To encourage and boost the highly volatile Start-up culture in India, the Govt. of India issued Consolidated FDI Policy in 2017. The thrust of the policy was to make India an attractive investment destination for foreign investors. A key feature of these policy announcements has been to boost fundraising options for home-grown startups by permitting startups to raise funds through issuance of Convertible Notes which was earlier not allowed.
The regulatory norms and practices were upgraded, to bring in alignment with prevalent economic conditions and market dynamics. One of the key initiative taken was the introduction of “Convertible Notes” (“CN”) which was first introduced by the Ministry of Corporate Affair vide amendment to Companies (Acceptance of Deposits) Rules, 2014 (“Deposit Rules”), to exempt money received by a company through issuance of CN from the definition of deposit.
Convertible Notes makes it easier for start up companies to raise investment from Hongkong, Silicon Valley, Singapore etc. as CN instrument are extremely popular in these advanced startup ecosystems.
Definition of Convertible Note:
A convertible note is defined under the Companies (Acceptance of Deposits) Rules, 2014 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 ("Convertible Note").
The notification dated 29 June 2016 effectively excluded any amount of INR 25,00,000 (Rupees 25,00,000) or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person, from the ambit of 'deposit'. However, the Rules define start-up as a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 (the "Act") and recognised as a start-up under the notification on start-ups issued by the Department for Promotion of Industry and Internal Trade ("DPIIT").
The issuing entity has to be a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognized as such under notification dated 17/02/2016 (“DIPP Notification”) issued by Department of Industrial Policy and Promotion, Ministry of Commerce and Industry (“DIPP”).
Convertible Notes may be issued to:
- A person who is 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. Also, the investors hailing from such countries sharing land borders with India can invest only through approval route vide Press Note 3 issued by Ministry of Commerce and Trade.
- A Non-Resident Indian (NRI), an Overseas Citizen of India (OCI), Company, a trust and a partnership firm incorporated outside India and owned and controlled by NRIs or OCIs. However, the investment will be deemed to be domestic investment at par with the investment made by residents.
Prior Government approval for the issuance of a convertible note will be required for cases where the startup is engaged in any activity that falls under the approval route under the existing regulatory framework for FDI. Startups engaged in sectors falling in the automatic route for FDI do not require any prior approval with respect to such issuance.
The amount against which Convertible Notes can be issued should be an amount equal to more than INR Twenty-five Lakhs (INR 25,00,000) in single tranche.
The amount either repaid or to be converted within 5 years and in case of conversion, it shall be converted into equity shares only.
The terms of conversion will have to be determined upfront at the time of issue of Convertible Notes. However, conversion price can be determined at the time of conversion and price shall not be lower than the fair market value prevailing at the time of conversion.
A start-up company shall receive the consideration towards Convertible Notes by inward remittance through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. Furthermore, the Repayment or sale proceeds may be remitted outside India or credited to NRE/ FCNR (B) account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.
The issue of equity shares in lieu of convertible notes must be in compliance with RBI’s pricing guidelines, that is, valuation must be done through any internationally recognised pricing methodology at an arm’s-length basis by a qualified chartered accountant or merchant banker.
Convertible notes are freely transferable and can be acquired/transferred by way of sale, provided the sale is in accordance with the pricing guidelines prescribed by the RBI.
Pricing guidelines-Convertible Notes
Unlike other capital instruments, like Equity Shares or CCPS or CCD, pricing guidelines need not to be complied with at the time of issuance of a convertible note. Valuation shall be determined on at the time of: (i) conversion of the convertible note into equity; or (ii) In case of transfer of convertible notes from a non-resident to a resident or vice versa. Therefore, the price of shares issued upon conversion or transfer must be at or above fair market value, determined by a certified chartered accountant in practice or cost accountant in practice or Merchant Banker registered with the Securities and Exchange Board of India.
Convertible Notes: Pros
- No valuation requirement at the time of issuance of Convertible Notes;
- Convertible Note is a preferred instrument over convertible debentures in case of bridge financing, wherein valuation of the Company and subsequent conversion of the instrument is deferred until the company can secure its next round of funding.
- Since Convertible Notes are debt instruments with an option to be converted into equity, The company does not have to part with control or voting power when such convertible notes are issued.
- Convertible note financing are simpler to document from a regulatory perspective, meaning that they are less expensive and quicker to execute.
Convertible Notes: Cons
- If future financing rounds are not completed, the investors may opt not to convert the notes into equity and the CN will remain as debt and thus require redemption, potentially pushing stillfragile companies into bankruptcy.
- Certain clauses of the CN agreement such as Valuation cap and the Conversion Discount can complicate future equity raises by anchoring the price expectations.
- Another disadvantage is the non-alignment of incentives/returns between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.
- Further, a Convertible Note has to be repaid or converted into equity shares of a start-up company within 5 years from the date of issuance of the Convertible Note. Since the maturity period is less, the risk involved becomes greater.
- The threshold to invest minimum INR 25 Lakhs for one tranche also becomes a hurdle for start ups struggling to seek from angel investors.
At the time of issuance of Convertible Notes: Convertible Notes being debt initially, there are no tax implication at the time of such issuance.
At the time of conversion of Convertible Note: The conversion price of such instruments shall have to be at fair market value. In case if the conversion price is above the fair market value, then the difference between the conversion price and fair market value may be taxable in the hands of the company under section 56 (2) (viib) of the Income Tax Act, 1961. However, this is exempted in case if the company is registered start-up and has tax exemption approval from Income Tax department at the time of conversion.
In case if conversion price is lower than fair market value, the difference between the conversion price and fair market value may be taxable in the hands of holder of convertible note under section 56 (2) (x) of the Income Tax Act, 1961.
Reporting requirements upon issuance
Companies Act, 2013
Under Companies Act, 2013 and allied rules and regulations thereunder, the Company raising investment by way of Convertible Notes need to comply with the below regulatory compliances:
- Approval of the Board of Directors to issue the CN;
- Approval of shareholders by way of Special resolution in a general meeting;
- Filing of Form MGT-14 with concerned ROC
- Execution of CN agreement incorporating the terms and conditions of such notes;
- Receipt of investment from the proposed investors in a single tranche;
- Taking note of the investment received and issuance convertible note certificates to such investors
The reporting requirements under FDI regulation include:
- filing of Form CN with 30 days from the issue.
- in case of transfer of such CN, Form CN to be filed within 30 days of such transfer.
- Information to be filled in the form include the details of investor, banking channel used, amount involved etc.
- The Authorised Dealer Bank shall submit consolidated statements to the Reserve Bank upon filing Form CN.
Delays in RBI reporting
The person / entity responsible for filing the reports provided in Regulation 4 above shall be liable for payment of late submission fee, as may be decided by he Reserve Bank, in consultation with the Central Government, for any delays in reporting.
Form CN : Single Master Form is available over FIRMS portal to file form CN on account of Issuance, Transfer, Conversion or Repayment