Corporate Law and Venture Capital in Italy: What Does the Empirical Evidence (Really) Tell Us?
Is Italian corporate law flexible enough to accommodate venture capital contracting? Initially, Italian scholars who addressed this question, including the two of us, converged on the view that it is not. However, some of them have now gathered empirical evidence that, they claim, supports the conclusion that Italian corporate law is more adequate than previously thought. This post pushes back against this conclusion.
- Corporate Law and Venture Capital (‘VC’)
A vibrant VC market relies on the adoption of complex private ordering solutions at the portfolio company level (Gilson, 2003), which, in turn, requires a flexible corporate law (Nigro & Enriques, 2021). In the United States, venture capitalists and entrepreneurs have capitalized on Delaware’s highly malleable corporate law (Brougmann, Fried, & Ibrahim, 2014) to develop a contractual framework that, while not necessarily socially optimal, is presumed to be efficient and thus bound to be exported globally (Kaplan, Stromberg, & Martel, 2007).
Elsewhere, however, rigid corporate laws can hinder the use of this contractual framework and, unless they allow functionally equivalent alternative arrangements, impede, at the margin, contract formation and VC investments, with negative consequences for social welfare (Nigro, 2019; Nigro & Enriques, 2021).
- How Does Italian Corporate Law Fare?
In parallel with similar initiatives in other jurisdictions (Neville & Sorensen, 2014), between 2012 and 2017 Italian lawmakers have modernized various aspects of the corporate law regime for private companies, inter alia, to make it more respondent to the needs of VC market players (Giudici & Agstner, 2019). These interventions addressed a few key areas but left unchanged both corporate law provisions with a broader scope and, more importantly, the ‘metarules’ that scholars and courts apply to interpret existing legal texts, as we elaborate in companion work with Tobias Tröger (currently in preparation).
Following those corporate law reforms, scholars have examined whether Italian corporate law displays the flexibility required to accommodate the VC contracting techniques developed in the U.S. Initially, there was agreement on the view that Italian corporate law imposed various regulatory constraints that hindered the adoption of the contractual solutions commonly found in US VC deals (Nigro, 2019; Giudici & Agstner, 2019; Nigro & Enriques, 2021; Nigro & Maltese, 2022).
Based on a map of the regulatory constraints stemming from both explicit and implicit mandatory corporate law, one of these studies (Nigro & Enriques, 2021) concluded that, under Italian corporate law: (1) conversion rights are unavailable; (2) as a consequence, anti-dilution provisions do not adjust the conversion price but require the issuance of additional shares and are at risk of being declared void even in this peculiar design; (3) liquidation preferences, which must be participating due to the unavailability of conversion rights, are also at risk of being declared void; (4) the legality of drag-along provisions depends on providing a minimum price based on the legally determined fair value of the shares in the event of a shareholder divestment (a ‘floor,’ in the local legal jargon).
Paolo Giudici and Peter Agstner, together with Antonio Capizzi, have now radically re-evaluated their initial conclusions in a new empirical study – summarized here. Their study analyses the charters of 183 firms incorporated between 2015 and 2021 and having an outsider financier, chiefly a VC. It aims to identify the presence of contractual solutions commonly found in US VC deals, such as convertible preferred shares, anti-dilution provisions, liquidation preferences, and drag-along provisions. It reveals that: (1) conversion rights are close to non-existent; (2) anti-dilution provisions are frequent, but mandatory corporate law may undermine their effectiveness or even lead to their invalidation; (3) liquidation preferences are mostly participating; some charters contain provisions resembling non-participating liquidation preferences but these are of dubious validity because courts may consider them as attempts to circumvent mandatory corporate law provisions and thus declare them void, as the study acknowledges; and (4) drag-along provisions consistently include a floor, which contracting parties seek to bypass through arrangements whose validity, again as acknowledged by the study, is highly doubtful. Based on this evidence, the study concludes that local transactional practice appears to be more advanced than initially believed, inferring that Italian corporate law is more accommodating to US-style VC contracting than previously thought. The study’s bottom line is that there is thus no justification for ‘the grim view expressed by some scholars.’
- Do Empirics Really Support This Conclusion?
Giudici, Agstner and Capizzi interpret their evidence as follows: the US contractual framework is key to fostering VC investments; contracting parties in Italy attempt to emulate it but encounter corporate law constraints in doing so; they thus experiment with alternative arrangements, which, however, admittedly prove less effective or possibly even unenforceable; nonetheless, all in all, corporate law works.
This conclusion appears to be logically inconsistent with its premises and is likely the result of loose usage of the idea of functional equivalence: implicit in the authors’ reasoning is that two alternative contractual arrangements are functionally equivalent so long as they aim for the same objective. Yet, functional equivalence requires more than that.
Two technologies are functionally equivalent if they deliver the same productive outcome, which is not the case if the production costs associated with them differ. Similarly, two alternative contractual arrangements are functionally equivalent if and only if they deliver the same response to a given governance challenge. This is not the case, however, if two alternative contractual arrangements entail different costs, including, for instance, when (a) one is self-enforcing and the other requires a number of procedural steps if not a court’s decision; (b) one coordinates smoothly with other components of the relevant contractual and legal framework while the other is inconsistent with other elements thereof; and (3) one is plainly in line with corporate law’s mandatory rules while the other is at risk of being declared null and void (cf. Davis, 2013). Variations in the costs associated with two alternative contractual arrangements imply divergence in their outcomes, ruling out the claim that they are functionally equivalent.
Now, let us build on these concepts to consider whether, for example, the anti-dilution provisions employed in Italian VC deals are genuinely functionally equivalent to those in the US. In Italy, the most frequently used anti-dilution clause stipulates that, following a down round (that is, a new issue of shares at a price lower than their valuation in the preceding round), all shareholders must unanimously approve an additional capital increase, allowing the venture capitalist to purchase additional shares at a minimal price to offset any dilution they may have incurred. These arrangements undeniably entail greater costs than the corresponding terms in the US. Firstly, they require VCs to follow a more cumbersome process. Secondly, they introduce the risk that the additional share issuance never materializes or is delayed, because these arrangements lack the essential feature of self-enforceability. Thirdly, their validity is uncertain. Claiming that these contractual provisions are functionally equivalent to those found in US VC deals is therefore simply wrong.
A similar analysis could extend to the alternative arrangements that aim to replicate US-style convertible preferred shares and drag-along rights as well as to nearly all the other private ordering solution included in US VC deals, as we document in companion work with Tobias Tröger.
In light of these qualifications, what do the empirical findings of Giudici, Agstner, and Capizzi really tell us? First, they corroborate our (and their prior) finding that bargaining in the shadow of the explicit and implicit mandatory provisions of Italian corporate law leads to the adoption of a contractual technology that is overall costlier and less effective than the US model; in other words, that Italian corporate law is unable to accommodate (US-style) VC contracting. Second, they indicate that, very much like in other jurisdictions (Lin, 2021; Pereira, 2023), highly specialized lawyers are responding to local corporate law’s rigidity by engaging in contractual experimentation and devising alternative arrangements whose legality, however, is highly uncertain.
We have argued that the reality of Italian VC arrangements and the legal obstacles to their transplant from US contractual practice do not really support the conclusion advanced by Giudici, Agstner, and Capizzi.
In fact, with their contribution, Giudici, Capizzi and Agstner now provide empirical evidence that Italian corporate law constraints do significantly impact local transactional practice, which in turn is consistent with ‘the grim view expressed by some scholars’ regarding the detrimental influence of Italian corporate law on VC contracting, if not on VC investments. What is undeniably true is that smart lawyers are engaging in contractual experimentation to (attempt to) circumvent the constraints imposed by Italian corporate law.
Luca Enriques is a Professor of Corporate Law at the University of Oxford.
Casimiro A Nigro is an Assistant Professor at the Foundations of Law and Finance Research Center, Goethe Universität, Frankfurt am Main.
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