What Financing Mechanisms and Organizations of Business Entities Best Facilitate Innovation?

In this final session, TANAKA Wataru (Seikei University) explained in detail the current status of business organizations in Japan by comparing them with those of other countries. Following this, Merritt FOX (Columbia University) gave a presentation on the law of publicly traded corporations and innovations, while SAITO Jun, (Core Technology Center, Nikon Corporation), and HISATAKE Masato (RIETI), extracted overall problems. YANAGAWA Noriyuki (Graduate School of Economics, the University of Tokyo), who served as session chair, presented a summary report, and Professor Tanaka gave a supplementary explanation.

The themes of this session were the types of business organizations suitable for reinvigorating companies and promoting economic growth through innovation and stimulation of research and development, and the ways in which funds should be raised for such purposes. Although the Japanese economy experienced a period of stagnation, various systems and frameworks were developed during such time. Specifically, this refers to moves pertaining to LLPs, LLCs, and VC firms, and moves for going private. Determining ways of making use of these systems to achieve development is an issue involving measures companies should take and methods for appropriate implementation of legal systems and disclosure of information. However, the weight of these issues varies depending on the proponent.

Even if employees of large companies have growth opportunities and seeds of innovation, it may be difficult to realize those opportunities in-house if they are not allowed to implement them as projects. In such cases, the procurement of external funds would enable financing and give rise to technological innovation. Attempts at innovation within large companies may result in the rejection of a proposal or the reduction in the scale thereof. By obtaining financing through spinoffs, employees can aim at achieving substantial results.

Nevertheless, well-functioning public equity markets and regulations concerning the same are important prerequisites for success. If an IPO is carried out in the market and pricing is conducted properly, funds can be raised without any problem, thus leading to the promotion of innovation and growth. It is vital that a contract be concluded with the possibility of an IPO in mind even when venture capitalists provide funds to a spun-off company.

As such, it would be difficult for venture capitalists to provide financing unless the securities and equity markets are functioning well. In public equity markets, however, it is essential not only that a large amount of funds be gathered but also that accurate pricing be carried out based on highly transparent information. VC firms seek return and invest in companies based on such information. Consequently, securities market regulations, especially concerning the problem of disclosure of information, are extremely important. The current situation in which funds are rarely being supplied by VC firms in Japan may be due to overinvestment in projects that are not highly productive given the buildup of cash at large companies, rather than to the outflow of funds from large companies resulting in non-investment. Thus, it is crucial to have a scheme in which the market mechanism functions in the final stage, and the method of creating business organizations according to the stages of growth of companies and the allocation of control rights should also become considerations.

The present environment of venture business is characterized by rapid changes, large investments, and low probabilities of success. In this environment, perhaps it would be better to separate to some extent the right of management and residual claims, i.e. the right to allocate profit and the person who can claim leadership, in enhancing the degree of freedom. Even in the U.S., the allocation of control rights of venture businesses is in many cases separated from the allocation of residual claims. Meanwhile in Japan, the LLC is a rather promising form of business organization. There are a number of constraints on the recently created J-LLP (Figure 8-P.1 [PDF:88KB] ), and there is probably room for studying and examining these constraints.

Japan's corporate laws underwent sweeping changes in a short period. In particular, with respect to the Company Law, the minimum capital requirement was abolished, making it possible to set up a kabushiki-kaisha (stock company) with initial capital of one yen. Among stock companies, privately held companies (under the Company Law, the transfer of shares is restricted by the Articles of Incorporation and requires the company's approval) can, generally speaking, freely determine the profit-sharing ratio, among other things, regardless of equity ownership, by control rights, specifically voting rights, in accordance with the Articles of Incorporation. This has spurred the deregulation of internal organization.

Furthermore, godo-kaisha (limited liability company: J-LLC) and yugen-sekinin jigyo-kumiai (limited liability partnership: J-LLP) were created as new forms of business organization. However, the LLC is ultimately a company. Given the fact that a company is an incorporated entity in Japan, it is taxed as a corporation under corporate taxation law unless there are special rules stating otherwise. The LLC therefore is taxed at the level of a corporation and taxed again when profit is shared among its members. However, the J-LLC enjoys limited liability and can adopt a more flexible governance structure than a stock company. These merits are highly rated, and the J-LLC therefore will likely be adopted as a form of business organization.

On the other hand, the J-LLP can receive pass-through tax treatment but is handicapped in many ways in exchange of this benefit. First, since it is not incorporated, it cannot be registered in its own name as a J-LLP, such as when being registered for real estate, but must be registered jointly in the names of the partners of the J-LLP. In addition to this inconvenience, it is not easy to convert from a J-LLP into a company. Under the governance structure, all partners must participate in the management of partnership affairs. But because there is uncertainty as to the nature of the management of partnership affairs, operations may encounter difficulties. As for privately held companies, including new startups, it would probably be reasonable to enable them to enjoy limited liability as well as pass-through taxation.

In the case of the J-LLC (corporation tax), in addition to the fact that profit is double-taxed, even if losses are incurred at the corporate level, they are disregarded since there is no negative corporation tax. An examination of this in terms of after-tax cash flow indicates that early losses, particularly as in the case of startup businesses, hinder the realization of businesses that are expected to, though not certain to, produce huge profits in the future.

In the case of the J-LLP (pass-through taxation), on the other hand, since losses can be offset by gains of members, the reduction of the overall tax amount has the merit of producing a more neutral effect on economic activities. From this perspective, the participation of all partners in the management of partnership affairs is required for the approval of pass-through taxation for J-LLPs. However, tax scholars are analyzing whether this is an inevitable requirement, and it is hoped that their efforts would generate further discussion.

Meanwhile, it would probably be necessary to deeply consider the cost and advantages of limited liability. Limited liability would, in most likelihood, not be so unfair to contract creditors. Creditors who have entered into business relations with a business entity based on a contract would first take into consideration their limited liabilities in determining the conditions for transacting business and demanding collateral or guarantees. If they cannot do so, there is no need to conduct business in the first place.

Nonetheless, this cannot be implemented in the case of tort creditors. In Japan, it had perhaps been believed that companies would rarely go bankrupt saddled with huge debts. However, an examination of recent incidents reveals that it appears that problems have not arisen simply because of the failure to salvage tort creditors. Regarding this point, corporate law has long contended that it would be appropriate for even business entities of limited liability to bear unlimited liability toward tort creditors. This merits careful consideration.