This article was first published on the European Regional Forum Newsletter
Almost 11 years ago, the first ad-hoc regulation for startups was introduced in Italy. That regulation facilitated growth of the Italian VC market by providing tax and corporate incentives for the setup and funding of startups. Indeed, in the years since, the size of the Italian VC market has grown steadily in terms of both new players (startups and investors) and the number and value of investments, and it began attracting foreign investors.
The expansion of the VC market and the engagement of foreign investors more familiar with investment instruments other than capital increases has in turn led to a need to find investment instrument alternatives to “simple” equity to help narrow financing gaps (e.g., facilitate investments in startups when it is still difficult to evaluate them), speed economic growth, and make businesses in the pre-seed and seed stages more resilient.
Italian players in the VC market looked to more experienced foreign ecosystems (e.g., those in the United States and the United Kingdom) to import best market practices and investment instruments, such as the convertible note and the Y-Combinator SAFE. The result has been increased reliance upon alternative financing instruments, such as convertible equity financial instruments, convertible loans, and subscription agreements for future equity. These appear to be the most suitable tools when there is no agreement on the startup’s valuation, or when investors do not seek control of the company, or founders are unwilling to involve investors immediately in operational decisions.
Convertible equity financial instruments (in Italy known as strumenti finanziari partecipativi convertibili) are equity-like instruments and not bond securities, because they grant holders the rights to portions of companies’ profits rather than repayment of investments. They may also be converted to equity within a certain period or under certain circumstances.
Until 2012, convertible equity financial instruments were only meant for joint-stock companies; then, the government opened up the field to allow limited liability companies qualified as innovative startups or innovative SMEs to issue them.
If a company decides to use this type of instrument to raise funds, the company bylaws must expressly allow their issuance, and the equity-holders (convened before a notary public) must adopt a regulation governing the issuance and conversion of the instruments and establishing their main features (e.g., number, value, price).
Because of the related formalities and costs, startups initially shied away from convertible equity financial instruments. However, in recent years, use of these instruments was boosted when certain VC funds started employing them as investment tools. Potential tax benefits for investors upon conversion into equity and the regulation of such instruments becoming increasingly standardized practice also helped raise their profile.
A convertible loan is a private financing agreement (not a bond security) entered into between (i) investors, who undertake to provide to the startup a loan convertible into equity; (ii) the startup, which undertakes to repay the loan with accrued interest or—alternatively—to convert it into equity after a certain period of time or when certain circumstances are met; and (iii) the equity-holders of the startup, who undertake to approve the capital increase reserved for investors for conversion of the loan.
Unlike bond securities and convertible equity financial instruments, convertible loan agreements require neither specific formalities nor the adoption of a specific regulation. The financing agreement for a convertible loan usually includes provisions on the conversion procedure, setting forth the relevant terms, conditions, and modalities. For instance, parties may agree that accrued interest shall be converted into equity, or that the conversion will take place when new investors come in and under a discount rate applied to the pre-money valuation agreed upon with new investors for first-round investors.
The use of convertible loans should be carefully assessed for two reasons: first, convertible loans are debt instruments and as such they may have impact on a startup’s financial statements; second, the possibility for entities other than banks to collect funds with an obligation to repay them is subject to specific requirements set forth by law to avoid unlawful collection of savings from the public.
A subscription agreement for future equity is another example of good practice imported into Italy to foster VC funding in seed and pre-seed stages. These agreements, such as the American SAFE (Simple Agreement for Future Equity introduced in the United States by Y-Combinator in late 2013), enable investors to pay in advance the subscription price for a future increase of startup equity (to be implemented when a liquidation event or a qualified investment round occurs), so that valuation of the company is postponed to a more mature stage.
To provide founders and investors with a ready-to-use agreement in the spirit of Y-Combinator’s post-money SAFE, our team of VC experts at Portolano Cavallo together with Linklaters Italia, Italian Tech Alliance, and Growth Capital worked for a full year to draw up a model subscription agreement for future equity. That agreement was offered to the public in March 2023.
This model subscription agreement for future equity is no mere reproduction of the SAFE developed in the United States. It was thoughtfully drafted to reflect the specifics of the Italian legal system and to be in line with the practices of the Italian VC market. However, while it shares much in common with the SAFE, it was designed to facilitate and incentivize investments in Italy from foreign as well as domestic players.
The model simplifies and facilitates the investment procedure. To conclude an investment, parties simply download the template, negotiate a few (mainly economic) terms, and then sign. We hope to see this model subscription agreement for future equity adopted by a broad swath of Italian VC players so that it becomes a commonly used tool for investment in startups in the pre-seed and seed phases of development.
We strongly believe that standardization of investment documents and adoption of alternative financial instruments are crucial to the organic growth of a sound and more attractive Italian VC market. We hope that Italian VC operators and practitioners will continue to support these trends by keeping pace with international best practices. We also hope that Italian authorities will encourage the adoption and development of alternative investment instruments by introducing additional incentives and appropriate measures to foster the use of such instruments.
