financing will qualify as a conversion event, and conversion will proceed at an unintended time. Conversely, if the threshold is set too high, a situation may arise in which, even though the company raises funds through preferred shares in the next round, the financing does not qualify as a qualified financing under the J-KISS definition, and the company cannot proceed to the conversion procedure associated with that financing. The template's definition of the next equity financing is not limited to financing through preferred shares, so check whether it matches the class of shares and terms you envisage for your next round. Note that the JPY 100 million threshold stated in the template is merely an example setting, not a statutory minimum.

The second element to negotiate is a simulation of whether the discount or the cap will actually apply. The investor's conversion price is determined by comparing the price based on the cap with the price after applying the discount, in accordance with the definitions in the terms and conditions, and choosing the more favorable one. Which one applies varies depending on the valuation in the next round and the basis for calculating the number of issued shares, so it is essential to set several valuation scenarios and concretely estimate the conversion price and the number of shares to be issued after conversion.

The third element to negotiate is whether to leave the choice of conversion to the investor. For the loan type, whether automatic conversion or optional conversion is adopted is determined by contractual agreement. Also, with J-KISS, the investor does not automatically become a shareholder without any procedure simply because the terms of the next financing have been settled. Shares are delivered through procedures in exchange for the investor's exercise of the share options or the company's exercise of the call provision. If the company exercises the call provision, it should be prepared to properly carry out the corporate decision, such as a board of directors' resolution, the acquisition date and the advance notice procedures in accordance with the terms and conditions and the Companies Act.

Treatment in an M&A Deal or When a Financing Does Not Materialize

The legal frameworks of convertible notes and J-KISS differ significantly in how they treat a situation where the company is acquired before conversion into shares takes place, or where the next financing does not close by the conversion deadline.

A convertible note investor is, in legal status, a creditor of the company. Whether the investor can receive cash repayment at maturity depends on the provisions of the contract. Note that the order of priority between creditors and shareholders in bankruptcy or liquidation is a separate issue from the rules for allocating the sale proceeds that shareholders receive in an M&A deal by way of share transfer. The fact that an M&A deal has taken place does not mean that creditors are automatically entitled to be paid in priority out of the shareholders' sale proceeds; you need to check, deal by deal, whether there is an acceleration clause, any individual agreement on repayment, and the conditions on whether the borrowing will remain outstanding.

With J-KISS, on the other hand, if a change-of-control transaction or similar event occurs before conversion, the investor can choose either to have the company buy back the share options for money equal to twice the issue price, or to convert into common shares based on the cap and then participate in the sale process of the M&A deal. In addition, if the next equity financing does not close by the conversion deadline, there is a mechanism under which conversion into common shares can be requested with the approval of investors holding a majority of the aggregate issue price; however, the share options do not automatically lapse, and no monetary repayment obligation arises, simply because 18 months have passed. The company will discuss with the investors, in light of its business progress and financial condition at that point, whether to negotiate a change of terms extending the conversion deadline or to proceed with conversion into common shares. A practical example of an extension agreement that changes the conversion deadline to a specific date is introduced in A Checklist Before Raising Funds with J-KISS.

Comparing the two, the loan type carries the risk of facing an obligation to repay principal and interest depending on the contract terms, whereas J-KISS is structured to deal with a failed financing through procedural negotiation in the form of building consensus among a majority of investors. Which is easier for the company to manage depends on the likelihood that the next round will be realized and on the content of the agreements with, and the state of negotiations with, the investors.

Checking Existing Investment Agreements and the Articles of Incorporation in Advance

Whichever instrument you choose, it is essential to review your existing investment agreements and shareholders' agreements, as well as your articles of incorporation, before carrying out the financing.

In companies that have previously issued J-KISS or raised funds through preferred shares, existing contracts sometimes provide for matters requiring prior consent before issuing new shares or share options, or for preemptive rights to prevent dilution of shareholding ratios. The official J-KISS template includes a representations and warranties clause confirming that the company is not in breach, in any material respect, of its existing contracts. Therefore, if the company issues a new J-KISS without giving prior notice to, or obtaining consent from, existing investors, it risks not only breaching its contracts with the existing investors but also being held liable to the new investors for breach of representations and warranties.

When issuing share options as a procedure under the Companies Act, a non-public company must obtain a special resolution of the shareholders' meeting to determine the offering terms (Article 238, paragraphs 1 and 2, and Article 309, paragraph 2, item 6 of the Companies Act). The steps for the corporate decision must be organized in advance, including where a resolution delegating authority to the directors or others under Article 239 of the Companies Act is used. In a company that has already issued class shares, also check whether a resolution of a class shareholders' meeting is required in light of the class of shares to be delivered and the provisions of the articles of incorporation.

On the other hand, when a convertible note is entered into as a monetary loan agreement, no share option issuance procedure is required unless share options are issued alongside it. However, the company must make any corporate decision required for the borrowing itself, and at the time of future conversion into shares, it must separately proceed with procedures such as an issuance of new shares. In exchange, other issues come up: whether the arrangement constitutes "lending conducted as a business" under the Money Lending Business Act or meets the exemption criteria, whether the interest rate ceiling under the Interest Rate Restriction Act is observed, and whether the arrangement conflicts with negative pledge clauses or financial covenants attached to existing loan agreements with the Japan Finance Corporation or private financial institutions. These areas require specialized analysis involving financial transactions and regulatory law, and it is important to check individually not only the contract terms but also the legal status of the lender and the restrictive covenants in existing contracts.

Situations Where Each Fits and Dilution Estimates Before Issuance

J-KISS has become widespread as a financing instrument from the seed stage through pre-Series A, but it is not suitable for every deal. When choosing, consider three factors: the bridge nature of the financing, whether there are existing preferred shareholders, and the likelihood of the next round.

First is the nature of the financing as bridge funding. The impact on capital policy differs greatly between a company that has never raised outside capital and is accepting its first outside funds, and a company that has already completed a preferred share round and is raising short-term working capital until the next round. In the latter case, the terms must be consistent with conditions such as the liquidation preferences attached to the existing preferred shares, and interests must be balanced against the existing preferred shareholders' preemptive rights, so the company cannot casually choose J-KISS with the same mindset as an early seed financing.

Second is whether there are existing preferred shareholders. In a company that already has preferred shareholders, skipping the prior consent or preemptive right procedures required under the investment agreements will raise issues of breach of contract. Even a company that has issued only common shares must not neglect the same review if it entered into investment agreements or shareholders' agreements in its founding period.

Third is the likelihood of the next round. A company with a high probability of carrying out a large preferred share financing in the near future is a good fit for a design premised on J-KISS converting into shares, and it can concentrate its preparation on conversion price simulations and class share design. By contrast, a company for which the timing and feasibility of the next financing are uncertain will need to consider, when the conversion deadline arrives, whether to obtain the necessary investor approval and convert into common shares or to discuss a change of terms. In such circumstances, the loan type, which carries a repayment obligation, puts more direct pressure on cash flow, but because it secures a priority repayment position for investors as creditors, it can also function as a bargaining term for drawing out an investment.

Whatever instrument you adopt, it is essential to prepare dilution estimates covering multiple scenarios before starting the issuance procedures. Elements to include in the estimates are the conversion price (both when the cap applies and when the discount applies) under several assumed company valuations for the next round, the breakdown of the fully diluted share count (issued shares, issued stock options, the unissued option pool, and the treatment of other share options), and the impact on existing shareholders' ownership ratios and the stock option pool. The scope of what is included in the denominator differs depending on whether a pre-cap or post-cap method is used, or on the definitions in the individual terms and conditions. Even where multiple share options exist, do not assume that an iterative calculation is automatically required; proceed with the calculation in line with the specific formula set out in the contract terms.

When moving forward with the actual analysis, the discussion goes more smoothly if you start by gathering the following four materials: first, the current capitalization table (the full picture, including issued shares, issued stock options and existing share options); second, the existing investment agreements and shareholders' agreements (the provisions on matters requiring prior consent and preemptive rights); third, the current articles of incorporation (the total number of authorized shares and the description of the content of class shares); and fourth, an internal memo summarizing the expected timing and expected valuation of the next round. Only once these are assembled can you objectively compare whether a convertible note or J-KISS suits your company better, or whether you should choose a direct financing through preferred shares. The financing support we provide, including the review of capitalization tables and existing contracts, is described on Startup Legal and Fundraising Support.

Frequently asked questions

Are convertible notes and J-KISS the same thing?

No. A convertible note is a loan based on a monetary loan agreement and is a debt-type financing instrument with a repayment obligation, maturity and interest. J-KISS is convertible equity that issues share options with a call provision for consideration, and it differs both in its legal vehicle and in its balance sheet treatment (liability or net assets). Including SAFEs and KISS, all of them share the feature of anticipating future conversion into shares, but treating them as the same thing leads to overlooking repayment risk.

Since J-KISS is a share option, is there no obligation at all to return the funds?

Because J-KISS is not a liability, the company does not bear a contractual repayment obligation like that of a convertible note. However, if a change-of-control transaction (such as an M&A deal) occurs before conversion, there is usually a provision under which the share options are acquired in exchange for money equal to twice the issue price, so it is not a design under which no cash outflow occurs. In my view, it should not be oversimplified as "it is not debt, so there is no risk."

Can J-KISS be used in the same way by a company that already has preferred shareholders?

Not necessarily. The investment agreement and shareholders' agreement accompanying existing preferred shares may set out matters requiring prior consent before share options are issued, as well as preemptive rights. Issuing without checking the existing investment agreements and the articles of incorporation could develop into a breach of contract with existing investors or a breach of representations and warranties to new investors.