JFTC and METI Proposes Guidelines for Business Collaboration with Startups and Investment in Startups

On December 23, 2021, the Japan Fair Trade Commission ("JFTC") and Ministry of Economy, Trade and Industry ("METI") proposed a draft of Guidelines for Business Collaboration with Startups and Investment in Startups ("Guidelines") for the purpose of promoting open innovation and ensuring fair and free competitive environments.¹ They are seeking comments from the public. Comments are due by January 21, 2022.

In recent years, open innovation, where large companies cooperate with startups to create new value, has become important. Previously, the JFTC and METI jointly published the Guidelines for Business Collaboration with Startups on March 29, 2021. The draft of Guidelines this time is an updated version of the previous Guidelines. In addition to the guidelines for business collaboration with startups, a new chapter has been added: guidelines for investment in startups (Chapter III). The new chapter provides antitrust and competition policy perspectives on investment in startups. This article focuses on the new chapter.

The draft of Guidelines categorizes potential issues related to investment contracts into nine: (1) disclosure of trade secrets, (2) violation of NDAs, (3) work without compensation, (4) bearing the cost of work outsourced by an investor to a third party, (5) purchase of unnecessary goods or services, (6) appraisal rights (i.e., right to demand purchase of the shares under certain conditions), (7) restrictions on R&D activities, (8) restrictions on business partners, and (9) most favorable treatment (MFN) conditions.

For each category, the draft of Guidelines indicates one or more of the following background of the issues: (i) lack of contractual and legal literacy on startup's end, (ii) lack of literacy about open innovation on investor's end and/or (iii) undesirable practices in promoting open innovation on the basis of equal footing. At the root of these issues, some business practices have arisen and continued as an extension of financing in the development stage of venture capitals (VCs) in startup investment in Japan. The rapid rise of corporate venture capitals (CVCs) has resulted in business practices that are based on a lack of understanding of the growth process of startups. There was a lack of class share system in the corporate legislation, and the governance method of the investees on the part of the investors was insufficient, resulted in a situation where they rely on appraisal rights, etc. However, the importance of startups as leaders of innovation is increasing, the number and amount of investments in startups in Japan has been increasing significantly, and as the corporate legislation such as the class share system has been developed; therefore it is necessary to improve the business practices related to investments in startups in Japan and make them more reasonable from a global perspective. The draft of Guidelines proposes direction of solutions for each issue.

(1) Disclosure of trade secrets

There are cases where a startup is requested by an investor to disclose trade secrets without signing an NDA. If trade secrets are disclosed without entering into an NDA, there is a risk that trade secrets will be used by an investor or leaked to a third party. There would be a risk of violating an abuse of superior bargaining position ("ASBP") under the AMA when an investor in a superior bargaining position requests a startup to disclose its trade secrets without concluding an NDA, and the startup has no choice but to accept the request due to concerns about the impact on future transactions, such as an inability to receive future investment.

Generally speaking, a risk of violating the ASBP is relatively lower at the time of entering into an agreement compared to the duration of an ongoing contract relationship. However, the draft of Guidelines warns that it may lead to a case where a startup has no choice but to accept it out of concern for the impact on future transactions, therefore a violation of the ASBP may be found even at the time of entering into an agreement if it is difficult for the startup to change the investor, for example, if an investment contract is signed just before the startup runs out of money and it is not realistic to restart negotiations with other potential investors at the time.

The draft of Guidelines indicates that the background of the issues (see the three categories described above) here are (i) lack of contractual and legal literacy on startup's end and (ii) lack of literacy about open innovation on investor's end. As a solution, it is necessary for both a startup and an investor to improve their literacy in managing confidential information, and to enter into an NDA in a way that both parties can manage when or before concrete discussions about investment begin.

(2) Violation of NDAs

There are cases where an investor leaks startup's trade secrets to another investee (e.g., startup's competitor) in violation of an NDA, and the another investee sells products or services that compete with the startup's products or services. Such violation of an NDA is obviously an unfair means of competition. Therefore there would be a risk of violating the AMA as an Interference with Competitor's Transactions (Article 14 of the Unfair Trade Practices Designation) when it interferes with transactions of the startup and its business partners.

The background of the issues (see above) here are (i) lack of contractual and legal literacy on startup's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing. The reasons why the problem is not readily apparent are mainly: (a) proof of violation of NDAs is difficult and (b) inability to conclude NDAs that increase the deterrence of NDA violations. To resolve the problem, it is important to consider each provision of an NDA in reverse order to be able to pursue legal liability in case of violation of the NDA. More specifically, it is important to identify confidential information to be subject to an NDA, and is desirable especially for a startup to be prepared to prove that it had the confidential information before an NDA was signed. In addition, it would be helpful to include damage provisions in case of violations. It would also be helpful to agree on the scope, amount and claim period of liability for damages in advance from the perspective to increase the deterrent effect against leakage.

(3) Work without compensation

A startup may be asked by its investor to do work for free that is not stipulated in a contract. If the work, which is not stipulated in the contract, is done without compensation absence of a justifiable reason, it means that the costs that should be borne by an investor will be passed on to the startup. There would be a risk of violating the ASBP when an investor in a superior bargaining position requests a startup to perform work without compensation, which is not stipulated in the contract, and the startup has no choice but to accept the request due to concerns about the impact on future transactions, such as an inability to receive future investment.

The background of the issues (see above) here are (ii) lack of literacy about open innovation on investor's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing. Startups risk depleting and exhausting their human resources and running short of funds by implementing such free work.

In order to avoid risks arising from non-contractual work, both a startup and an investor should coordinate the work that will occur depending on startup's business conditions in the negotiation of the investment contract. For example, in a Proof of Concept (PoC), it is important to communicate a common understanding of the goal of the PoC, the compensation and the terms and conditions of the investment.

(4) Bearing the cost of work outsourced by an investor to a third party

A startup may be requested by an investor to bear all costs associated with the work that the investor has outsourced to a third party. In this case, the costs that should be borne by the investor are passed on to the startup. There would be a risk of violating the ASBP when an investor in a superior bargaining position unilaterally requests a startup to bear all costs related to the work that the investor outsourced to a third party, and the startup has no choice but to accept the request due to concerns about the impact on future transactions, such as an inability to receive future investment.

The background of the issues (see above) here are (i) lack of contractual and legal literacy on startup's end and (ii) lack of literacy about open innovation on investor's end. In most cases, the cost of due diligence in considering investments in a startup is usually borne by an investor, but there are some cases where the startup side bears the cost due to the special nature of the startup's business. If such cost-sharing is introduced not as a result of coordination with the startup, but merely to secure profits for the investor, it would hinder the promotion of open innovation.

In order to avoid such a risk, it is important for both a startup and an investor to discuss and to have a common understanding of the cost burden. Also, dialogue on an equal footing between a startup and an investor is required to prevent a startup from easily incurring the cost of the work outsourced to a third party.

(5) Purchase of unnecessary goods or services

There are cases where a startup may be requested by an investor to purchase unnecessary goods or services from a business designated by the investor (e.g., another investee invested by the investor). There would be a risk of violating the ASBP when an investor in a superior bargaining position unilaterally requests a startup to purchase goods or services even though the startup does not need or wish to purchase, and the startup has no choice but to accept the request due to concerns about the impact on future transactions, such as an inability to receive future investment.

The background of the issues (see above) here are (i) lack of contractual and legal literacy on startup's end and (ii) lack of literacy about open innovation on investor's end. If the purchase of goods or services occurs through the introduction by an investor, and the cost burden is borne by the startup side as a result of discussion, that should not be a problem. However, if the cost burden is not a result of discussion between the startup and the investor, but merely from the perspective of securing profits for the investor or the company in which the investor invests, it would hinder the promotion of open innovation.

When a startup purchases goods or services through an introduction by an investor, they should discuss and have a common understanding on whether the goods or services are necessary for the startup's business as well as how to bear the costs. To avoid unnecessary cost burden on the startup side, dialogue between a startup and an investor on an equal footing is required.

(6) Appraisal rights

Disadvantageous request by an investor based on the appraisal rights

There are cases where a startup receives a disadvantageous request from an investor, such as a transfer of intellectual property rights without compensation, and is told that the investor will exercise its appraisal rights (i.e., rights to demand the purchase of the shares) if the startup does not comply with the request (e.g., transfer of the intellectual property rights without compensation). The appraisal rights may enhance the bargaining position of the investor. There would be a risk of violating the ASBP when an investor in a superior bargaining position makes a disadvantageous request to a startup, such as a free transfer of intellectual property rights, and the startup has no choice but to accept the request due to concerns that the investor will exercise its appraisal rights to purchase all of the shares held by the investor.

Appraisal rights are reasonable in many ways, for example, in the sense that it secures the right to claim money equivalent to the value of the shares acquired by an investor in the event of a breach of contract. However, problematic cases have been reported, such as a request for purchase at a significantly high price and/or an exercise of appraisal rights that do not meet the conditions. The back ground of such issues (see above) are (ii) lack of literacy about open innovation on investors end and (iii) undesirable practices in promoting open innovation on the basis of equal footing.

To avoid such issues, a startup and an investor should fully discuss the provisions of the appraisal rights, and the conditions for exercising the appraisal rights should be clearly limited to material breach of representations and warranties and material breach of contract. In addition, an investor should refrain from providing undue pressure by suggesting an exercise of appraisal rights.

Rights to request a purchase at a significantly high value

There are cases where a startup, in a situation where its business is being depleted, is requested by an investor for appraisal rights which grant rights to request purchase of shares at a price significantly higher than the amount of the investment. The issues described above (i.e., disadvantageous request by an investor) basically apply here as well. There would be a risk of violating the ASBP when the startup has no choice but to accept the investor's request due to concerns about the impact on future transactions, such as an inability to receive future investment.

Exercise of appraisal rights without meeting conditions

There are cases where an investor requests a startup to purchase a part of its holding shares by exercising its appraisal rights even though the conditions are not met. The funds that the startup could have continued to use will be recovered by the investor if the investor exercises its appraisal rights even though the conditions are not met. There would be a risk of violating the ASBP when an investor in a superior bargaining position requests the startup to purchase a part of its shares, and the startup has no choice but to accept the request due to concerns about the impact on future transactions, such as the termination of the investment agreement.

The background of issues and the proposed resolution are the same with above (i.e., disadvantageous request by an investor based on the appraisal rights.)

Appraisal rights that can be requested to individuals

There are cases where a startup may be requested by an investor for appraisal rights that grant the investor to demand individuals (e.g., startup's management) to purchase the shares. This may hinder a startup's founder, who often becomes a management shareholder (e.g., a representative director of the startup who also holds shares), its incentive to start a business with capital investment. For enhancing startup motivation and promoting open innovation and employment, it is desirable to exclude individuals from subject of the demand of the appraisal rights from the competition policy perspective.

In Japan, a management shareholder(s) of a startup often owns the majority of shares in the startup and influences the decisions of the board of directors and shareholder's meetings. In other words, the ownership and management of the startup are the same in many cases. Therefore, the actions of the startup tend to be considered as of the management shareholder(s). In addition, there are cases where VCs have developed business practices that require a management shareholder(s) to be jointly and severally liable with the startup as an extension of their loans in the course of the development of VCs in Japan, and these practices apparently still remain today. Further, while CVCs have been increased rapidly, there may be a lack of understanding about the growth of startups, which sometimes leads to business practices that ensure the dominance of CVCs.

The draft of Guidelines indicates that the background of those issues (see above) are (ii) lack of literacy about open innovation on investor's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing.

To resolve such issues, it is necessary to comply with global standards in investments. It is desirable that appraisal rights should be limited to the rights to demand purchase of shares to a company only (e.g., not to include the management of the startup).

(7) Restrictions on R&D activities

There are cases where an investor prohibits a startup from conducting R&D activities that compete with the investor or its investee (e.g., startup's competitor.) There is a risk of reducing competition in future technology markets and/or product markets, and there would be a risk of violating the AMA as a Trading on Restrictive Terms (Article 12 of the Unfair Trade Practice Designation).

The background of the issues (see above) are (ii) lack of literacy about open innovation on investor's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing.

Startups in general have diverse growth potential; restrictions on R&D activities are likely to be an obstacle to business expansion and are basically undesirable.

(8) Restrictions on business partners

There are cases where a startup may be restricted by its investor from collaborating with other businesses and/or from receiving investments from other investors. In principle, it would not be a violation of the AMA when an investor restricts a startup from doing business with other businesses due to its necessity to maintain the confidentiality of the investor's confidential information (e.g., know-how.) However, there is a risk of violating the AMA as a Trading on Exclusive Terms (Article 11 of the Unfair Trade Practice Designation) or a Trading on Restrictive Terms (Article 12 of the Unfair Trade Practice Designation) when an investor, who is "an influential enterprise in a market" prohibits a startup from doing business with other businesses beyond reasonable limits, and when such conduct would have a foreclosure effect.

The background of the issues (see above) are (ii) lack of literacy about open innovation on investor's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing.

To avoid such risks, it is important for both parties to have a common understanding of whether such restrictions will function reasonably as an option after adjusting their interests in consideration of the future business expansion of the startup.

(9) Most favorable treatment (MFN) conditions

There are cases where an investor requests a startup for MFN conditions. In many cases, such conduct would not violate the AMA. However, there is a risk of violating the AMA as a Trading on Restrictive Terms (Article 12 of the Unfair Trade Practice Designation) when an investor, who is "an influential enterprise in a market" requests a startup for MFN conditions, and if it becomes difficult for the investor's competitor to do business with the startup on more favorable terms, reducing the incentives for such competitors to do business, and restricting competition between the investor and such competitors, which would have a foreclosure effect.

The background of the issues (see above) are (ii) lack of literacy about open innovation on investor's end and (iii) undesirable practices in promoting open innovation on the basis of equal footing.

To resolve such issues, it is important for both a startup and an investor to have a common understanding of whether the MFN is an option that can function reasonably after adjusting their interests in anticipation of the startup's future funding direction. The parties, especially a startup should be aware that if more favorable conditions are included in a contract with other investor in the future, it will apply to the previous investors who agreed with the MFN conditions with. In addition, it is important to clarify the terms and conditions of a contract as well as to have sufficient discussions on the consideration.

As mentioned above, the JFTC and METI are seeking public comments, which are due by 6:00 p.m. on January 21, 2022, JST. The draft of Guidelines is available only in Japanese.

_{¹The JFTC press release on December 23, 2021 is available only in Japanese. The METI press release on December 23, 2020 is available only in Japanese.A draft of Guidelines is available only in Japanese.}

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_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}

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