CONVERTIBLE NOTE: INVESTMENT VENTURE
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;
(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.