In recent times, convertible notes have become a popular instrument of fund-raising for start-up companies, particularly at the seed stage. A convertible note is essentially a short-term debt that converts into equity, typically linked to a future financing round. While convertible notes are structured as debt instruments and include terms like maturity date and interest rates, they allow the principal plus accrued interest to convert into an equity investment at a later date. The event of conversion is typically a future equity financing round. In the construct of a convertible note, the investor would receive equity shares in the start-up company, instead of a return in the form of principal and interest, only because the common vision is for the start-up company to raise further equity funding. The conversion typically occurs at a discount to the price per share of the future round.
Advantages of Convertible Notes
Convertible notes have proved attractive as it does not force the start-up company and investors to determine the valuation of a company, especially when there may not be sufficient material which could be used to fix a valuation. Here, valuation of the start-up company and subsequent conversion of the instrument is deferred until it is able to secure its next round of financing. Additionally, as convertible notes are debt instruments at the time of issuance, with an option to be converted into equity, the start-up company does not have to give up voting power at the time of issuance of convertible notes (except to the extent of certain contractual rights such as affirmative matters which the investors may negotiate). Furthermore, the documentation pertaining to convertible notes is simpler, quicker and less expensive to execute than a pure equity financing documentation. Another significant advantage is that the convertible notes serve as a useful mode of bridge financing between larger round of equity financings.
Convertible Note under Indian Law
In the Indian legal landscape, till very recently, a convertible note structure was not permitted and for a company to raise equity financing, a company was required to issue either compulsorily convertible preference shares or compulsorily convertible debentures, which necessarily involved a valuation and a pricing ceiling to be assigned to the start-up. However, this changed with the Government of India permitting ‘recognized start-ups’ to raise funds through the convertible notes route. The concept of convertible notes was introduced in 2016 vide amendment to the Companies (Acceptance of Deposits) Rules, 2014, (“Deposit Rules”). Further, the RBI also amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2016, to introduce the concept of convertible notes under FEMA.
The Deposit Rules define 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.” The effect of amendments to the Deposit Rules is that a recognized start-up company can raise an amount of INR 25,00,000 or more in a single tranche, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding ten years from the date of issue). The amount raised by way of a convertible note is either required to be repaid or be converted within ten years and in case of conversion, it shall be converted into equity shares only. While the terms of conversion have to be determined upfront at the time of issuance of convertible notes, the conversion price itself can be determined at the time of conversion.
A start-up can issue convertible notes to both resident (persons resident in India) and non-resident (persons resident outside India) investors. The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) governs the issue of convertible notes by a start-up to person resident outside India. Under the NDI Rules, ‘convertible notes’ have been defined as an instrument issued by a start-up 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 five 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. It is pertinent to note that while a convertible note issued by a start-up to a person resident in India would require to be converted into equity shares within a period of ten years, in case a convertible note is issued to a person resident outside India, it would require to be converted into equity shares within a period not exceeding five years.
The Indian start-up which has issued convertible notes to a person resident outside India is required to file Form CN within 30 days of such issuance. On the other hand, an obligation has been imposed on the person resident in India, who holds convertible note issued by an Indian start-up, either in the capacity of the transferor or transferee, to report such transfers to or from a person resident outside India, as the case may be, in Form CN within 30 days of such transfer.
Convertible notes represent a viable option of financing for Indian start-ups who are registered with the DPIIT. The clear benefit of a convertible note for a foreign investor is that it is deemed to be equity and not an external commercial borrowing. This is due to the fact that a convertible note is not compulsorily convertible (i.e., it only converts if there is an equity financing in the future). In the absence of these recent amendments, a convertible note would be construed as an external commercial borrowing under Indian foreign exchange laws- which has onerous mandatory provisions on commercials.
The other benefit of the convertible note is the ability to skip valuation and postpone valuation to a time there is an equity financing. This is beneficial to start-up companies. The upside of this for start-up companies is diluted to the extent there is a valuation cap negotiated by the investors. Other than this legal aspect, the convertible note is yet another investment contract involving negotiated rights including affirmative rights and lock-ins in favour of the investor.
This update has been prepared solely for information purposes and does not constitute legal advice. Please do not act or rely on the information contained in this update without seeking the advice of an attorney. Responses to inquiries, whether by email, telephone, or other means do not constitute legal advice, nor do they create or imply the existence of an attorney-client relationship.
A start-up is defined as a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 and recognised as a start-up under the notification dated 17th February 2016 (which has been superseded by G.S.R. notification 127 (E) dated February 19, 2019) on start-ups issued by the Department for Promotion of Industry and Internal Trade ("DPIIT").  Rule 2 (1) (c) (xvii), Deposit Rules.  Paragraph 12 of the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.