Ten tips for starting an innovative and sustainable new business

This article has been also published on the EACCNY website on October 28, 2021.

Nowadays, a company that wants to be successful will almost always need to deal with the challenge of innovation and sustainability.

Innovation and sustainability typically involve the business model or the services or products offered by the company. However, they can also have impact on a company’s operations and organization. Indeed, a flexible and forward-looking corporate structure can be crucial to the growth and development of a startup.

Below are ten tips for managing and developing a new business in an innovative and sustainable way, including from an organizational and managerial standpoint, with an ambitious and clear perspective. A practical decalogue intended both for entrepreneurs who want to build solid companies and for investors who want to make sustainable investments that go beyond typical sustainable financing.

  1. Make investments through an ad hoc vehicle or a trust mandate, especially in the seed-early stages

A small company structure that is not overly fragmented can facilitate management of a startup and new investment fundraising.  In the case of a large number of investors, they could become shareholders of a company through a newco set up by them or through a trust company. Formally speaking, the trust company or newco is then the sole owner of a stake in the startup and the relationship between the individual investors is regulated at the trust and newco levels. The startup is not involved in the dynamics of the relationships between investors, so the bylaws and agreements between the founders and investors can be simpler and more streamlined. This solution may be more difficult to implement when the investors are not all family and friends and do not know each other. However, even in those circumstances, it may be the most appropriate solution.

  1. Don’t block operational decisions with too many reserved matters and veto rights

Frequently investors request control mechanisms over the management of the company in which they invest. Typically, the investor asks to be granted the power to influence decision-making on certain matters falling within the competence of the shareholders’ meeting or the board of directors by means of veto rights or qualified quorums that require the investor’s vote to be met. These kinds of requests may conflict with the founders’ need to provide the startup with a streamlined operating structure. It is advisable to be open-minded and thoughtfully negotiate both the list of “reserved” matters and the higher quorums or veto rights on such matters. The aim should be to reach a solution that does not unnecessarily weigh down the management of the target company, but instead trusts the founders’ entrepreneurial initiative and benefits from investors’ skills and experience.

  1. Arrange for reasonable management of investors’ rights to appoint directors and auditors

Another common request from investors is to have the right to appoint a director or a statutory auditor (membro del collegio sindacale). As with qualified quorums and reserved matters, these rights grant investors a certain degree of control over the company’s activities; however, a large number of directors can stiffen and burden the management of a still-small company. If the company in question is a limited liability company (S.r.l.), it may not yet have exceeded the size limits provided by law for the mandatory appointment of the auditors. How to deal with these requests? Try suggesting that investors (i) jointly appoint one or two directors to represent them (avoiding the appointment of a director for each investor if possible), or (ii) appoint a hearer (uditore) per investor, who would be entitled to attend board meetings and, while not granted voting rights, has the right to receive the same information as directors. As regards the auditors, in the case of a S.r.l., it may be appointed a sole statutory auditor, which could also be entrusted with the functions of external audit of the accounts.

  1. Preserve the shareholding of the founders

Founders should pay particular attention to adopting adequate solutions not to lose the majority equity stake already after initial investment rounds and grant them a sufficient degree of control over management of the company. In practice, it is quite common to recognize the founders’ right to appoint the majority of directors, and to grant at least one of them operational powers for the performance of day-to-day activities. For transactions that fall outside the ordinary management (e.g., loans and guarantees, real estate transactions), founders usually negotiate with investors to set value thresholds below which they can carry out such transactions without investors’ prior consent. Indeed, loss of control over the company or excessive dilution by founders before an A round may undermine credibility in later rounds and discourage new investors, especially international investors, from getting involved.

  1. Startups and SMEs in the form of S.r.l.: classes of quotas or assignment of special rights?

An S.r.l. that qualifies as an innovative startup or an SME (including a non-innovative SME) can issue various classes of quotas with different administrative and economic rights. An S.r.l. may also grant certain rights as “special rights” to one or more shareholders in particular. The choice between issuing a new class of quotas or granting special rights to an investor should be based on several factors. If there is more than one investor with “homogeneous” interests, it may be convenient to issue a new class of quotas for such investors: in this way, investors aren’t named in the bylaws (meaning the bylaws don’t have to be changed every time an investor enters or exits the company) and the same rights can be allocated to new investors simply by issuing new quotas of the same class. If there is only one investor or if the investors have different interests, it may be more appropriate to give them special rights rather than creating a class of quotas for each investor. Also, it is possible to issue classes of quotas that do not grant voting rights at all, or that grant voting rights only on certain matters or rights that are not proportional to the shareholder’s stake, in order to assign them to the shareholders with less weight in the decision-making process: special rights do not achieve the same result.

  1. Use incentive plans and work for equity to drive strong and sustainable growth

The success of a startup depends in part on the involvement of employees and others who contribute to its growth. Indeed, a startup can benefit greatly from granting employees and other workers a stake in its equity through incentive plans and work-for-equity mechanisms. Doing so encourages key people to stay with the company, which is extremely important in areas where “human capital” is crucial to the success of an initiative (“loyalty effect”). Additionally, incentive plans may give the company a competitive advantage in the labor market, especially in areas where competition is tight. As an added benefit, replacing (all or part of) cash consideration with equity may allow a company to make up for any liquidity shortfalls, and the employee or other worker to benefit from the value of the company and the tax incentives provided by current regulation.

  1. Think about alternative equity investment means: convertible participatory financial instruments (“SFPCs”) and equity crowdfunding

Startups by their very nature burn cash and need ongoing capital injections to establish themselves and start scaling up. The choice of means for raising capital must be made carefully, especially in the initial stages of growth. A preliminary distinction should be made between equity financing (where capital is raised by subscribing or selling quotas in the company) and debt financing (where money is borrowed and later repaid by the company). Two alternative and “innovative” equity financing instruments have emerged in recent years: SFPCs and equity crowdfunding.

The holder of an SFPC does not become immediately a shareholder but is entitled to convert this instrument into a stake in the company. This right can be exercised only when a triggering “liquidity” event occurs (e.g., a listing, a subsequent investment, an exit) or within a certain time period. An SFPC structured in this way is an equity instrument. The money paid for an SFPC is allocated to a reserve in the company’s equity. The conversion is carried out based on the company’s valuation at the time of conversion, usually discounted by a certain percentage to reward the investor, who initially subscribed to the SFPC at a time of greater business risk.

Through equity crowdfunding, people may invest even small amounts of money to support projects or initiatives of a startup or SME via online platforms. A startup or SME does not need to qualify as “innovative” to launch an equity crowdfunding campaign. This investment tool is being used increasingly frequently in Italy and abroad, and it is a sustainable tool for several reasons. It allows people to invest in a transparent and direct way; investors learn about the team behind the initiative and freely choose projects to which they allocate their money. Also, it is increasingly common for people to promote ethical and sustainable projects through crowdfunding platforms, thereby increasing both their visibility and the odds of obtaining support (including financial support).

  1. Consider alternative debt financing instruments: venture debt

Banks are notoriously risk-averse entities that are unlikely to provide funding to startups at the beginning of their activity, when companies are not yet economically and financially solid. As an alternative to bank financing, when certain requirements are met, private parties may finance a company and have their financing converted into equity upon occurrence of certain events (known as convertible financing). However, excessive or inappropriate use of such private financing may conflict with regulations on collecting savings from the public. Financing between private parties may also lead to other problems, for example, lengthy negotiation of the terms and conditions of the financing agreement with each investor.

To overcome these and other difficulties (e.g., a company’s process for issuing bonds and other debt securities), we would like to suggest cultivating the system known as “venture debt” in Italy.

Unlike convertible financing, venture debt is financing provided to startups by financial and non-financial entities, typically as an alternative or complement to an equity investment in the same company. It is short- to medium-term interest-bearing financing granted via guarantees on the company’s equity rather than on its assets (which may not be substantial in the startup phase). Unlike equity investments, venture debt prevents excessive dilution of the founders’ shareholdings. This form of financing is most often provided to companies that have already successfully completed their first rounds of VC equity investment (exhibiting a positive track record), but do not yet have sufficient cash flow to obtain conventional loans (e.g., from banks). Venture debt allows these companies to bridge such gaps and receive the liquidity to acquire the capital assets they need to accelerate growth and reach operational milestones. Among other things, the amount disbursed through venture debt is usually calculated based on the amount of equity investments previously obtained by the company (usually 30% of the total obtained in the last equity investment round). The venture debt phenomenon is gaining ground abroad, while in Italy it is still barely used.

  1. Adopt sustainable development policies and strategies within the company: ESG (Environmental, Social, and Governance) factors and benefit companies

Today it is increasingly important for a company (of any size) to conduct its business in a sustainable way, bringing into play not only the company’s economic aspects but also its social and environmental policies. Conducting business in a sustainable way means efficiently and strategically managing the available (financial, natural, and human) resources, as well as paying attention not only to what the company does but how it does it. In this way, the company develops better capacity for innovation, analysis, and risk management and, in the case of a startup, becomes more attractive to investors. Indeed, European legislation[1] has imposed sustainable investment objectives on financiers (including managers of alternative investment funds and qualified venture capital) and they are required—among other things—to verify and evaluate the sustainability of their investment targets and their compliance with ESG factors.

As a result of this burgeoning focus on sustainability and social impact, more and more innovative startups are aiming to qualify as benefit companies (“SBs”). SBs are not a new type of company; they are companies that pursue non-economic goals in addition to profit objectives. This mission can certainly help startups attract social impact investment capital and increase their “intangible capital,” as well as establishing reputations as creators of social and environmental benefits.

  1. Founders and investors should work together toward a shared business vision

Founders and investors should share the same vision for the development and management of the company. This creates a healthy and cooperative environment where roles are respected and means no time is wasted on power games or staking one’s ground. Investors should trust the founders and their business instincts; after all, investors have decided to bet on those very instincts. For their part, founders should be open to receiving advice and, to a certain extent, being guided by the experience of their investors, who may support an initiative with their knowledge, but also may help with organizational structure. Adopting sound yet flexible operational strategies during the life of the startup and investment helps grow the value of the company and of the stakes held by founders and investors, with positive impact on a future exit. A shrewd and forward-looking approach to company management can only drive growth and returns—to the benefit of all the parties involved.

[1] Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability reporting in the financial services sector, subsequently supplemented by Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 establishing a framework to encourage sustainable investment and amending Regulation (EU) 2019/2088.

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