DCC Startup Investment Promotion Working Group’s Interim Report

Earlier this month, the Digital Asset Co-Creation Consortium (DCC), led by Progmat, published the Interim Report of the Startup Investment Promotion Working Group.

Executive Summary

The interim report explores the potential of tokenizing Venture Capital (VC) Funds in Japan, focusing on the benefits, legal and regulatory considerations, proposed scheme mechanics, and necessary actions for implementation.

Key Benefits

• Increased Funding for Startups: Tokenization broadens the investor base for VC funds, attracting individuals alongside traditional institutional investors. This influx of capital promotes a stable and efficient flow of funds to promising startups.
• New Asset Class for Individual Investors: VC fund tokens offer individual investors a new avenue for portfolio diversification and access to a previously exclusive asset class.
• Streamlined Fundraising for Startups: Tokenization allows startups to raise capital without directly dealing with a large number of individual shareholders, reducing administrative burden and complexity.

Proposed Scheme and Entities

• Structure: The report proposes using a Specific Purpose Vehicle (SPV) structured as a Specific Beneficiary Securities Investment Trust (Specific JS) for tokenizing VC funds. This structure is deemed advantageous due to its legal stability for rights transfer and favorable tax treatment compared to other SPV options.
• Asset Tokenization: The tokenized assets within the Specific JS would comprise the Limited Partner (LP) investment interests in the VC fund and operational cash reserves.
• Investment Decision Making: The VC fund’s General Partner (GP) retains full control over investment decisions regarding the selection and allocation of capital to startups.
• Regulatory Compliance: The report argues that the VC fund, receiving investment from the tokenized SPV, would generally qualify for the “Professional Investor Exemption” under the Japanese Financial Instruments and Exchange Act, provided certain conditions are met.
• Information Disclosure: While legal disclosure requirements must be met, the report recommends voluntary disclosure of additional information, such as VC fund portfolio company names and allocation percentages, to enhance transparency for investors.
• Investor Protection: To mitigate risks for individual investors, the report suggests implementing investor suitability checks and potentially setting investment limits based on factors like income or net worth.

Key Considerations & Challenges

• Regulatory Clarity: Further discussions with regulatory authorities are required to solidify the legal interpretation and ensure compliance of the proposed VC fund tokenization scheme, particularly concerning the “Professional Investor Exemption”.
• Information Disclosure Standards: Determining the appropriate level of information disclosure for VC fund tokens is crucial. The report acknowledges the need to balance investor transparency with the confidentiality concerns of VC funds and their portfolio companies.
• Investor Suitability & Protection: Establishing clear investor suitability criteria and potentially setting investment limits will be vital for protecting less sophisticated investors participating in this relatively illiquid and high-risk asset class.
• Accounting Treatment: The report identifies challenges related to accounting for unrealized gains in the Specific JS due to fair value adjustments of non-listed stocks held by the underlying VC fund. This raises concerns about potential breaches of the 2.5% profit retention rule for Specific JS.

Call to Action

• Establish “Trust Accounting Rules WG”: Form a new working group comprising trust banks, accounting experts, and relevant stakeholders to address the accounting challenges specific to tokenized VC funds and other tokenized assets.
• Engage with Regulatory Authorities: Collaborate with the Trust Companies Association of Japan and relevant authorities to propose necessary rule amendments and legal interpretations that facilitate the smooth and compliant implementation of VC fund tokenization.

Detailed Breakdown of the Report

1. Introduction: Progmat, DCC, and the Working Group’s Objectives

This section introduces Progmat, a company aiming to build a programmable network for digitizing various asset classes using blockchain technology. Progmat has established the Digital Asset Co-creation Consortium (DCC), an industry-wide initiative to foster innovation and collaboration in the digital asset space.

The DCC’s Startup Investment Working Group, responsible for this report, focuses on promoting startup investment through VC fund tokenization. The group aims to identify key considerations, propose solutions, and drive the implementation of this novel investment vehicle.

2. Significance and Value Proposition of VC Fund Tokenization

This section outlines the benefits of VC fund tokenization for various stakeholders:

• Startups: Access to a larger pool of capital, leading to increased funding opportunities and accelerated growth.
• VC Funds: Attracting a broader investor base, enhancing fundraising capabilities and potentially increasing fund size.
• Individual Investors: Gaining access to a previously exclusive investment class with potentially higher returns, albeit with increased risk.
• Financial Institutions: Expanding business opportunities by offering innovative investment products and attracting new clients.
• Japanese Economy: Promoting innovation and entrepreneurship by facilitating capital formation for startups, aligning with government initiatives like the “Startup Development 5-Year Plan” and promoting “Web3.0” advancements.

The report compares VC fund tokens with similar investment vehicles like listed venture capital funds, equity crowdfunding, and unlisted stock investment trusts. It highlights the unique value proposition of VC fund tokens, offering benefits for both individual investors and VC funds that are not fully met by existing options.

3. Proposed VC Fund Tokenization Scheme

This section details the proposed framework for VC fund tokenization, outlining the legal structure, key entities involved, and transaction flow:

3.1 SPV Selection: Specific Beneficiary Securities Investment Trust (Specific JS)

The report recommends using a Specific JS as the preferred SPV for housing the tokenized VC fund interests. This structure is chosen due to:

• Legal Stability: Offers greater legal certainty for rights transfer compared to other SPVs like Anonymous Partnerships or Prioritized Equity Securities.
• Favorable Taxation: Provides more advantageous tax treatment for both individual investors and the SPV itself, especially for investors with higher taxable income, compared to other SPVs.

3.2 Reference Schemes

The report references existing schemes like Real Estate Security Tokens (REITs) and Japanese Depositary Receipts (JDRs) to illustrate the mechanics of asset tokenization and investor participation. These examples showcase the feasibility and regulatory acceptance of similar structures within the Japanese financial market.

3.3 Proposed Scheme for VC Fund Tokens

The report proposes the following structure for VC fund tokenization:

Establishment:

• A Securities company acting as the “Entrustor” establishes a Specific JS with a Trust Bank acting as the “Trustee.”
• This Specific JS will hold the tokenized LP interests.

Fundraising:

• The Securities company raises capital from investors by issuing Security Tokens representing beneficial interests in the Specific JS.
• The Securities company invests the raised capital into the VC fund by acquiring LP interests.

Management:

• The VC Fund’s GP manages the fund’s assets and investment decisions independently.
• The Trust Bank, as the Trustee, oversees the Specific JS and ensures proper management of the tokenized assets.

Distribution:

• Profits generated by the VC fund are distributed to the Specific JS.
• The Specific JS then distributes the profits to token holders according to their respective holdings.

4. Detailed Scheme Mechanics and Considerations

This section dives deeper into the practical considerations and potential challenges associated with implementing the proposed scheme:

4.1 Regulation & Investor Protection: Key Discussion Points

Three main regulatory challenges are identified:

1. “Professional Investor Exemption” Applicability: The report analyzes whether the Specific JS, as a single investor entity holding the tokenized LP interests, can satisfy the conditions of the “Professional Investor Exemption” for the VC fund to maintain its private placement status.
2. Information Disclosure Levels: The report discusses the appropriate level of information disclosure for VC fund tokens, considering the balance between investor transparency and the VC fund’s need for confidentiality regarding portfolio companies.
3. Target Investor Criteria: This section examines the ideal target investors for VC fund tokens, weighing the risks associated with this asset class against investor sophistication and potential investment limits.

4.2 “Professional Investor Exemption” Applicability

The report argues that the VC fund receiving investment from the tokenized SPV can likely utilize the “Professional Investor Exemption,” fulfilling the following conditions:

• No Circumvention of Law: The structure is not designed to bypass existing regulations.
• Eligible Entrustor: The Securities company acting as the Entrustor and making the initial LP investment decision is a registered Type 1 Financial Instruments Business Operator and qualifies as a Professional Investor.
• Eligible Trustee: The Trust Bank acting as the Trustee and receiving the LP interest transfer is a Professional Investor.
• Independent Decision-Making: The Specific JS operates independently from the VC fund, with the potential to exit the investment if deemed necessary.
• No Direct Transfer of LP Interest: The Specific JS does not directly transfer the LP interests to individual investors, mitigating concerns about unintended regulatory breaches.

4.3 Information Disclosure Standards

The report acknowledges the need for transparency while recognizing the limitations on information disclosure imposed by VC funds and their portfolio companies.

The report recommends:

• Mandatory Disclosures: Compliance with all legal disclosure requirements for Specific JS offerings.
• Voluntary Disclosures: Encouraging, but not mandating, VC funds to disclose additional information, such as portfolio company names and allocation percentages.
• Long-Term Goal: Striving for greater transparency by potentially including excerpts from Limited Partnership Agreements (LPAs) in disclosures, subject to confidentiality concerns and evolving market practices.

4.4 Target Investor Criteria (Trading Commencement Standards)

The report suggests a tiered approach to investor suitability:

• Professional Investors: No investment limits.
• Non-Professional Investors: Potential investment limits based on income or net worth, such as a maximum of 10% of either.
• Less Sophisticated Investors: Excluding investors with income or assets below a certain threshold from solicitation efforts.

In the long term, the report envisions a more open market for VC fund tokens with secondary trading on Proprietary Trading Systems (PTS) and potentially peer-to-peer (P2P) platforms. This would require implementing safeguards to prevent unfair trading practices and ensure market integrity.

4.5 Transaction Flow Examples

The report provides detailed examples of transaction flows for various scenarios, including:

• New Fund Setup: Outlines the process of establishing a new VC fund alongside the tokenized SPV, including legal documentation, capital calls, and token issuance.
• Ongoing Management: Explains the mechanics of handling fund expenses, financial reporting, and information disclosure during the fund’s lifecycle.
• Additional Capital Calls: Details the procedure for handling capital calls from the VC fund, ensuring sufficient liquidity within the Specific JS to avoid additional token offerings.
• Term Extension: Describes the process of extending the investment term for both the VC fund and the corresponding Specific JS based on predetermined conditions outlined in the initial agreements.
• Exceptional Events: Outlines the actions taken in case of unforeseen circumstances requiring potential fund restructuring, liquidation, or early exits.
• Maturity: Explains the process of liquidating the VC fund upon maturity, distributing proceeds to the Specific JS, and subsequently to token holders.

4.6 Proposed Scheme Participants

The report clarifies the roles and responsibilities of key entities involved in the scheme:

• Entrustor & Initial Beneficiary: A Securities company typically assumes this role, requiring a Type 1 Financial Instruments Business Operator license and potentially an investment management license.
• Liquidation Beneficiary: The report suggests the Entrustor also assumes this role, as transferring it to a third party offers minimal benefits and increases complexity.
• Fund Administrator: While not mandatory, outsourcing fund administration tasks to a specialized provider is recommended to ensure efficient and compliant handling of fund operations.

4.7 & 4.8 Accounting Treatment:

This section discusses the accounting treatment of LP interests held within the Specific JS, focusing on two key issues:

1. Classification of LP Interests: The report analyzes whether LP interests should be classified as “Investments in Associates and Joint Ventures” or “Investment Securities” under Japanese accounting standards. It concludes that classifying them as “Investments in Associates and Joint Ventures” is more appropriate, reflecting the underlying economic substance and minimizing potential accounting discrepancies.
2. Fair Value Measurement: The report highlights the challenges of fairly valuing illiquid assets like LP interests and the potential need to rely on Net Asset Value (NAV) provided by the VC fund.

4.9, 4.10, 4.11 & 4.12 Accounting Treatment Challenges & Potential Solutions

The report identifies two key challenges related to accounting for VC fund interests in a Specific JS:

1. Financial Reporting Timelines: Misaligned financial reporting deadlines between the VC fund and the Specific JS can pose challenges for incorporating the fund’s financial results into the Specific JS’s reporting.
2. Unrealized Gains & 2.5% Retention Rule: Fair value adjustments of non-listed stocks held by the VC fund can lead to unrealized gains within the Specific JS. This creates a conflict with the 2.5% profit retention rule for Specific JS, as these unrealized gains cannot be readily distributed to token holders.

The report proposes addressing these challenges by:

• Aligning Financial Reporting Dates: Encouraging closer alignment of financial reporting deadlines between VC funds and Specific JS to minimize reporting discrepancies and ensure timely reflection of financial performance.
• Rule Amendment for Profit Retention Calculation: Advocating for a rule change to exclude unrealized gains from the profit retention calculation for Specific JS. This would align the accounting treatment with the economic reality of unrealized gains and prevent unintended breaches of the 2.5% rule.

5. Necessary Actions for Realizing VC Fund Tokenization

This final section outlines the crucial steps needed to make VC fund tokenization a reality in Japan:

5.1 Establish a “Trust Accounting Rules WG”

• Objective: Address the unique accounting challenges associated with VC fund tokens and other tokenized assets within Specific JS structures.
• Participants: Include representatives from trust banks, accounting experts, and other relevant stakeholders to ensure comprehensive and practical solutions.
• Outcome: Develop standardized accounting guidelines for tokenized assets held within Specific JS, promoting transparency and facilitating wider adoption.

5.2 Engage with Regulatory Authorities

• Objective: Propose rule amendments and seek clarifications on legal interpretations related to VC fund tokenization, ensuring regulatory compliance and certainty.
• Key Stakeholders: Collaborate with the Trust Companies Association of Japan and relevant regulatory bodies to advocate for necessary changes.
• Desired Outcomes: Secure regulatory clarity regarding the applicability of the “Professional Investor Exemption” for VC funds receiving investment from tokenized SPVs; implement necessary rule amendments regarding profit retention calculations for Specific JS to accommodate unrealized gains from fair value adjustments.

Conclusion

This report highlights the immense potential of VC fund tokenization in democratizing access to a previously exclusive asset class, increasing funding opportunities for startups, and fostering innovation within the Japanese economy.

Realizing this vision requires a collaborative effort between industry stakeholders, regulatory bodies, and policymakers to address the identified challenges and establish a clear, robust, and investor-friendly framework for VC fund tokenization. The proposed actions outlined in this report provide a roadmap for navigating these challenges and unlocking the full potential of this transformative technology.

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