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Legal Capsule by Law Office of Madhavan Srivatsan


Authors: Madhavan Srivatsan, Aiyush Gupta and Khizer A. Qureshi

1.              Preface

With the term ‘start-up’, the term ‘investment’ immediately comes in one’s mind and in the present context, there are various modes of investment in a start-up. Generally, when we talk about “investing” or “investments”, we exclude “debt” from it and focus on “equity” or “equity instruments”. In a very generic understanding, “equity” or “equity instruments” are those instruments which provides equity ownership to the investor either at the time of investment or after a specified period of time. However, in order to issue such instruments, one of the pre-requisites is “valuation” of the company. Generally, a start-up in its initial stages of operations is not able to arrive at its valuation, i.e. not able to value its equity, thus, the only option left for such start-up as a source of funding is “debt”. Now, with the start-up culture, “debt” may not be a favourable route because of lack of security mechanism as well ability to repay the debt in future. In order to bridge this gap and understand the investors’ view of investing in start-ups and to assist such start-ups in obtaining investments, the Ministry of Corporate Affairs (hereinafter referred as “MCA”) vide Companies (Acceptance of Deposits) Amendment Rules, 2016 has introduced the concept of Convertible Notes (hereinafter referred as “Convertible Note”).

There is no specific law for Convertible Note till date for domestic investors. However, MCA has excluded Convertible Note from the purview of ‘Deposits’ by way of Companies (Acceptance of Deposits) Amendment Rules, 2016. Moreover in 2017, pursuant to amendment in Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, the Government of India and RBI, allowed the start-up companies to procure investments from foreign investors by way of the issuance of Convertible Note.

Moreover, it is necessary to clarify here, that only a “start-up company”, which is recognized by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry (hereinafter referred as "DIPP") i.e. fulfilling the specified criterion (hereinafter referred as “Company”), is allowed to issue Convertible Note.

2.              Convertible Note: A Hybrid Of Debt And Equity

In the Indian context, pursuant to amendment in Companies (Acceptance of Deposits) Rules, 2014, Convertible Note was given a legal definition under Explanation II to Rule 2(vii) as:

“Convertible Note means 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.”

Later, in 2017, another definition was introduced under Regulation 2(vi) of Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 stating: 

“Convertible Note means an instrument issued by a start-up company evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such start-up company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument”

In 2019, Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 (hereinafter referred as “NDI Rules) were enacted and enforced, and superseded the above-mentioned 2017 regulations, wherein Regulation 2(e) of NDI Rules, defines a “Convertible Note” as:
“ It means 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 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.”

Summarily, Convertible Note is an instrument reflecting debt in the Company but a special feature which they carry is an option to either redeem the debt, or convert it into equity shares of the Company as agreed in Convertible Note Agreement/Investment Agreement (hereinafter referred as “Agreement”) by the investor.

3.              Viability of Convertible Notes

Principally, investing in a Company solely based on an ‘idea’ may not be viable for an investor. Further, the determination of the value of the company is a cumbersome task at this point.  Convertible Note allows an investor to infuse funds early in the Company and receive the appropriate interest till such debt is converted into equity at a discounted price (subject to terms of Agreement), with a special feature of choice of redemption on demand in case the Company fails. This makes an investment worthwhile for an investor, with an early stake in the company and a safety net of fixed return on income over the investment.

Convertible Notes may act as an advantageous mode of investment, as mentioned below:

(i)            Safe Investment: Investors enjoy downside protection as debt-holders during the critical growth stages of the company and impliedly, the element of interest ensures the said investment has a minimum positive return.

(ii)          Getting the plot not the apartment: Investors today are looking for the next mega/super-star start-up and opportunity of holding stake in such Company before it becomes an attraction for the public akin to investing in a plot and building on it instead of buying an apartment in a building built on the said plot.

(iii)        Equity at discounted rate to the next round valuation: Convertible Note by way of providing equity at a discounted price to the investor to the valuation in the next round funding, rewards the faith which investor had in the initial stages of operations of the Company, provided the law with respect to issuance of shares as per valuation norms are followed.

(iv)         More equity when interest accrued: The equity is issued on the amount of investment, plus an agreed upon rate of interest (if accrued). Thus, the value of investment at the time of maturity stands increased and when converted, it results in providing more equity than which would have been provided on the principal debt amount. But such conversion is subject to the valuation cap, if any and other terms and conditions of the Agreement.

4.              Important Clauses Of Agreement For Convertible Note

Before issuing or investing in a Convertible Note, it is important for a Company as well as investors, to comprehend and understand certain crucial clauses in the Agreement which are as follows:

(i)            Interest: Each investor desires of earning a fixed rate of return on investment and Convertible Note like any other debt instrument duly fulfils it. But at the same time, it levies an additional burden of high interest on the Company which is itself trying to lay a foundation. Thus, rate of interest needs to be negotiated in a balanced manner.

(ii)          Conversion Provisions: The elementary part of Convertible Note is its conversion into the equity shares. There can be certain triggers specified in Agreement for conversion, the common ones being maturity date and subsequent equity investment exceeding certain threshold. There can be additional trigger points stated in the Agreement.

(iii)        Valuation Cap: This is the most important aspect of the Convertible Note. In the event, Convertible Note is to be converted into the equity shares, the conversion price shall be as per the Agreement. The provisions on Convertible Note do not specify or provides for any guidelines in this regard. However, as per the NDI Rules, the Convertible Note is  not a part of the “equity instruments” (defined under Rule 2(k) of NDI Rules) and thus, the price at the time of conversion (and not the price at the time of issuance) needs to be equal to or higher than the minimum price under the NDI Rules. Similarly, as per the provisions of Companies Act, 2013 the pricing of shares under private placement/preferential route cannot be less than the price determined on the basis of valuation report of a registered valuer. This allows the company and the holder to negotiate on the mechanism of the conversion price, which can be either based on a formula, certain trigger events, price in the next round of fund raising, financial results of the company, future valuation of the company etc. Thus, the Company and its Promoters would generally prefer to prescribe certain ceiling limit (maximum cap) for conversion in order to ensure least possible dilution and the investor would prefer to have a provision of minimum holding (minimum cap) in order to ensure substantial equity holding in the Company. These valuation caps for conversion of Convertible Note into equity shall be clearly specified in the Agreement.

5.              Issuing Convertible Notes

In India, though DIPP/ Companies Act, 2013/ NDI Rules give recognition to Convertible Note, but it is very important to note that neither of aforesaid provides any provision which allows issue of Convertible Notes to domestic investors, whereas with respect to foreign investors, Rule 18 and Schedule IV of NDI Rules enables a Company to issue Convertible Note to foreign investors.

6.              Compliance On Account Of Company

(a)           Rule 18 of NDI Rules specifies the following:
  • Company shall ensure that minimum investment tranche of Convertible Note is INR 25 lakhs (Indian Rupees Twenty-Five Lakhs only);
  •  Company shall obtain the Government approval, if it is engaged in a sector falling under Approval Route;
  •  If the investor opts for conversion of Convertible Note to equity shares, Company shall ensure that such issue is in compliance of sectoral caps, pricing guidelines and other attendant conditions for foreign investment.
(b)           Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 provides the following:
  • Regulation 3.2 states that the Company shall receive the remittance either by way of banking channels or by debit to the NRE/FCNR (B)/ escrow account maintained by the investor in accordance with 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 funds are utilized or within a period of 6 months, whichever is earlier. However, in no case, continuance of such escrow account shall be permitted beyond a period of 6 months.
  • Regulation 4(2) obligates Company to file Annual Return on Foreign Liabilities and Assets (FLA) on or before the 15th day of July of each year, whereby contribution towards Convertible Note is received by it in the previous year including the current year.
  • Regulation 4(12) obligates Company to file Form Convertible Notes (CN) when issuing Convertible Note to a person resident outside India within 30 days of issue.
(c)  In the event of redemption, the sale proceeds may be either remitted outside India or be credited to credited to NRE/ FCNR (B) account maintained by the investor in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

It is to be noted that as per provisions of NDI Rules, the price/conversion formula may be determined up-front at the time of issuance of Convertible Note or at a later stage.

7.              Compliance On Account Of Investors

Pursuant to Rule 18(1) of NDI Rules, a person resident outside India, other than an individual citizen of or an entity registered/incorporated in Pakistan or Bangladesh, only is eligible to participate in issuance of Convertible Notes. Also, it shall be noted that a Non-Resident of India (NRI) or Overseas Citizen of India (OCI) may acquire Convertible Notes on non-repatriation basis.

The investors shall comply with the following:

(a) Before investing in the Convertible Note of a Start-up, the investor shall ensure that the entity has conducted due-diligence on its part and are compliant of all legal obligations including the ones specified above.

(b)  The investor, if acquiring or transferring Convertible Notes to another person be it a resident or non-resident, shall ensure that:

(i)       Such transfer is compliant of the pricing guidelines put forth by RBI.

(ii)    Also, if the concerned entity is engaged in a sector which falls under Approval Route for foreign investment, then such transfer/acquisition to a non-resident person shall be carried out after obtaining prior government approval.

(iii)  The person resident in India, whether transferor or transferee shall 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.

8.              Conclusion

The recognition of Convertible Note by the Government of India is unquestionably a positive move towards development of financing models of Companies in India. Now, such Companies will be able to attract even the conventional investors as the Convertible Note carries a safety net of fixed return on investment. Though, it carries the minimum limit of investment at Rs. 25 lakhs in a single tranche by an investor, but it can be debated that, this limit can be lowered in order to allow the retail investors as well to invest in such Companies by way of Convertible Note.

In practice, the investors shall make sure that the Company is not issuing multiple notes with different Valuation Caps and conflicting terms, as it may lead to chaos which may be very difficult to reconcile. Thus, it is advisable that the Agreement shall specify the procedure to be followed in case such situation arises.

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