Navigating Convertible Notes for Start-up Funding

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Navigating Convertible Notes for Start-up Funding

January 23, 2024

Introduction:

In the volatile landscape of start-ups, where failure is a common thread, innovative financing instruments become essential. One such tool gaining popularity is the convertible note, offering a unique approach to fundraising without immediate equity sacrifice. This article delves into the nuances of convertible notes, their benefits, legal considerations under the Companies Act, 2013, and the intricacies involved in issuance, particularly for foreign investors.

Understanding Convertible Notes:

Convertible notes provide start-ups with a flexible means of raising capital without an immediate equity commitment. Investors lend money to the company, with the option to convert their debt into equity at a later stage. This structure benefits both parties: investors can potentially share in the company’s success without an immediate equity stake, while start-ups secure capital without diluting ownership or taking on long-term debt.

Benefits of Convertible Notes:

Ideal for start-ups lacking clear initial valuations or where founders are hesitant to issue equity early on.
Structurable with conversion price discounts, allowing investors to acquire shares at a lower price.
Attractive to investors as they participate in potential future successes without an immediate equity commitment.
Legal Considerations:

Definition of Start-up:

As defined by the Companies Act, 2013, a start-up is an entity incorporated as a private limited company, registered partnership firm, or limited liability partnership. It must operate for less than 10 years, have an annual turnover not exceeding INR 100 Crore, and focus on developing or improving products, processes, or services with a scalable business model.

Convertible Notes under Companies Act, 2013:

Definition:

The Companies Act defines a “convertible note” as an instrument initially representing debt, repayable at the holder’s option or convertible into equity shares upon specified events.

Valuation Requirement:

Convertible securities’ resultant shares’ price must be determined upfront at the time of offering or when the holder becomes entitled to apply for shares. This decision must be disclosed in the convertible note agreement.

Exemption under Deposit Rules:

Amounts exceeding INR 25 lakhs received through convertible notes in a single tranche are not considered deposits as per the Companies (Acceptance of Deposits) Rules, 2014.

Conversion and Redemption:

Convertible note holders can choose to convert their debt into equity or opt for redemption after the note’s tenure. The conversion price and terms are communicated during subscription.

Conclusion:

Convertible notes emerge as a strategic fundraising tool for start-ups, offering a balance between securing capital and retaining equity flexibility. Investors and start-ups alike should approach these instruments with a clear understanding of the associated risks and benefits.

Author: Prashant Kumar Jain, Managing Partner

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 info@samistilegal.in

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