Do You Need Legal Due Diligence to Buy a Small Business in Japan? Ten Things to Check

Buying a small company in Japan is no longer unusual. Marketplaces such as BATONZ and TRANBI list businesses from a few million yen upward, and the buyers are often individuals: an employee buying their way out of employment, a sole trader adding a second business, someone acquiring a web service as a side venture.

At that price, the instinct is to skim the financial statements, glance at a contract or two, and get on with it.

The difficulty is that in a share transfer you are not buying revenue and equipment. You are buying the company, and everything the company has ever signed, hired, borrowed, infringed or been sued over stays inside it. Japan's SME Agency makes the same point in its guidelines on small and medium-sized M&A: because the legal entity does not change in a share transfer, the risk of off-balance-sheet and contingent liabilities is comparatively high, and more detailed due diligence tends to be carried out.

Legal due diligence is not an attempt to prove the company is clean. It is a way of finding out, while you still have leverage, what you would be taking on — and then deciding what to do about it in the price and in the contract.

Can an individual really buy a company in Japan?

Yes. There is no minimum deal size and no requirement that the buyer be a corporation. An individual can acquire a small company, a shop or a web business, either by buying the shares or by buying the business itself.

The two routes are structurally different. In a share transfer, you become the shareholder of a company that continues to exist unchanged, so its rights and obligations stay where they are. In a business transfer, specified assets, contracts and operations move across, which lets you leave liabilities behind but means each contract, employee and licence has to be dealt with one by one. The trade-off is set out in share transfer or business transfer.

If you are not Japanese, two further questions sit alongside the purchase: whether a filing is required under the Foreign Exchange and Foreign Trade Act, and whether your status of residence allows you to run the business from inside Japan. Both are summarised on the buying a business in Japan page.

Why does a small deal still need legal due diligence?

Suppose you buy a company for JPY 8 million. The accounts show steady revenue and a modest profit.

After closing, any of the following can surface:

• the contract with the largest customer lets them terminate on a change of control
• a former employee claims three years of unpaid overtime
• the source code of the main product is still owned by the freelance developer who wrote it
• there is another shareholder, and the ownership of the shares is disputed
• the licence the business runs on cannot be maintained under the new structure
• a serious dispute with a customer or supplier was already under way

A small purchase price does not imply small legal risk. For an individual buyer, a few million yen is usually a significant personal decision, which is a reason to check rather than a reason not to.

How is legal due diligence different from financial due diligence?

Due diligence comes in several kinds — financial, tax, legal and commercial — and they do not substitute for one another.

Financial due diligence analyses earnings, assets and liabilities and cash flow. Tax due diligence looks at historical tax treatment and latent tax exposure.

Legal due diligence asks a different question: what rights and obligations does this company actually have, and what legal risks is it carrying?

A lawyer reading the contracts cannot tell you whether the business will keep earning. An accountant reading the financial statements will not find the change-of-control clause or the gap in the chain of title to the source code. On a small deal, where you cannot afford everything, it is worth being deliberate about which questions you are paying whom to answer.

The ten things to check

1. Does the seller actually own the shares?

In a share transfer, this is the starting point. The shareholder register is not the end of the inquiry: the history of share issuances and transfers, the articles of incorporation, any restriction on transfer, and the position of co-founders may all need to be traced.

A seller who says "I hold one hundred per cent" may be describing what they believe rather than what the records support. Defects here are expensive to fix after closing and relatively cheap to fix before it.

2. Will the key customer contracts survive the deal?

In a small company, a handful of customers often account for most of the revenue. For each significant contract, the term, termination rights, automatic renewal, damages, exclusivity and non-compete provisions, and any notice or consent requirement on a change of control all matter.

If the largest customer can walk away the week after closing, the premise of the price has changed.

3. What employment liabilities are sitting in the company?

Unpaid wages and overtime, the state of the employment contracts and work rules, social insurance enrolment, harassment complaints and disputes with former staff are all live issues in small acquisitions.

Where people are engaged as independent contractors, the question of whether the relationship is legally employment can also arise, which is the subject of a separate note on contractors who may be employees.

4. Does the company own its intellectual property?

This is the one most often got wrong in web, SaaS, e-commerce and content businesses. Source code, logos, designs, photographs, video, trade marks and domains all need to be traced to the company, either as owner or under a licence that survives the deal.

Using something for years is not the same as owning it. Work done by an outside developer belongs to the developer unless the contract says otherwise.

5. Can the licences be maintained?

Where the business requires a permit, registration or notification, check that the current licence is valid, whether a change of shareholder or representative director affects it, and — in a business transfer — whether a fresh licence has to be obtained. Some regimes impose requirements on the individuals running the business, which is worth knowing before you become one of them.

6. What do the borrowings, security and personal guarantees look like?

Balances, repayment terms, security, guarantees and financial covenants all need to be seen. In Japanese SMEs the outgoing owner has often personally guaranteed the company's bank debt, and how that guarantee is released or replaced is frequently a condition to closing rather than a detail.

7. Is anyone suing, or about to?

Not only pending litigation. Customer damages claims, disputes with former employees, payment and quality disputes with suppliers, communications from regulators and intellectual property warning letters all belong on the list.

8. Is personal data being handled properly?

For any business holding customer data: the privacy policy, how data is collected and used, transfers to third parties and to overseas services, supervision of subcontractors, and any past incident. The specific issue of sending personal data to overseas cloud services is covered in a separate note.

9. Are there related-party arrangements you are inheriting?

Small companies are often entangled with their owner: the premises are leased from the owner personally, a sister company supplies services, there is a loan account with the representative director. The question is whether the business can continue on the same terms once that person has gone.

10. Can the contract deal with what you found?

Finding a problem does not mean abandoning the deal. It can be reflected in the price, fixed by the seller before closing, made a condition to closing, covered by a representation and warranty, or addressed by a specific indemnity.

Due diligence and the purchase agreement are one exercise, not two. How a finding becomes a term is set out in turning due diligence findings into deal terms.

Red flag due diligence: scope that fits the deal

Investigating a small company to the standard of a large transaction produces fees out of proportion to the price.

Red flag due diligence is the usual answer: concentrate on what could change the decision or the price, and say so plainly rather than producing a catalogue. In practice that means prioritising title to the shares, key contracts, employment, intellectual property, licences, borrowings and serious disputes, and sorting whatever is found into four questions:

• is this bad enough to stop the deal?
• should it come off the price?
• should the seller fix it before closing?
• what needs to go into the purchase agreement?

When should a buyer bring in a lawyer?

Earlier than most people do. The useful moment is when the target has been narrowed down and disclosure is about to begin, because then the document request list and the questions to the seller can be shaped from the start.

That is particularly so if this is your first acquisition, if you are buying the whole company by share transfer, or if the value of the business sits in intellectual property and data rather than in equipment. If an intermediary is already involved, their role and a buyer-side lawyer's role are not the same thing, as explained in brokers and buyer-side counsel.

In short

Individual buyers have a legitimate interest in keeping professional fees down. The mistake is to conclude from a small purchase price that the legal risk is correspondingly small.

The workable approach is to narrow the scope to the size of the deal, confirm the legal risks that could actually change your decision, and then make sure the answers show up in the price and in the contract.

Primary sources

• SME Agency, Guidelines for Small and Medium-sized M&A (3rd edition) (Japanese)
• SME Agency, warning on M&A-related trouble (Japanese)
• e-Gov, Companies Act (Japanese)