Convertible notes also known as convertible promissory notes (“Notes“) are a form of debt instruments that convert from debt to equity upon the occurrence of a predetermined conversion event or lapse of a fixed time period, and often at a predetermined conversion rate. Notes are often issued by start-ups as a form of raising capital in their early stages, in exchange for equity being offered to the investor and to be provided at a later stage.
In the recent decade, Notes have become increasing popular among start-ups due to the advantages that this debt instrument offers. The primary reason is that Notes allow the start-up entity to procure investment in its early stages and not have to worry about the valuation of the company at the time of issuing Notes. A few other reasons making this form of procuring investment attractive are the simplicity and streamlined nature of the procedure, the flexibility in terms of investing, and lower regulatory thresholds. This preference for Notes is prominent, with even companies such as Dunzo, PharmEasy, and Udaan using convertible notes to raise funds in their early years.
The Companies (Acceptance of Deposit) Rules, 2014 (“Rules“), defines a “Convertible Note” 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. It was only vide a 2016 notification amending the Rules, that Notes were introduced as an exempted deposit (with respect to start-up companies). Prior to 2016, any amount in excess of Rs. 25,00,000/- (Rupees Twenty-Five Lakhs) received by a start-up company by way of Notes, was to be treated as a Deposit. Even subsequent to the 2016 notification, only start-up companies in India were permitted to issue Notes and subject to certain pre-conditions set forth under the Rules. Start-ups are defined under the Rules as a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognised as a start-up by the Department for Promotion of Industry and Internal Trade (DPIIT).
A private company is recognised as a start-up company by DPIIT for a period of 10 (ten years) from the date of its incorporation/ registration, provided that (i) the turnover for any financial year since its incorporation has not exceeded Rs. 100,00,00,000 (Rupees One Hundred Crores) ; and (ii) the entity is working towards the innovation or development of products or processes or services, or it a scalable business model with a high potential for employment generation or wealth creation.
The pre-conditions to issuing Notes by recognised start-up companies, as provided by the Rules are that (i) the minimum amount to be invested, by way of Notes, in one tranche by one investor is Rs. 25,00,000/- (Rupees Twenty-Five Lakhs), and (ii) the Notes should be convertible or repaid within a period of 10 (ten) years from the date of issuance. If the conditions are not met any amounts received by the start-up company by way of Notes will be considered as Deposits.
Notes may be issued to persons resident outside India, in addition to resident Indians and non-resident Indians. The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“FEMA Rules“) provides that a person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered or incorporated in Pakistan or Bangladesh), may purchase convertible notes issued by an Indian startup company for an amount of Rs. 25,00,000/- (Rupees Twenty-Five Lakhs) or more in a single tranche. This minimum threshold is in keeping with the Rules, as applicable to issuance of Notes to residents. The FEMA Rules also allow for the acquisition, by way of sale, of Notes by a person resident outside India from a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by the Reserve Bank of India.
The process for issuing Notes by a start-up company is detailed under Section 62(3) of the Companies Act, 2013. According to this Section, a start-up company may issue Notes by passing a special resolution for the same. The Companies Act, 2013 does not provide any timeline or restriction on when the Notes may be issued. The issuing of Notes will take place in accordance with the terms agreed upon by the start-up company and the investors. At the conversion event of such Notes, or at 10 (ten) years from the issuance of the Notes (whichever is earlier), the Company shall convert the Notes in equity at the valuation method agreed upon. This conversion is to be filed before the Registrar of Companies for approval. Upon approval, the Company is to issue the share certificate to the investor.
These provisions will allow Indian start-ups more time to develop their business and reach stability before having to issue equity to investors.
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