Convertible Notes are hybrid financing instruments originally issued as a debt instrument issued by a start-up[1] company with an option for the subscriber to convert into equity shares of the issuer company upon a predetermined trigger point or conversion event. In simple terms, a Convertible Note is a loan from investors that allows a start-up company to raise funds without immediately determining their company’s valuation.
In the contemporary world, it is often difficult to arrive at a consummate valuation of start-up companies or valuation becomes a resource-intensive exercise, especially at the initial stages. Accordingly, a Convertible Note is seen as a viable alternative to traditional equity or preferential shares, especially during the early stages of the corporate cycle i.e. pre-seed and seed stages.
Advantages of Convertible Note
No Valuation Requirement: Unlike traditional equity investments, Convertible Notes don’t necessitate a valuation report under Indian corporate laws at the time of issuance. The conversion can be based on a predetermined valuation, or the valuation of equity shares of the company at the time of conversion.
Discount Rate: Investors appreciate Convertible Notes as they receive certain benefits at a later fund-raising stage in return for betting on the company at an early juncture. They can purchase shares at a discount to the market valuation when the Convertible Note matures.
Interest on Capital: As the Convertible Notes are initially issued as a debt instrument, there is also an interest payable on the capital amount to the note holder. At the end of the tenure or in case of conversion of the Convertible Notes, the note holder has the option to either get repaid or subscribe to the equity shares for a value worth the principal amount plus the interest component.
Valuation Cap: Another incentive that the holders of Convertible Notes receive in return for backing the company during an early stage is the valuation cap. The upper limit of the price at which the investment will be converted to equity is fixed, regardless of the valuation at the financing round. Investors seek a lower cap as it allows them to purchase a greater stake in the startup.
Valuation Floor: Valuation floor is the lowest valuation at which the Convertible Note will convert into equity shares. This protects the founders from excessive dilution if the company’s valuation is lower than expected in the next round. Without a valuation floor, if a startup performs poorly and raises its next round at a much lower valuation than anticipated, the Convertible Note would convert into a large percentage of the company’s equity. This significantly dilutes the founders’ ownership.
Legal Considerations in India
A Convertible Note is defined under the Companies (Acceptance of Deposits) Rules, 2014 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[2].
Further, the following conditions have to be met while issuing a Convertible Note:
- Eligibility: The issuing company must be registered as a start-up with DPIIT;
- Tenure: The Convertible Note has to be repaid/converted within a maximum period of 10 (ten) years from the date of issuance;
- Minimum Investment: INR 25 (twenty-five) lakhs per tranche from each investor. This amount should be either converted to equity shares or repaid within the abovementioned tenure; and
- Issuance Procedure: The procedure for private placements is to be followed as provided under Section 42, read with Section 62 of the Companies Act, 2013, along with the relevant rules.
Conversion / Repayment of Convertible Note
A valuation report is not required at the time of issuance of Convertible Notes. However, the price of the resultant shares pursuant to conversion of such Convertible Note is to be determined either upfront at the time when the Convertible Note is being offered or such pricing can be determined as per the valuation at the time of conversion. This decision is required to be made at the time of the offering of Convertible Notes[3].
Moreover, as the Convertible Note is a hybrid instrument, the note holder has the option to not convert the Convertible Note into equity shares. In such cases, the note holder shall be repaid the principal amount (i.e. the issuance consideration) along with the agreed interest on the same.
It is important for the issuer company to keep in mind that the convertible note must be either converted or repaid within a period of 10 (ten) years from the date of issuance.
Requirements vis-à-vis Foreign Investments
Indian foreign exchange laws permit foreign investors to invest into Convertible Notes subject to compliance with certain conditions.[4] For instance, an individual who is citizen of Pakistan or Bangladesh or an entity which is registered or incorporated in Pakistan or Bangladesh is prohibited from investing in Convertible Notes.[5] Further, in case of a startup company that is engaged in a sector where investment by a foreign investor requires Government approval, it may issue convertible notes to such foreign investors only with Government approval.[6] Additionally, in cases where Government approval was required for issuance of Convertible Notes, upon conversion of Convertible Notes into equity shares, it is required that such issue of equity shares against the Convertible Notes is made in compliance with the entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment.[7] Similar conditions are also required to be met in case of transfer of Convertible Notes by or to a non-resident investor.
Non-Resident Indians (NRI) and Overseas Citizens of India (OCI) are also permitted to acquire Convertible Notes on non-repatriation basis and in such cases, the investments are considered to be domestic investments.[8]
As part of foreign exchange law compliance, a start-up company issuing Convertible Notes to a foreign investor is required to file ‘Form CN’ within 30 (thirty) days of issue.[9] Similarly, upon the conversion of Convertible Notes, the start-up company issue shares to a foreign investor, the start-up company will be required to file ‘Form FC – GPR’ with the Reserve Bank of India.[10]
References:
- Start-up companies shall mean the start-ups as defined in notification number G.S.R. 127(E), dated 19th February, 2019 issued by the Department for Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce and Industry Government of India, Government of India.
- Explanation II to Rule 2 (1) (c) (xvii), Companies (Acceptance of Deposits) Rules, 2014.
- Rule 13 (2) (h), Companies (Share Capital and Debenture) Rules, 2014
- Rule 18, Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 (“NDI Rules”).
- Rule 18 (1), NDI Rules.
- Rule 18 (2), NDI Rules.
- Rule 18 (2), NDI Rules.
- Rule 18 (4), NDI Rules.
- Rule 4, Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.
- Rule 4, Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.
For any queries or discussions, you can reach out to our contributors:
Akash Kumar ([email protected])
Asutosh Mahapatra ([email protected])
We want to acknowledge the efforts of Mr. Shubham Sharma (IV Year, B.B.A. LL.B., Chanakya National Law University, Patna) in assisting us with this blog piece.
Disclaimer: This work is intended for general information only and does not constitute legal or other advice and the reader acknowledges that there is no relationship (implied, legal or fiduciary) between the reader and the author/A Square Legal. It is recommended that professional advice be taken based on the specific facts and circumstances. A Square Legal neither assumes nor accepts any responsibility for any loss arising to any person acting or refraining from acting as a result of any material contained in this work.
