During the initial phase of operation, start-ups are prone to high risk of failure and therefore it is of utmost important for these start-ups to heavily focus towards unique innovation, regular development and efficient improvement of their business model. It is customary for most start-ups to face the challenge of incurring heavy expenditures with limited revenue on hand. Due to this, most of these start-ups are compelled to seek capital funding from a variety of sources including (without limitation) from family and friends (popularly known as ‘bootstrapping’), venture capitalists, crowdfunding, etc. One of the common ways for raising the funds by the start-ups are by way of issuance of convertible notes.
Convertible notes have sufficiently emerged as one of the attractive forms of raising capital by start-ups in today’s current market. In simpler terms, a convertible note is a popular financing tool used by start-ups and early-stage companies to raise capital without giving up equity immediately. These debt instruments allow investors to lend money to the company with the option to convert their debt into equity at a later date. Convertible Notes are attractive option for investors as it allows them to participate in the potential future success of the company. Further, Convertible Notes are also an attractive option for companies as it allows such company to raise capital, instead of issuing any equity or debt securities and/or without diluting ownership or taking on long-term debt obligations.
Convertible Notes are beneficial for those start-ups which lacks having a clear valuation at its initial stage or where the promoters lack interest towards issuing equity shares at an early stage. It is also pertinent to note that convertible notes can be structured with any discount on the conversion price, thus, allowing investors to acquire shares in the company at a lower price than they would otherwise be able to.
In this article, we have attempted to briefly analyze the procedure and provisions to be compiled by a private company which is a recognized start-up issuing convertible notes. However, prior to delving into the concept and process of issuing ‘convertible notes’, it is important to understand the legal scope and meaning of a ‘start-up’.
Definition of Start-up:
Start-up means an entity incorporated either as a private limited company or as registered partnership firm or a limited liability partnership in India along with following factors in consideration:
- Period of existence and operations shall not be exceeding 10 years from the date of incorporation/registration;
- the annual turnover of such entity for any of the preceding financial years since incorporation or registration shall not exceed INR 100 Crore;
- The business model of such entity has to work towards a development or improvement of a product, process or service and/or have scalable business model with high potential for creation of wealth & employment; and
- Such entity should not have been formed by splitting up or reconstructing an already existing business.
Convertible Notes by a private company as per Companies Act, 2013:
Under this Companies Act 2013 (“Act”), “convertible note” is defined 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.
Valuation requirement for Convertible Securities
As per Sub-clause (h) of Clause (xii) of Rule 13 of the Companies (Share Capital and Debenture) Rules, 2014, where convertible securities are offered on a preferential basis with an option to apply for and get equity shares of the issuing Company, the price of the resultant shares pursuant to such conversion shall be determined either upfront at the time when the convertible securities is being offered or at the time, when the holder of convertible securities becomes entitled to apply for shares.
Provided that the company shall take such decision at the time of offer of convertible security itself and make such disclosures in the convertible note agreement.
Exemption under deposit rules
Pursuant to Clause (xvii) of Rule 2 of Companies (Acceptance of Deposits) Rules, 2014, an amount of INR 25 lakhs or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding ten years from the date of issue) in a single tranche, from a person, will not be considered as a deposit.
Process of issuance of convertible notes as per Companies Act, 2013:
The Act does not explicitly provide for issuance of convertible notes. However, Section 62(3) of the Act enables a company to raise loan with an option to convert it into equity. The issuance of convertible notes shall be conducted in accordance to the following process:
- Finalization of terms and conditions of convertible notes by the start-up.
- Execution of convertible note agreement by the start-up entity and the proposed investors.
- Convening of board meeting for approval of issuance of convertible notes and towards fixation of date, time and venue for conduct of the extra-ordinary general meeting of the shareholders.
- Convening of extra-ordinary general meeting of the shareholders for approval of issuance of convertible notes and draft letter of offer.
- Filing of eForm MGT-14 with the Registrar of Companies (ROC) within 30 days from the date of passing the special resolution.
- Issuance of offer letter to the proposed investors for subscription of convertible notes.
- Receipt of the amount by the investors towards subscription of convertible notes.
- Convening of the board meeting for allotment of convertible notes to the investors and issuance of letter of allotment of convertible notes.
The holder of convertible notes shall be informed about the conversion price and terms of conversion at the time of subscription to the convertible notes. Once the holder subscribes to a convertible note, he/she can choose either for conversion or redemption after the completion of the tenure of such note.
Wherein if he/she chooses to opt for conversion, he/she can get the equity shares of the start-up at a pre-defined valuation. However, in case, if he/she does not want to exercise the conversion option, then he/she shall opt for redemption of the same.
The rate of interest on convertible notes are usually higher than the regular securities. So, it would be fair to state that, in either situation, the holder shall enjoy a beneficial position pertaining to its investment in the start-up.
Issuance of Convertible Notes to person resident outside India under automatic route:
The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 defines ‘convertible note’ as an instrument issued by a startup company acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding 5 years from the date of issue of the convertible note, upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.
Individuals’ resident outside India (excluding the citizens of Pakistan and Bangladesh or entities registered or incorporated in Pakistan or Bangladesh) may purchase convertible notes issued by an Indian startup company for an amount of Rs. 25,00,000/- or more in a single tranche.
Additional Filing Requirement as per Foreign Exchange Management (Non-debt Instruments) Rules, 2019:
In addition to the process and procedure mentioned under the Act and rules made there under, the start-ups are mandated to comply with the following procedure as per FEMA Regulations.
File “form CN” with Reserve Bank of India (RBI) within 30 days from the date of receipt of the consideration from the proposed investor with the following documents/information.
- Date of issue of convertible notes;
- Total amount of inflow;
- Number of foreign investors;
- Details of foreign investor (Name of the foreign investor, address, country, constitution, remittance bank details, mode of payment);
- The following attachments are the mandatory to complete the filing.
- FIRC and KYC copy;
- Debit authority letter;
- A certificate from the practising Company Secretary as per the FEMA (Non-Debt Instruments) Rules, 2017;
- Convertible Note agreement;
- Board resolution for allotment;
- Certificate of Incorporation;
- Start-up Registration Certificate.
Issuance of Convertible Notes to person resident outside India under approval route:
When a start-up company is engaged in a sector, which requires prior approval from the central government for obtaining foreign direct investment (FDI) from person resident outside India, such start-up may issue convertible notes to a non-resident investor only with prior approval of the government.
A person resident outside India may acquire or transfer, by way of sale, convertible notes, from or to, a person resident in or outside India, provided that the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the government shall be obtained for such transfer in case the startup company is engaged in a sector which requires government approval.
It may be noted that a start-up engaged in the following sectors and exceeds the FDI limit specified in the Schedule I of the FEMA Act, 1999, requires prior approval from the central government before its convertible notes can be converted into equity shares.
- NBFC’s activities in Financial Services Sector;
- Civil Aviation;
- Petroleum including exploration/ refinery/marketing;
- Housing & Real Estate Development sector for investment from persons other than NRIs/OCBs;
- Venture Capital Fund & Venture Capital Company;
- Investing companies in Infrastructure & Service Sector;
- Atomic Energy & related projects;
- Defence and strategic industries;
- Agriculture (including plantation);
- Print Media;
- Postal services.
The information pertaining to sectoral cap on investments by persons resident outside india is available at Reserve Bank of India – Foreign Exchange Management Act Notification (rbi.org.in).
Convertible notes are beneficial for start-ups at such an early stage and are useful tool for start-ups and early-stage companies looking to raise capital and for investors who are looking for a flexible and potentially high-return investment option. However, it is important for the investors to understand the risks and benefits associated with this type of financing before entering into a convertible note agreement.
Author: Prajakta V Gokhale, Senior Associate (assisted by Venkata Chandra Gonugunta).
Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at firstname.lastname@example.org