Joint Ventures in Japan 1 (General Overview) | Articles

1. The Concept of Joint Ventures

A joint venture generally refers to the formation of a single business entity by multiple companies pooling their respective management resources and jointly executing the business.

Its characteristics include a significant concern for the minority party, who may find the joint venture controlled by the majority party, reducing their role to merely a financial contributor without any involvement in management. Additionally, since their shares are in a private company that requires board approval for the share transfer, they lack liquidity and cannot be sold easily.

Therefore, to ensure substantial participation and involvement in the management of the joint venture, the minority party typically seeks prior agreement with the majority party including the right to dispatch a certain number of directors and the necessity of their approval for specific matters.

2. Contents of a Joint Venture Agreement

(1) Business Form

When forming a joint venture in Japan, it is generally assumed to be a Japanese Stock Company (Kabushiki Kaisha, KK). Unlike the U.S. LLC, the Japanese limited liability company (Godo Kaisha, GK) does not allow pass-through taxation, making its tax benefits limited.

(2) Organizational Design

If a KK is chosen as the structure for the joint venture, a simplified organizational design involving only shareholders’ meetings and directors is permissible for a private company. It is generally assumed that the few shareholders actively participate in the operations and management of the joint venture, with all matters being decided among the shareholders, potentially rendering the board of directors’ decisions nominal. Given these characteristics, not establishing a board of directors might be considered. Instead, a steering committee consisting of representatives from each shareholder can be set up to handle important decisions, with directors executing the business based on the committee’s decisions.

(3) Investment Ratio

In principle, if a party’s investment ratio exceeds 50%, they can control the board of directors, and if it exceeds two-thirds, they can influence special resolutions at the shareholders’ meeting. Therefore, minority parties will demand rights to ensure their involvement in management.

(4) Appointment of Directors

Even if minority parties do not constitute a majority of directors, they can still monitor the management of the joint venture directly through discussions at board meetings. Thus, they will demand the right to appoint a certain number of directors. For example, it might be stipulated that Shareholder X can appoint three directors and Shareholder Y can appoint two. However, even if voting rights binding clauses are violated, it is generally considered a breach of contract and does not affect the validity of resolutions. Therefore, a mechanism allowing minority shareholders to directly appoint directors through different classes of shares (Article 108, Paragraph 1, Item 9 of the Companies Act) might be considered. The method of appointing directors by class meetings of shareholders is widely practiced in the U.S. as class voting, particularly in shareholder agreements of joint ventures and startups.

(5) Veto Provisions

To ensure involvement in the management of the joint venture, minority parties may demand veto provisions requiring their prior approval for certain important management matters. Matters subject to veto can include fundamental issues related to the company’s articles of incorporation and organizational restructuring, as well as the annual budget and business plan, which determine the joint venture’s direction. Individual operational matters, however, might not be subject to veto, leaving them to the management appointed by the majority party.

(6) Financing

Joint venture parties need to consider whether they are obligated to provide funding or not. If funding is required, they need to determine whether it will be through direct loans to the joint venture, guarantees or collateral for third-party borrowing (debt financing), or through subscribing to new shares issued by the joint venture (equity financing). In the latter case, due to the critical importance of shareholding ratios in joint ventures, the contract usually grants pre-emptive rights to the parties to subscribe to new shares in proportion to their initial shareholding ratios.

(7) Agreements Restricting Share Transfers

A joint venture is a collaborative business, and any change in the joint venture party undermines the premise of the collaboration. The Companies Act’s restrictions on share transfers stipulate that if the board of directors disapproves the transfer, the shareholder can still transfer the shares to the company or a designated person at a certain price (Articles 136 to 145 of the Companies Act). Therefore, additional share transfer restrictions need to be stipulated in the joint venture agreement.

Practically, the Right of First Refusal (ROFR), Right of First Offer (ROFO), call options, and put options might be implemented to ensure investment recovery while preventing any undesired third party from becoming a joint venture partner.

Right of First Refusal (ROFR): Allows a shareholder intending to transfer shares to negotiate with a third party and, upon agreeing on the terms, offer other shareholders the opportunity to purchase the shares on the same terms. Only if other shareholders refuse, the shares can be sold to a third party.
- The party granted the ROFR can prevent unwanted third parties from becoming joint venture partners, provided they can arrange the purchase funds or find a new partner.
Right of First Offer (ROFO): Grants a shareholder intending to transfer shares the right to offer other shareholders the chance to purchase the shares first. If no agreement is reached within a certain period, the shareholder can then negotiate with a third party.

(8) Agreements Facilitating Share Transfers

A. Transfer to Third Parties

Tag-along Rights: Allow minority shareholders to sell their shares to a third party under the same conditions if the majority shareholder intends to exit the joint venture by selling their shares. This ensures minority shareholders receive the same economic benefits.
Drag-along Rights: Permit majority shareholders to force minority shareholders to sell their shares to a third party, ensuring the sale of 100% of the shares, increasing the likelihood of a sale, and potentially raising the sale price.

B. Transfer Between Shareholders

Call Option: Allows one party to purchase the other party’s shares under certain conditions.
Put Option: Allows one party to sell their shares to the other party under certain conditions.

Majority shareholders may favor call options to buy out obstructive minority shareholders, while minority shareholders may prefer put options for assured investment recovery.
Additionally, it is an important issue how the transfer price is determined when the parties exercise options such as call options and put options.

(9) Termination of the Joint Venture Agreement (Exit)

Although parties may hesitate to discuss exit rules when forming a joint venture, the reasons for termination should be stipulated in the agreement. Potential reasons include:

Failure to Meet Milestones: Setting specific milestones in the agreement to review and adjust the joint venture’s direction or to decide on its continuation.
Change of Control: Defining a change in control as a reason for termination, considering the closed nature of joint venture management and the reliance on a mutual trust relationship.
Deadlock: Defining deadlock as a reason for termination, in cases where there is a deadlock at the board of directors or shareholders’ meetings due to equal voting rights or continuous exercise of veto rights.

Upon dissolution of the joint venture, discussions are necessary regarding the distribution of remaining assets, debt waivers, and the handling of losses. If one party withdraws, discussions on non-compete obligations are also necessary.