In our new paper, we conducted extensive empirical research on more than 5,000 corporate charters of new Italian companies. We aimed to test whether the law reforms of 2012-2017, mainly addressed at the LLC/GmbH-type, were successful in making Italian corporate law more amicable towards startups and venture capital contracting techniques. Our article is part of the literature that analyzes whether investments in startups outside the US have features that reflect the predictions of financial contracting theories and US practice, identifying and seeking to explain eventual divergences.
Methodology
We analyzed the charters of 5,095 small and medium sized LLCs (SME-s.r.l.) incorporated from 2015 to 2021 in seven Italian provinces. This is the first research in Europe that analyzes such a large number of charters and goes into an in-depth, granular review of the charters’ clauses for startups. We focused only on charters and did not consider other (private) documents of financing deals, such as shareholders’ agreements. Indeed, charters are probably more important in Italy than in other countries, such as the US. This is because they are the only documents with a so-called erga omnes effect in that the obligations stemming from those agreements are not owed by shareholders bilaterally or multilaterally but are also entered into in the corporation’s interest and are therefore opposable to third parties. This makes it much easier for shareholders to enforce duties commanded by the charters rather than suing for breach of contract under a shareholder agreement and claiming damages or fixed sums as penalties. For this reason, we expected to find as many clauses as possible in Italian charters and all the main ones we were interested in.
The 5,095 charters were first made searchable through Optical Character Recognition (OCR) software and then indexed through another software based on a list of 94 keywords. Our purpose was to identify those charters containing the typical elements that, in the light of the financial contracting theory, usually signal the existence of an outside investor such as business angels or venture capitalists. Among those provisions, we focused on three: convertibility, antidilution, and liquidation preferences.
Our Findings
We found almost 200 charters that reflect the features predicted by the financial contracting theory for startups with outside investors, although with some significant variations compared to the US experience. The most recurrent contractual provisions we document are co-sale clauses and preference rights. According to our data, outside investors in Italy want co-sale clauses and liquidation preferences more than any other contractual arrangement.
Co-sale clauses are almost a regular feature in our sample. There is a high level of standardization, and virtually all clauses reflect the problem of “fair value protection” in the case of a shareholder exit. The need for fair value protection in drag-along clauses is not expressly mandated by Italian law but is adopted by most scholars, public notaries, and courts. A certain number of charters seek to tame this mandatory constraint through tailor-made evaluation criteria, probably aimed at limiting the rigidity of a one-size-fits-all criterion based on fair value determination. These criteria try to limit the discretion of the expert witness that the court can appoint in case of controversy on the fair value of the dragged-along stock. Whether these attempts will be successful in case of litigation remains to be seen.
Preferred shares with liquidation preferences are less problematic in the Italian legal environment. Liquidation preferences attached to preferred shares are also highly standardized. They are already widely used in private equity practice and restructuring. Hence, there is no major variation from US practice in how they are drafted. We report a prevalence of participating preferred shares over non-participating shares. In addition, and more importantly, we also find liquidation preferences that work as functional equivalents of US non-participating convertible preferred. The prevalence of full-participating and the emergence of such functional equivalents explain the absence of convertible preferred shares – a striking difference from the US world, which also seems true for the Chinese market.
Antidilution clauses are a new component of Italian charters emerging from the transplant of mechanisms adopted by VCs operating in the US practice. Since convertible preferred shares are not used, antidilution mechanisms are not based on the conversion rate but on the attribution of additional shares to the protected shareholder. Given that these contractual techniques are brand new in the Italian experience and there is still uncertainty on the best-suited mechanisms for implementation, we observe significant variability in drafting the relevant clauses. This field certainly deserves further research at an Italian and European level since the topic seems to be under-researched across Europe.
“Simple Agreement for Future Equity” and “Keep it Simple Security” (SAFE and KISSes) are also transplanted in Italy through hybrids, which are structured in order to comply with local legal capital rules. However, charters are not fully informed about how market participants use such instruments. The same is true about work-for-equity incentive schemes, even though it appears that such vesting schemes are implemented in Italy and reproduce the US standard. Our results concerning hybrids and vesting schemes show a limitation of our study, which relies exclusively on charters and therefore does not offer a complete picture. Future research should expand the spectrum of investigation in order to include also side arrangements.
Summing up the results, we can say that market practices look more advanced and courageous than we originally thought possible. From this standpoint, the Italian reforms of 2012-2017 regarding the LLC look rather successful. Of course, some issues can be greatly improved. The topics investigated mainly concern non-participating liquidation preferences and the general principle of fair value determination in case of an exit. From this perspective, full liberalization of the LLC regulation would eliminate the grey areas created by a legal environment like the Italian one, where the boundaries between mandatory and default rules are sometimes unclear. This uncertainty heavily depends on Italian scholars’ propensity to extract high-order principles from statutory materials to infer mandatory rules or solve interpretative issues in favor of the mandatory alternative, usually out of concern to prevent abusive corporate behavior at the expense of the weaker contractual party. Adopting a principle in which any provision not explicitly qualified as mandatory is a default would prevent this process of mandatory rules’ creation.
Nevertheless, deals are made, and charters appear to be very advanced, and this marks a significant difference between the business world exposed to international competition and some national, idiosyncratic theoretical discussions that seem detached from business needs and economic theory. Thus, market practices push the envelope of Italian corporate law, with startup law at the forefront of this transformative process. Furthermore, we hope that through our empirical analysis, courts can learn about market practices and needs that are not adequately explored by traditional legal studies.
Paolo Giudici is a Professor of Business Law at the School of Economics and Management of the Free University of Bozen-Bolzano, Italy.
Peter Agstner is an Assistant Professor of Business Law at the School of Economics and Management of the Free University of Bozen-Bolzano, Italy.
Antonio Capizzi is an Assistant Professor of Business Law at the University of Rome Sapienza, Italy.
