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Convertible notes: New Gasoline for Startups

Convertible notes: New Gasoline for Startups

Money is like gasoline during a road trip. You don’t want to run out of gas on your trip, but you’re not doing a tour of gas stations.”

Indeed an apt quote by Tim O’Reilly, O’Reilly Media founder and CEO.

In the startup world, funding can catapult the startup to success as funding is required at different stages. Indian startup ecosystem is no different. Swinging another pendulum in the favor of startups, Reserve Bank of India (RBI) has amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, (hereinafter referred as “ The Regulations”) with effect from January 10, 2017 so as to allow “startups” to issue convertible notes.

It is worthwhile to note here that in India, an Indian Company can receive foreign investment by issue of equity shares or fully and mandatorily convertible preference shares /debentures. This means that investment in companies generally cannot involve an option for the investor to redeem or demand repayment of monies invested.  Further, optionally convertible debentures are considered External Commercial Borrowings (ECBs) and are required to comply with the more stringent ECB Guidelines.

Convertible note is a clear deviation from above existing policy. How? This article will attempt to explain.

Convertible note – Term defined

Clause (iia) has been inserted in Regulation 2 of the Regulations to define “Convertible note” as:

“an instrument issued by a startup 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 startup 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.” 

Basis the above definition, the features of convertible note can be summed as follows:

1. It is an instrument issued by a startup company.

Convertible notes can be issued by a startup company only.  The Regulations define ‘startup company’ as a “private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognised as such in accordance with notification number G.S.R. 180(E) dated February 17, 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry.”

Accordingly, we have prepared the following diagram that provides a visualization of Startup Company as recognised by definition.

visualization of Startup

2. It evidences receipt of money initially as debt.

Convertible notes are issued against money received in the nature of loan.  Fair enough!!

3. The instrument is repayable at the option of the holder.

Convertible notes are repayable at the option of holder. But usually prepayment is not what angel investors look for. They look for startup to hit success, achieve an exit at a hefty valuation, and ultimately generate a greater return on their capital.

Also, this repayment option feature generally leaves OCDs to be treated as external commercial borrowing in India, which is not the case with convertible note. A marked change indeed!!

4. The note is convertible into equity shares within a period not exceeding 5 years from date of issue of the note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.

The regulation provide for conversion within a period of 5 years. However, conversion is contingent upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.  The regulations are silent about conversion in case the “specified event” does not occur.

I hope the definition is now clear. Let us see an illustrative example for convertible note.

A startup company XYZ granted INR 5,00,000 convertible note to the investors with the condition that this money shall be converted into Series A Preferred Stock at a discount of 20% to the next round of funding, which ought to take place within 36 months.  If XYZ is unable to raise the money, it has to return the loan along with interest at 10 percent immediately upon the expiry of the 36th month or any other time that the investors demand.

Twelve months later, XYZ raises Rs 10 lakhs from a venture capital fund that pays INR 5 per share.

Accordingly, the INR 5 lac loan will convert into shares of Series A at INR 4 (INR 5 less 10%) per share which gives 125000 shares. A new Series A investor would receive only 100000 shares of Series A Preferred Stock for INR 5 lac. On paper, 125000 shares at INR 5 per share are worth INR 6.25 lac with an unrealized return of 25%

In other words, the first investors will get more shares for their money and get compensated for investing early in Company XYZ

We now move on to discuss the regulatory aspects relating to issue of convertible notes.

New Regulation 6D to regulate for issue of convertible notes

1. Who are eligible to purchase convertible notes issued by startups?

A person resident outside India is eligible to purchase convertible notes. The FEMA Act defines “person resident outside India’ as “a person who is not resident in India”.

Crudely, the following persons qualify to be “a person resident outside India”:

  • a person who stays in India for less than 182 days;
  • any person or body corporate not registered or incorporated in India

Citizens of Pakistan or Bangladesh or entities registered in/incorporated in these countries cannot purchase convertible notes in Indian entities.

Further, NRIs may acquire convertible notes on non-repatriation basis in accordance with Schedule 4 of the Principal Regulations. NRI are defined to mean “person resident outside India who is either a citizen of India or a person of Indian origin.”

2. Minimum purchase amount

Convertible notes issued by an Indian startup company may be purchased for an amount of twenty five lakh rupees or more in a single tranche.

It is interesting to note here that last year, the Ministry of Corporate Affairs (MCA) has amended and expanded the list of Exempted Deposits under the Companies (Acceptance of Deposit) Rules, 2014 to include “amounts of Rs. 25 lacs or more received by a start-up company by way of convertible note (convertible into equity shares or repayable within a period not exceeding 5 years from date of issue) in a single tranche, from a person.”

Accordingly, the convertible notes will not be treated as public deposits, thereby relieving such startup from stringent provisions relating to public deposits. 

3. Requirements for remittance of consideration

Consideration on issue of convertible notes to be received by inward remittance through banking channels or by debit to the NRE / FCNR / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

Such escrow account shall be closed immediately after the requirements are completed 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 six months.

4. Transferability of notes

Convertible notes may be acquired or transferred, by way of sale, 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 startup company is engaged in a sector which requires Government approval.

5. Certain startups to require Government approval

A startup company engaged in a sector where FDI requires Government approval may issue convertible notes to a non-resident only with approval of the Government. The issue of shares against such convertible notes shall have to be in accordance with the Schedule 1 of the Principal Regulations.

6. Reporting and compliance

The startup company issuing convertible notes shall be required to furnish reports as prescribed by the Reserve Bank.

Better but not best!

Convertible notes allow investors to invest in startups without concerns about their valuations, which are difficult to determine at the inception, as convertible notes are merely an instrument advanced as a loan and converted to equity at a later stage when the startup’s business model is more evolved.

The amendment has opened up a new channel for raising funds for Indian Startups. However, it is expected to have limited impact, as it is applicable only to entities defined as ‘startups’ by the DIPP. Further, clarity is warranted on various aspects such as interest rate restrictions, pricing restrictions, redemption after 5 years etc.

Hope you find the article useful. Pour in your comments. Keep visiting www.taxingtax.com for more information and updates.

Sources:

  1. Notification number G.S.R. 180(E) dated 17 February, 2016 – Definition of startup
  2. Notification No.FEMA.377/2016-RB
  3. Companies (Acceptance of Deposits) Amendment Rules, 2016
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