The Diverging Perceptions of Preferred Stock Conditions in Startup Investments between the US and Japan

Recently, the Japanese startup investment market has been facing controversy surrounding the conditions of preferred stock. This stems from a clear difference in startup investment practices between Japan and the United States. Specifically, there is a difference in perspective between the two countries regarding the participating and non-participating designs of preferred stock. In Japan, the participating type, which is advantageous for investors, is common, while in the United States, the non-participating type, which is advantageous for startups, is the standard.

Preferred stock is one of the types of stock stipulated in company law, which allows holders to receive dividends and residual asset distributions preferentially over common stock holders. In the case of a company sale, such as an M&A, the preferred shareholders are allocated their investment first, and the remaining amount is then distributed to other shareholders. In this case, in the participating type, preferred shareholders also share the remaining proceeds of the sale with common shareholders, but in the non-participating type, preferred shareholders only recover their principal investment, and the rest is all distributed to common shareholders.

It is reported that as many as 97% of startups in Japan issue participating preferred stock, which is investor-friendly. On the other hand, over 95% of startups in the United States prefer the non-participating type, which is startup-friendly. There are various interpretations for this stark contrast.

Some argue that Japan's preference for participating type is due to its smaller M&A market size, but there are counterarguments that even within the US, fierce competition among VCs creates incentives for them to maximize profits through participating type. Another explanation is that Japanese companies favor participating type to increase their valuation (variation), but some point out that most entrepreneurs do not properly understand the difference between participating and non-participating types.

US investors like Y Combinator strongly criticize investors who introduce participating type. They argue that participating type excessively advocates for investors' interests, hindering the growth incentives of startups and ultimately pushing sound entrepreneurs out of the country. On the other hand, there is a viewpoint in Japan that participating type is required to prevent moral hazard from distrust of entrepreneurs.

In a situation where mutual distrust exists between the parties involved, long-term co-growth becomes difficult. The controversy surrounding the participating and non-participating contract terms ultimately suggests that building trust between entrepreneurs and investors is crucial for the development of the startup ecosystem.