Convertible Note

Introduction-

In recent years, there has been a huge start-up growth in India. More people especially youngsters come up with innovative ideas to start a business. Many young people have the potential and capability to initiate their startups. Everyone is aware of the fact that one of the basic requirements to start a business is raising funds. There are multiple sources of funding available for startups. One of them is Convertible Note.

Convertible Note:-

A convertible note is a way to raise capital for an entrepreneur. The way convertible notes work is that an investor lends money to the startup just like debt, which has a certain rate of interest attached to it. But, it also gives the investor an option to convert his debt investment into an equity investment at the end of the loan term or when the company goes out to raise more funds.

Statute:-

Ministry of corporate affairs for the first time introduced and recognized convertible instruments as Companies (Acceptance of Deposit) Rules, 2014.

Definition:-

A convertible note is defined under the Rules 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 a 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 Rules define a start-up as a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 and recognized as a start-up under the notification on start-ups issued by the Department for Promotion of Industry and Internal Trade.

How it works:

Startup begins its initial round of fund-raising (seed round)

↓

Investor agrees to lend the business a certain amount of money, with specific repayment terms (the convertible note)

↓

Startup seeks a second round of fund-raising (Series A round)

↓

Company value is determined

↓

Convertible notes convert into shares as repayment (principal + interest) based on the note’s terms

↓

Convertible note owner now has an ownership stake (i.e., owns stock), just like the startup’s other investors

?

Terms of Convertible Notes-

Interest rate: This is similar to an interest rate on a traditional loan. In exchange for providing cash to your business, an investor can require a minimum return on the amount invested. A 10% interest rate on an investment of $100,000 allows the investor to convert it to $110,000 after one year.

Discounted rate - This represents a discount on the valuation of the startup for the investor who had invested through convertible note prior to the funding round where your startup is getting a valuation and raising more capital. This simply means, that if your startup is now valued at say $10 million and this investor is getting a discounted rate of 20% and he previously invested $1 million, instead of getting a 10% equity, he will be getting 12.5% while all the new investors will get the same 10% for their $1 million investment. This is the benefit of an investor who had invested early on in your startup for taking a higher risk.

Maturity date: A maturity date is nothing but the date when your startup needs to pay back the investment or allot him his equity. This date is usually decided during the time of raising the money through a convertible note. It can either be a specific date with a set time period like 1/2 year or the date when your startup goes out to raise its next funding round.

Valuation Cap: A valuation cap limits the price at which equity can be converted with a pre-money valuation. Like, when the note converts into shares, the investor can receive the shares equal to the pre-money valuation, regardless of what new investors are paying. When the price of conversion is determined, investors can opt to use either the discount rate or the valuation cap.??

Execution aspect of convertible note :-

?? Register with Start-up India from Department for Promotion of Industry and Internal Trade.?

?? Conduct and convene a Board Meeting for approving issuance of Convertible Note.

?? Conduct and Convene a Shareholders’ Meeting for approving issuance of Convertible Note.

?? Draft a Convertible Note Agreement.

?? Draft a Convertible Note certificate.

?? If the Articles of Association do not allow the Board to borrow money, amend the Articles of Association to give the Board the power to borrow by passing board and shareholders resolutions.

?? Drafting board resolution for approving Convertible Note.

?? Drafting a shareholders’ resolution for approving Convertible Note.

?? Stamp the Convertible Note Agreement.

?? Procuring signature of all Parties concerned on the Convertible Note Agreement.

?? After the receipt of investment amount then issue Convertible Note Certificate which has to be? duly stamped and executed.

?? File Form MGT-14 within 30 days of Shareholders Meeting.

?? File Form DPT-3 by 30th June of every year.

?

Conditions to be fulfilled for issuance of convertible notes to non-resident or foreign investors:

• A person who is a resident outside India (other than an individual who is a citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), can purchase Convertible Notes issued by a recognised start-up company.
• The minimum amount to be invested for subscription to Convertible Notes is INR 25 lakhs in a single tranche.
• If the start-up is engaged in a sector that requires government approval for foreign investment, Convertible Notes shall be issued only with prior approval of the government. Also, the issue of shares against such Convertible Notes has to be in accordance with Schedule 1 of the RBI Regulation.
• The start-up issuing the Convertible Notes shall receive the consideration amount by inward remittance or by debit to the NRE/FCNR (B)/ escrow account maintained by the investor following the Foreign Exchange Management (Deposit) Regulations, 2016. In the event an escrow account is maintained for the above purposes, it shall be closed immediately after the requirements are completed or within a period of 6 months, whichever is earlier. However, continuance of such escrow account shall not be permitted beyond a period of 6 months.
• NRIs may acquire Convertible Notes on non-repatriation basis in accordance with Schedule 4 of the RBI Regulation.
• A person resident outside India can acquire or transfer, by way of sale, Convertible Notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the Government shall be obtained for such transfers in case the start-up company is engaged in a sector which requires Government approval.
• Compliance with the reporting requirements prescribed by the RBI is also required.

Alternatives to a convertible note:-

A convertible note can be a good way to get funding for your startup, but there are other ways to get cash that don’t require you to give up equity in your company.

Startup business loans: These loans cater to newer businesses that might have difficulty getting loans from banks. They have more flexible requirements for revenue, credit score, and time in business.

Small business grants: Grants can provide your business with cash with no repayment required. However, this can be a difficult source of funding to obtain due to limited availability and competition from other businesses.

Funding from friends and family: Asking for funds from friends and family can give you more flexibility for interest rates, repayment methods, and other loan terms. They may even be willing to gift you some funds.

?

Conclusion:-

Recognition of Convertible Notes as a capital investment instrument is definitely a positive move to make the process of investments into Indian companies swifter, easier, and less expensive.

However, it is important to note that the advantage is available only for recognised start-ups, which means that non-recognised start-ups are still not allowed to issue Convertible Notes as a capital instrument under the RBI Regulation or as a non-deposit under the Rules.

Further, a Convertible Note has to be repaid or converted into equity shares of a start-up company within five years from the date of issuance of the Convertible Note upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument. In case of conversion, the instrument would be converted into equity shares as per Section 62(3) of the Companies Act, 2013.

?