Issue of Convertible Notes by Start-Ups

Varun Hariharan

06 Sep, 2022

Start-ups are dominating the Indian Market. Every start-up requires capital for carrying out daily activities. Even a start-up would require some form of seed capital or angel investment financing from foreign firms in the world. Foreign Venture capitalists and private equity firms have kept an eye on the start-up environment offered in India. This article is going to speak about the issue of convertible notes by a start-up for raising some form of additional funds.

What is a Start-Up?

In layman’s terms, a start-up is understood as a budding business or technology which does not have multiple revenues and capital investment. Therefore a start-up can be understood as a business in the inception phase. In India, there are different definitions of the meaning of a start-up company.

The DPIIT (formerly known as the DIPP) has provided the meaning of the term start-up, if the operations of the start-up or company haven’t crossed more than ten years, then the company is known as a start-up.

Apart from this, there are also other criteria which define the meaning of a start-up. If the turnover of the business is less than 100 crores, then the business would be depicted as a start-up company.  The products and services offered by the start-up are also considered in the definition provided by the DPIIT. The primary services or products produced must be in the areas of innovation, technology and commercialisation.

Before this definition, the DIPP considered a start-up as a business which is lesser than seven years old, and at the time of formation, the turnover is about 25 crores.

The above definition is from the government perspective. Under the Companies Act, 2013^[1] or the Companies Act, 1956: any company which is formed and satisfies the minimum criteria for a start-up is considered as a start-up company.

What is a Convertible Note? (Issue of Convertible Notes)

A convertible note is a form of instrument which is issued by an entity. It is related to a debt instrument or a debenture. The convertible note provides the individual holder to convert the convertible note into specific equity shares.

The Reserve Bank of India (RBI) has explained the meaning of a convertible note as some form of instrument acknowledging a debt. However, convertible notes must be differentiated from debentures. Usually, debentures can be issued by an entity such as a company. However, the issue of convertible notes can only be carried out by a start-up company.

Convertible notes once issued will be present for a particular period in the hands of the holder of the instrument. On fulfilling a condition, the note can be converted into equity shares or preference shares. The holder of the instrument has the option to convert this note into equity shares or preference shares after a particular period.

If this is not possible, then the issue of convertible notes can be converted after five years or maturity whichever is earlier. Hence the issue of convertible notes by start-up companies are governed by the rules which are determined by the RBI and the Foreign Exchange Management Act, 1999 rules.

When did the Government of India bring out the legislation for the issue of convertible notes?

Issue of convertible notes is regulated around the world. A start-up utilizes these instruments in western and highly advanced cities such as London, Tokyo and Singapore. Hence, the government of India brought out a regulation through which the issue of convertible notes is regulated in India.

Under the leadership of Narendra Modi, the initiative for Start-Up India and other such initiatives such as technology India have been launched. Apart from the above, the government has launched the scheme for ease of doing business in India. Through this scheme, different incentives are offered to foreign investors and companies that want to generate business in India.

Through such initiatives, the routes for foreign investment in India were also liberalised. Foreign investment in India is governed by the automatic route and the government route. Through this scheme, many investments were allowed to go through the automatic route. FDI proposals were liberalised at a national level allowing start-ups to also receive investment through the issue of convertible notes.

The RBI brought out the foreign exchange management act, 1999 with a view of increasing the amount of foreign investment in the country. Apart from this act, some different rules and regulations affected the amount of foreign investment in the country. Some of the notifications brought out by the government were the introduction of the deposit rules under the foreign exchange management act. Apart from this, the government brought out the Foreign Exchange Management (Transfer or Issue of Security by a Person outside India) Regulations, 2017.

Under these regulations, the government allowed the issue of convertible notes by a start-up company to foreign investors. Previously only the issue of equity and preference shares were allowed for foreign investors. In light of the above amendment, a start-up company can benefit from the advantages of raising foreign investment through the issue of convertible notes.

How is the convertible note different from another capital instrument?

Firstly a convertible note has been utilised by start-ups and other companies around the world. The government, with the view of liberalising foreign investment in start-ups, considered that issue of convertible notes by a start-up.

When convertible notes are issued, they would have the features of a debt instrument, that the company will pay the remaining amount to the holder of the instrument.

Equity Shares are normal shares which are issued by an entity or company. These shares can be issued to both domestic investors as well as foreign investors. There are no issues when it comes to the issue of equity shares.

Preference shares have a meaning under the companies act, 2013 and previous company law. When a company issues preference shares to shareholders, they have some form of preference for shareholders. Hence, if a preference share is issued to a shareholder, then those shareholders would receive preference when it comes to matters such as payment of dividends. Also, when a company is winding up, there is preference given to the shareholders who are holding preference shares.

Under the foreign exchange regulations, companies and entities are allowed and entitled to issue CCPS (Compulsory Convertible) and non-convertible preference shares. When it comes to the issue of convertible notes, then they would be treated as debt instruments when issued by a start-up to an angel investor.

Valuation- Apart from these differences, there are also stark differences between the valuation of preference shares/ equity shares and valuation of the issue of convertible notes by a start-up. As per the current valuation theories which are considered, usually, valuation is carried out by a Securities Exchange Board of India (SEBI) certified banker or any other individual who is certified to consider valuation techniques. Apart from this, when instruments are valued, they are considered under international practices which are adopted across the globe.

When it comes to the valuation of the issue of convertible notes, then the international methods of valuation is not considered by the start-up for the issue of convertible notes. However, the convertible notes which are issued to a Non-resident to a resident or transferred from a non-resident Indian to a resident Indian have to be valued according to the international standards of valuation.

The pricing guidelines for valuation must be followed for such instruments which are valued at market price or at a fair price which is considered by the parties.

Did Government Allow the Issue of Convertible Notes previously?

As per the guidelines, capital instruments such as equity shares and convertible preference shares were only allowed before the government brought out the 2017 regulation for the issue of convertible notes. Before the amendment, the issue of convertible notes for raising any form of foreign direct investment.

While the government gave the nod for companies and other entities to primary issue equity shares, preferences shares, compulsory convertible shares and other forms of shares, there were restrictions when it came to the issue of convertible notes by start-ups. All the instruments which created some form of debt or acknowledgement as a debt would be required to comply with the regulations of FEMA and the External Commercial Borrowings.

Due to this, new start-ups that wanted to raise capital through seed funding and angel investment found it hard to consider these form of investments.  Apart from this, the issue of convertible notes was not considered by the government as they would be treated as some form of Debt under the Companies Act, 2013 and respective companies’ rules.

The above reasons caused issues when it came to raising funds for start-ups. However, the government brought out the permanent solution in 2017 by bringing out the amendment on the transfer of instrument from an Indian entity to an NRI outside India. This amendment was a landmark for all start-ups within India. Apart from start-ups in India, even foreign investors benefitted from this amendment.

Situation Before 2017

Before the government came up with the amendment related to the issue of convertible notes, start-ups and entities similar to start-ups had to depend on other sources of financing. If start-ups secure some form of debt, then compliance has to be maintained as per the requirements under the ECB regulations and FEMA. Many start-ups which were heavily dependent on the foreign investment considered this amendment crucial for the future of start-up India.

What are the conditions for the issue of convertible notes?

When a start-up company wants to raise some form of finance, they must issue convertible notes to foreign investors and other agencies which are interested in the start-up. However, there are specific conditions which have to be adhered by the start-up while issuing such instruments to foreign investors.

The following are the conditions:

• Convertible notes which are issued by Start-Ups have to be compliant with the guidelines issued by the RBI. This would also relate to compliance with the Foreign Exchange Management (Transfer or Issue of Security to a Person or Individual outside India).
• The issue of convertible notes by start-ups do not need to adhere to the pricing guidelines which are used by companies when transferring equity shares and preference shares. However, when the convertible note is transferred from a non-resident Indian to a resident Indian, then the pricing guidelines have to be followed for such transfer.
• There is a minimum investment that is required for the issue of convertible notes.  This would range starting from the minimum at 25 lakh rupees. When providing a note to a foreign investor, they have to abide by the different guidelines which are brought out.
• There is a minimum maturity period for the issue of the convertible note. This convertible note has to be either converted to an equity instrument within five years.
• When issuing the convertible note, the terms and conditions for the issue of convertible note have to be decided prior to such an issue. This is also known as a call option for the convertible note.
• When an NRI is purchasing a convertible note, then the consideration or the purchase price can be debited from the NRE or the FCNR account. If the escrow account is used for the purchase of convertible note, then the same must be closed immediately or within six months. In the above, whichever period is earlier must be used.
• Valuation guidelines have to be considered when the convertible note is transferred from a Non-resident Indian to a resident Indian. Internationally accepted methods must be adopted, and the price must be calculated at an arm’s length basis.
• There are two routes for foreign investment in India: the automatic route and approval route. If in case, the investment in the start-up is in an area which requires some form of regulatory approval from the government, then the same has to be taken.
  

Conclusion

Read our article:What is meant by FDI Approval Route in India?