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Introduction:
Early stage startups are prone to growth hurdles given the incurrence of heavy expenditures. The flourishing startup ecosystem in India has led to the need for innovative and flexible financing options for growth. Indian markets are in demand for types of equity financing that balances the interests of both entrepreneurs and investors. Convertible note1 is a form of debt instrument that can be converted into equity at a future agreed date thereby bridging the gap between debt and equity financing. Compared to traditional equity investments, convertible notes are less time consuming, which can be particularly important for startups that need to raise capital quickly. Consequently, convertible notes have become a viable financing mechanism among Indian startups or early-stage companies that are not yet mature enough to attract traditional equity investments.
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What are Convertible Notes?
Convertible notes have emerged as an alluring instrument for entrepreneurs as equity in the startup is not given up at an early stage. Whereas, investors favour convertible notes as they are considered as debt until converted to equity upon the achievement of specific milestones or after maturity of a specified period. Further, issuance of convertible notes does not require producing a valuation report thereby making it a simple and quick route for startups to raise funds at various stages or as a bridge round until the next series round.
The Reserve Bank of India ("RBI") amended certain regulations, to include the concept of convertible notes under Foreign Exchange Management Act, 1999 ("FEMA")2. Further, the Companies (Acceptance of Deposits Rules), 2014 ("Rules") defines "convertible note" as an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the start-up company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument (typically an agreement).
In June 2016, the term 'Convertible Note' was introduced by the Ministry of Corporate Affairs ("MCA)" in the Indian legal regime through an amendment to the Rules.3 The Rules define deposit to include any receipt of money by way of deposit or loan or in any other form, by a company.
Deposits are highly regulated by the Companies Act, 2013 and the Rules, for example, private companies can only accept deposits from its members up to 100% (hundred per cent) of paid up capital, securities premium account & free reserves and upon receipt of funds shall file details of such monies accepted with the MCA in e-form DPT-3.4
However, the amendment set out an exception for an amount of INR 25,00,000 (Indian Rupees Twenty Five Lakh) or more received by a start-up company from a person, by way of a convertible note, which is convertible into equity shares or repayable within a period not exceeding 10 (ten) years5 (earlier 5 years) from the date of issue in a single tranche would be considered an 'exempted deposit'.
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Eligibility conditions:
Convertible notes can be issued only by such entities which are registered as 'start-ups' with the Department for Promotion of Industry and Internal Trade ("DPIIT"). Set out below are certain criteria6 to be met by a private limited company7, a registered partnership firm,8 or a limited liability partnership9 to fall under the ambit of a startup. An entity shall be considered a startup:
- Up to the period of 10 (ten) years from the date of incorporation of the entity; or
- If its turnover for any financial year has not exceeded INR 100,00,00,000 (Indian Rupees One Hundred Crore); or
- If the entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
An entity formed by splitting up or reconstruction of an existing business is not considered a 'Startup'.
Registered startups in India can issue convertible notes to investors who are foreign nationals, non-resident Indians, resident Indians and Indian companies. Convertible notes cannot be issued to non-resident individuals who are citizens of Pakistan or Bangladesh.10
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Regulatory Compliance and Procedure:
Set out below are steps to be undertaken to issue a convertible note:
- Board or the Partners of a startup to approve the issuance of a convertible note;
- An approval to be obtained from the shareholders in an extraordinary general meeting and subsequently file e-form MGT-14 with the MCA within 30 (thirty) days of approval;
- Preparation and execution of issuance of /purchase of a convertible note agreement which clearly sets out the understanding agreed between the parties. Prominent clauses in the agreement typically cover (i) issuance and subscription of note; (ii) closing deliverables; (iii) rights of the parties; (iv) terms of conversion such as conversion price, conversion events and interest rates; and (v) transfer restrictions;
- If the funds for the purchase of a convertible note are remitted by individuals residing outside India, it is to be determined if such remittance falls under the ambit of automatic route or approval route and form CN is to be filed with the RBI;11 and
- Indian startups in receipt of foreign direct investment are mandated to submit an annual return in form FLA with the RBI.12
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Valuation and Conversion:
A valuation report is not required at the time of issuing a convertible note. It is to be noted that as per the foreign direct investment regulations of India, a valuation report is mandatory at the time of issue of shares on conversion.
After subscribing to a convertible note, its holder has the option to either convert or redeem the note upon completion of 10 (ten) years or upon occurrence of certain events contemplated in the convertible note agreement. Upon opting for conversion, the holder shall receive equity shares at a pre-determined valuation and the startup entity will have to undertake necessary steps for issuance of shares as prescribed in the applicable laws. Additionally, since convertible note is a debt, (until converted) which typically carries a higher rate of interest, the holder has the benefit of not exercising conversion and opting for redemption. A conversion ratio of a convertible note is to be determined either:
- Based on a predetermined valuation determined at the time of issuance; or
- In accordance with the valuation on the date of conversion.
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Case studies:
Real world examples of startups issuing convertible notes offer valuable insights into the fundraising journeys of successful businesses. Notably, Dunzo and PharmEasy issued convertible notes to secure additional funding exemplifying the growing popularity of this funding route. Further, in 2022, B2B e-commerce startup – Udaan raised nearly $400,00,000 (United States Dollars Four Hundred Million) through a combination of convertible notes and debt.13
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Conclusion:
Convertible notes are an effective financing tool for the growing startup ecosystem of India. By understanding the viable terms of issuing convertible notes in accordance with the prevailing legal landscape, entrepreneurs can utilize convertible notes to attract critical investments and bolster the growth of their startup.
Footnotes
1. Rule 2, Companies (Acceptance of Deposit Rules), 2014.
2. The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019..
3. Ministry of Corporate Affairs, notification dated 29th June, 2016.
4. Rule 3, Companies (Acceptance of Deposit Rules), 2014.
5. Ministry of Corporate Affairs, notification dated September 07, 2020.
6. Notification number 13[G.S.R. 127 (E), dated the 19th of February, 2019 issued by the Department for Promotion of Industry and Internal Trade
7. defined in section 2(68) of the Companies Act, 2013
8. Registered under section 59 of the Partnership Act, 1932
9. defined under section 2(1)(n) the Limited Liability Partnership Act, 2008
10. Point 8 of the RBI notification dated November 07, 2017.
11. Sectoral caps given in Notification No. FEMA 20 /2000-RB dated 3rd May 2000 issued by the RBI.
12. Annual Return on Foreign Liabilities and Assets (FLA) under FEMA 1999.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
