19 December 2017

Italy – Start-up investments

Convertible notes, SAFE Agreements, participative financial instruments: the growing interest in start-up investing has led to a progressive differentiation both in investment strategies and, as a consequence, in legal/contractual instruments so to best suit the investors’ needs.

The introduction of these tools, specific to foreign ecosystems such as the Silicon Valley, and the difficulties in sourcing sufficient capitals to back the development of start-up companies, in particular with regard to the early/seed stage, has encouraged several players to opt for instruments alternative to equity investment, either developed “nationally” or under common law systems.

This mind-set has many positive side effects since it opened up the capital raising landscape that now includes venture capital funds, business angels networks, family offices and even club deals composed of small investors willing to buy into start-ups (mostly over the incubation/acceleration stage) with an injection of capital for a relatively small amount of shares.

In Italy, this trend towards non-equity or demi-equity instruments had two major results: it contributed to dust off legal instruments first introduced by the latest comprehensive reform of the Italian company law in 2004 (e.g. participative financial instruments – in Italian: Strumenti Finanziari di Partecipazione or SFP – art. 2346, par. 6 of the Italian Civil Code); and it fostered the creation of new contractual models plainly inspired by well-known instruments used in the Silicon Valley. That is the case of Convertible Notes and SAFE Agreements (Simple Agreement for Future Equity).

These instruments, together with the SFPs, have a trait in common: they all require a cash investment which is meant to be converted to equity at a specific milestone or on a pre-set date. On the other hand, none of them entails the possibility for an investor to hold a participation as a shareholder (at least not straightaway). Investors become stakeholders instead and they may hold as many administrative/patrimonial rights as they manage to negotiate with the company or with the founders themselves as well as depending on the specific contractual instrument they selected. It is important to point out that profits distribution rights are not included among those subject to negotiation since innovative start-ups (namely early-stage companies that meet certain criteria set by the law: i.e. high level technology of the company’s scope, R&D expenditure or number of graduates employed, etc.) are prevented from distributing profits for the first five years according the pertaining Italian regulation (see art. 25, par. 2 of the D.L. 179/2012).

Convertible Note and SFP

Starting off with convertible notes: these instruments are extremely flexible and mainly used by club deals and family offices. They are structured as a hybrid between convertible obligations and traditional loans. Investors in facts lend money to a start-up on a specific interest rate and according to a contract where the parties have previously set out terms and conditions that would preside over their relationship. The investment is classified as a liability of the company to third parties and, more specifically, as a long term liability.

The parties set two different dates, one for the conversion of the credit to equity and another one for the possible payback (in case the conversion has not been exercised). Sometimes the parties decide to leave the payback aside and set directly the date of the conversion to equity thus transforming the instrument from a demi-loan to an option on a prospective capital increase, where the money invested in the company would be considered as the price of the option; or even an obligation that can be converted to shares, an hypothesis admitted by eminent scholars not only for corporations, but also for limited liability companies.

The conversion date is usually set before the reimbursements, for the latter is meant as the last resort in the event the capital increase has not been approved by the company and provided that the parties had previously agreed upon such possibility. Furthermore, the reimbursement might be considered as a consequence of certain events, in particular when there is a payback request for cause or when a party violates any of the representations and warranties set out in the contract. In order to avoid unpleasant surprises, it is “customary” to provide for a future capital increase specifically dedicated to the investor – as well as an obligation for the investor to convert his loan – directly in the contract. The parties are free to determine whether the conversion should take place on a certain date or subject to the company meeting specific milestones such as: turnover goals, the achievement of specific results both economically and with reference to the development of its tangible/intangible technological assets (for instance, the development of software or the patenting of an invention). The actual conversion may take place at once or in instalments through a resolution of the shareholders to schedule the capital increase in two or more tranches. The convertible note must provide for a price per share for the conversion based on the so-called pre-money valuation; it is quite usual to set also a conversion discount, that is a price per share lower than the per share price paid by other investors in that round.

SAFE Agreement

The SAFE Agreement – developed and used by the world-renowned California-based incubator “Y Combinator” – is neither a debt instrument, unlike convertible notes, nor an equity one since it does not give its holder the right to profit sharing or the right to vote as a shareholder. It is rather a financial instrument that incorporates a prospective right to buy out preferred shares.

Although SAFE Agreements do not have an Italian counterpart, SFPs may look alike when they are “designed” as semi-equity participative instrument (without payback) and used to collect capitals to be allocated in a specific equity reserve, which should be used only to cover the company’s operating losses and be considered otherwise unavailable. However, the extent of this unavailability is still a matter of debate among scholars and the possibility for the parties to a SFP agreement to determine that the reserve at issue might only be used upon depletion of the others (legal reserve fund included) is not undisputed as well. In one of the latest ruling on the matter, the judge has indeed opted for the availability of the reserve created upon issuance of the SFPs on account of its statutory nature, stating that it can therefore be depleted before legal reserve fund and equity (Court of Naples, 25/2/2016). This is basically the main reason why SAFE agreements cannot be implemented tout court in Italy.

In any case, the Italian Civil Code allows the possibility to design the SFPs so as to meet specific requirements since they are essentially “empty boxes” that can be filled by the parties based on the needs of either the issuing start-up company and/or the investors willing to fund it. In fact, the law only sets two guidelines: i) it excludes that the SFP could grant its holder the right to vote as a shareholder; ii) it establishes that these instruments can be endowed with patrimonial or even administrative rights. The possibility for a company to issue SFPs must be specified in the articles of association/bylaws, which refers to a future extraordinary meeting of the shareholders for the adoption of the pertaining regulation, which will also set out the functioning rules of the special assembly dedicated to the holders of SFPs.

Turning to the SAFE Agreement, the American model sets a conversion price that cannot exceed a certain cap, according to which the company assigns shares on a capital increase (i.e. SAFE preferred) with privileged rights and with restrictions closely similar to those typical of standard “preferred shares”. Furthermore, it also sets a discounted conversation price which, in the US experience, is in the range of 15-20%, while there no provision as to a future deadline for paying the investment back.

Nothing prohibits to adapt the regulation of the SFPs to the best practice resulted from the implementation of the SAFE Agreement in the US. That is the case of the “acceleration” clauses that allow the investor to convert its investment before the original date set out in the agreement in case of equity-financing/liquidity events, namely the acquisition of the start-up or a capital increase that brings new investors in. This type of clauses is also often used in convertible notes. Some clauses, on the contrary, cannot be transferred into a SFP. That is the case of the clauses that regard the payback in relation to dissolution events such as: (i) the voluntary suspension of the business activity of the company; (ii) the transfer of the company’s assets to benefit the creditors or (iii) the company’s winding-up process both voluntary and not. According to Italian law, the winding-up due to a total loss of equity implies the possibility to use the reserve destined to SFPs with the consequent loss of the money invested by the SFP holders. Hence the common practice – still debated among scholars – that sees the possibility to use the reserves created upon issuance of the SFPs subordinated to the complete depletion of the other reserves, legal reserve fund included.

Eventually, these practices have taken hold over the last few years since they are meant to provide the investors with more and more flexibility when dealing with financial/investment instruments as those described above. They represent in fact an opportunity for both start-ups, that can obtain capital on the short period, and investors, who can grade their entrepreneurial risk allocating their investment as a debt or not – depending on the chosen instruments – with a view to a conversion to equity that will eventually depend on several factors, not least the company’s business metrics and economical standing.

In conclusion, the dynamism of this sector and the recent intervention of the Italian legislator show that there is plenty of room for growth in the Italian start-up ecosystem.

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Milena Prisco

Corporate, M&A.

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