Convertible notes and other alternative financing instruments

Companies and investors increasingly ask for alternative instruments to carry out their investments in Italy, and convertible notes are one of the most demanded. A convertible note is a very common instrument in the US venture capital market, but in most cases, it seems to be not well-known by Italian market players and it is not clear whether it is a mean of financing allowed “as it is” by the Italian legal system.

What is a convertible note?

A convertible note is a financing instrument usually used in the US by early-stage start-ups, as it represents a simple, fast and quite cheap way to raise funds.

More specifically, a convertible note is a bond issued by start-ups in favour of investors in exchange for financing: indeed, when certain circumstances occur, as a bond it grants to the owner the right to request the repayment of the financing or, alternatively, to convert the note into an equity participation of the start-up.

Can Italian start-ups issue convertible notes?

In Italy, convertible bond securities represent the legal instrument closest to US convertible notes. However, the legal provisions governing convertible bond securities[1] make such instruments less attractive than convertible notes in the eyes of investors in early-stage start-up companies.

Generally speaking, to issue convertible bond securities, any type of company shall meet and bear certain  formalities and costs, but limited liability companies (S.r.l.) – which constitutes the corporate form commonly chosen by Italian start-ups – may issue such securities only in favour of professional investors subject to prudential supervision (e.g. banks, investment vehicles, open-ended collective investment companies – SICAV, etc.). Moreover, only if the issuing S.r.l. is qualified as an innovative start-up may the professional investors be granted with the additional right to convert the bond securities into equity.

The above short considerations should be sufficient to argue that convertible bond securities may not be suitable instruments for financing Italian early-stage start-ups.

Are there in Italy other tools which could somehow overlap US convertible notes?

In Italy, the expression “convertible notes” is sometimes – but incorrectly – use to refer to  convertible loans (finanziamenti convertibili) or convertible equity financial instruments (strumenti finanziari partecipativi convertibili).

Let’s briefly explain how convertible loans and convertible equity financial instruments work, when it would be advisable to use them and why they are different from the US convertible notes and from the Italian convertible bond securities.

Convertible loans or convertible equity financial instruments could facilitate the investment when founders and investors fail to agree on the start-up’s evaluation (also known as the “pre-money valuation”), by postponing the evaluation until the time of the repayment or conversion into equity of the financing.

Furthermore, both convertible loans and convertible equity financial instruments may help raising funds in case the investors are not interested in achieving control over the company or, on the other hand, the founders prefer to not involve investors in managing the company or somehow taking operational resolutions.

Let’s see the main characteristics of such instruments under Italian law.

a.                Convertible loans

Convertible loans are private financing agreements – not bond securities – entered into between investors and the start-up, whereby investors undertake to finance the start-up and, on the other hand, the start-up undertake to repay the financing (even partially) with accrued interest and/or to convert it (in whole or in part) into equity, after a certain period of time or when some circumstances are met. Unlike the bond securities, such agreements do not require specific formalities to be executed and are not subject to a special regulation. Such financing agreements usually include provisions on the conversion proceeding, setting the relevant terms, conditions and modalities: for instance, parties may agree that accrued interests shall be also converted into equity, or that the conversion will take place when new investors come in and by applying to first investors a discount to the pre-money valuation defined with new investors.

In this way, the risk to invest when it is not yet easy to determine the value of the company might be offset by some incentives (e.g. discount rate, interest rate, etc.) granted to the first investors at the time of the conversion into equity of their investment.

Convertible loans may have an impact on the financial statements of the company, since they shall be accounted as debt. Therefore, their use should be carefully considered by taking into account the economic and financial situation of the company at issue.

b.               Convertible equity financial instruments

Convertible equity financial instruments are not bond securities but equity like instruments, accounted as equity, because they grant to their owners the right to a portion of the company’s profits and not the right to the repayment of the financing. Convertible equity financial instruments may also be converted into equity within a certain period of time and/or under certain circumstances.

Only joint-stock companies and S.r.l. qualified as innovative start-ups may issue convertible equity financial instruments, and their by-laws must expressly allow such issuance. If the company decides to use those instruments, the equity-holders’ meeting shall adopt a regulation governing the issuance and the conversion of the instruments and defining their main features (e.g. number, value, price, etc.), in accordance with the terms previously agreed between the parties: such regulation will become part of the company’s by-laws.

Convertible equity financial instruments are still poorly used in practice, probably because of the related  formalities and costs.

Common characteristics

Italian law provides some tax benefits for investors in innovative start-ups. However, the investors who execute any of the above financing instruments (convertible loans or convertible equity financial instruments) might enjoy such benefits only in case of conversion of the same into equity. With respect to any of the above financing instruments, in case of conversion, an equity-holders’ meeting of the company shall be held and resolve upon a capital increase that will be used for the conversion into equity of the financing instruments.

[1] Refer section 2420-bis of the Italian civil code

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