When Good Ventures Go Bad

The results of a venture's failure here can be quite different than in the US, where courts tend to enforce previously agreed terms unless there has been egregious conduct. "When a venture goes off track, the investors will often first look at whether the venture breached any of the representations it made about itself," explains Alexander Lourie, attorney at Chicago law firm Barack Ferrazzano. These representations could be related to intellectual property (Did the venture actually own that key piece of software it told the investor it did?) or to conduct (Did the venture spend more money than it said it would)? The VC contract will often specify the remedy: payment of an indemnity, for example. "The contract may also allow for the investor to take over the venture by converting the equity stake into an unconditional controlling position," Lourie says.

And what if the venture's products or services simply don't sell well, despite everyone's best efforts? In that case, the investor is "stuck holding an investment which is not worth as much as he thought," says Lourie, providing a crisp definition of "risk capital."

In Japan, in cases of fraud on the part of the entrepreneur, a suit could be brought in civil court, but unless there are assets that can be seized, this process may be all but useless. One source explained that here, it is easy to change the title of assets to evade attachment, making litigation even more futile.

Realistically, investors here do not have much recourse under the law. Like elsewhere, most ventures in Japan do not own substantial assets, although there may be patents or other IP. Their primary source of funding tends to be equity, not debt, and their primary asset tends to be their people. When they go under, there is usually not much left, and a bankruptcy trustee-mediated shutdown generally sees the assets and patents sold off, with the employees leaving for other companies and the founders left to deal with angry investors.

With most ventures here taking corporate form, the VCs become shareholders, and any agreement between shareholders will generally be upheld by the Japanese courts, as will any agreement between a corporation and its shareholders. Savvy VCs will have negotiated some sort of bankruptcy protection. For example, they may get repaid prior to any other stockholders being paid -- if there's anything left of the venture's carcass.

Japan's new Minji Saiseiho (Civil Rehabilitation Law), which came into force in April, provides for procedures roughly equivalent to Chapter 11 bankruptcy in the US. Management may be left in place, and the court can order a rehabilitation plan. Japan has already seen several hundred filings under this statute, but it's still new. "Bankruptcy law in Japan traditionally is a liquidation law. People may talk about restructuring, but in the end, it comes down to liquidating and selling off," says Satoru Murase, a Japan-experienced lawyer working in corporate finance at New York law practice Bingham Dana Murase. "The new law, which is more forgiving than the severe practices of the old, may help change the stigma towards people who go bankrupt, and encourage entrepreneurism."

Further, when a company can plausibly remain in business, a judge here is likely to place a great deal of weight on maintaining employment and social stability. This hasn't happened much with new ventures (not that many have failed yet), but a lesson can be drawn from experiences with traditional industries going broke. "One of the first things a judge talks to the bankruptcy trustee about is maintaining employment. Whether that's in the best interests of the company, the creditors, or the stockholders is another question," says Murase. "I've seen tremendous efforts in the past by a judge and trustee to maintain employment -- and find a buyer for the company as soon as possible." Unless a venture is on the brink of bankruptcy, it's unlikely that the judge would order the firm to shut down. "The law provides for allowing the firm to operate," says Atsushi Karashima, attorney at Tokyo law firm Hamada & Matsumoto. In such cases, however, the judge would have to be satisfied that mismanagement is not an issue. One lawyer here says that the best an investor might hope for is a court-ordered repayment plan spread out over 20 years!

Likewise, when management has been found negligent, judges here have thought it necessary to mete out punishments that fit the crime, on the basis that managers have a special responsibility to run their companies well. Startups -- usually run by young, inexperienced entrepreneurs -- however, would likely get a fairly sympathetic hearing. "In mature industries, we've seen severe punishment dished out -- it's the whole Japanese 'moral hazard' idea -- that senior management should be held accountable. But at a startup, it's a difficult question, and with people running the venture who are not management types, who are basically engineers, a Japanese judge would find it difficult to hold them to the same standard of review," says Murase. Of course, in cases of outright fraud or double-dipping into the VC's treasure chest, there would be no hesitation to refer the matter to the public prosecutors. "No one wants to get in the way of the Tokyo prosecutors," says Murase.

Ultimately the biggest difference between Japan and the rest of the world lies in how failure is viewed not only by the courts, but also by society at large. In Japan, as in Europe today and as in the US in the past, failure and bankruptcy are viewed as shameful things meriting punishment, and this can make a rehabilitated soft landing or continued business quite difficult. It may take some time for Japan to develop a venture-friendly culture that looks upon failure as not necessarily a bad thing, perhaps even as a badge of startup honor. "The US's advantage to date has been that there's a lot more lawyers to thrash things out, and investors have more avenues for relief," says Murase. "But in the end, most investors just walk away from it."