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Convertible Notes– A Brief Overview

May 9, 2019     by Rahul Verma

We are in the golden age of seed financing. Venture capital funds, seed funds, super angels, angel groups, incubators and “friends and family” are all playing the seed financing game and investing early in startups.

The vast majority of high-growth startup companies rely on some form of outside financings such as funding from angel funds, traditional venture capital, high net worth investors, etc. Amongst all of the mode of investments, Convertible notes have become increasingly popular in the world of startup financing, particularly in seed stage companies.

Convertible Notes: A hybrid of Debt and Equity

A convertible note (CN) is a debt instrument that allows raising funds by granting the holder of the note the right to be repaid the amount or the right to convert the amount invested into equity shares of the issuing Company. In short, convertible notes are originally structured as debt investments but have a provision that allows conversion of the principal plus accrued interest into equity investment subsequently.

It also carry a unique characteristic among investments. Typically, investors can only cash out during a liquidity event, like the sale of the company, but convertible notes are technically debt, and as such if held to maturity, a note holder could demand payback. Convertible Notes usually include a provision in which the notes automatically convert to equity, at a discount or at a set valuation, on the maturity date.

Advantages of Convertible Note

  • The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there may not be much to base a valuation on – in some cases the company may just be an idea. The valuation will usually be determined during the Series A financing, when there are more data points to base a valuation.

  • Another significant advantage of issuing convertible notes is to avoid giving the investors any control.

  • Finally, another advantage of issuing convertible notes is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round and also allow more flexibility in price. As Paul Graham competently noted in his post High Resolution Fundraising:

‘The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors wait to see who else is going to invest.

The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So, you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.’

Convertible Notes in India

Raising early-stage money through a convertible note is quite common in startup economies like Silicon Valley, Singapore, etc. making the funding process easier and quicker. India allowed foreign direct investment (FDI) only in equity instruments or such other instruments that were considered at par with equity (compulsorily convertible preference shares/debentures, etc.). However, with effect from January 10, 2017, the RBI amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, (superseded by Notification No. FEMA 20(R)/2017-RB of RBI dated November 07, 2017) to allow “startups” to issue convertible notes to foreign investors.

Governing Laws:

In India, convertible notes are regulated by the Reserve Bank of India vide notification number FEMA 20(R)/2017-RB and the Companies Act, 2013.

Key features:

  • It has been defined as an instrument issued by a startup 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 upon occurrence of certain specified events, within 5 (five) years from the date of its issue and as per the terms and conditions set out in the instrument.

  • The minimum amount of investment for a convertible note is INR 25,00,000 (Indian Rupees Twenty-Five Lakhs) in a single tranche.

Conditions governing issue of convertible notes:

  1. Convertible notes may be issued to:
    1. a person 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); and

    2. 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.

  2. Where convertible notes are issued under FEMA 20(R)/2017-RB:
    1. RBI approval: A startup company, engaged in a sector where foreign investment requires Government approval, may issue convertible notes only with such approval. Further, issue of equity shares against such convertible notes shall follow the entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment provided in FEMA 20(R)/2017-RB.

    2. Mode of payment: The amount of consideration by inward remittance shall be through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

    3. Remittance of sale proceeds: 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.

    4. Transfer: The convertible note may be transferred by way of sale to a person resident in or outside India, provided the transfer takes place in accordance with the entry routes and pricing guidelines as prescribed for capital instruments.

    5. Pricing guidelines: While there are no pricing guidelines applicable at the time of issuance of a convertible note, the conversion of a note into equity must be in accordance with the pricing guidelines applicable to capital instruments.

Reporting requirements

  1. Under FEMA 20(R)/2017-RB:
    1. The Company issuing convertible notes to a person resident outside India shall report such inflows to the Authorised Dealer Bank in Form Convertible Note within 30 (Thirty) days of such issue.

    2. A person resident in India, who may be a transferor or transferee of convertible notes issued by the Company shall report such transfers to or from a person resident outside India, as the case may be, in Form Convertible Note to the Authorised Dealer Bank within 30 days of such transfer.

    3. The Authorised Dealer Bank shall submit consolidated statements to the Reserve Bank.

  2. Under Companies Act, 2013:
    1. Unlike issuance of shares by private placement or preferential allotment, the procedure for issuance of a convertible note is comparatively easier.

    2. As it is a debt instrument, the issuing Company is required to seek approval of its members by way of a special resolution at the General Meeting. This must be notified to the Registrar of Companies by filing of eForm MGT-14 within 30 (Thirty) days of the General Meeting.

Parting Thoughts

Issuance of equity or preference shares can only be through private placement or preferential allotment, which requires compliance with the valuation and extensive reporting requirements under the Companies Act, 2013. On the other hand, a convertible note has minimal reporting requirements and there is no hassle of valuation at the time of issuance. The ease of issuing convertible notes is the reason for its popularity among startup companies.

However, it is pertinent to note that the advantage is available only for recognised start-ups, which means that non-recognised start-ups are still not allowed to issue Convertible Notes as a capital instrument under the RBI Regulation or as a non-deposit under The Companies (Acceptance of Deposit) Rules, 2014. The regulators need to make it easier for all companies, not just start-ups, to raise funding through convertible notes.

16 thoughts on “Convertible Notes– A Brief Overview

  1. Do we need to file FLA Returns if CN is issued?(neither allotted/transferred/repaid). The company has just issued the CN. Please assist

    1. FLA (Foreign Liabilities and Assets) return is to be filed by all the Indian companies which have received Foreign Direct Investment and /or made Overseas Investment in the previous year(s) including the current year i.e. who holds foreign assets or liabilities in their Balance Sheet.

      Hence, if you have issued CN against which Foreign Direct Investment has been received and it’s still outstanding in your Balance Sheet as on 31st March, 2020 then you have to file FLA Return irrespective of the fact whether your company has/ has not allotted/ transferred CN.

    1. No pricing guidelines are prescribed by the Reserve Bank of India for issuance of convertible notes. However, in case of conversion of convertible notes into equity and transfer between resident and non-resident investor, the same shall be in accordance with the pricing guidelines.
      Further, note that an Indian startup company can issue convertible notes to persons resident outside India for an amount of twenty five lakh rupees or more in a single tranche.
      Hence, no benchmark rate is specified for issuance of convertible notes. However, the Companies shall comply with the minimum investment criteria.

  2. How are we determining the process to issue CN? If converted, it will be a security of the company, shouldn’t we follow the private placement process?

    1. The Company issuing Convertible Notes is required to comply with necessary provisions, requirements, approvals (If required) as prescribed by RBI Vide notification no. FEMA 20 (R)/2017-RB alongwith Companies Act, 2013.

      On conversion of Debt into Equity, it would be security of the Company and the same can be issued through Private Placement by complying with provisions of Section 62(1)(c) and Section 42 of the Companies Act, 2013.

  3. This article really helps in understanding the concepts better.
    Query – OCI holder having US Citizenship currently living in India – can Convertible notes be issued to him if he transfer money from Indian Bank Account? Will RBI compliances be involved?
    Note – The company has already issued CN to the same investor who has invested through foreign account already and 5 years did not lapse till.

    1. Firstly, it should be noted that an OCI holder is treated at par with Non- Resident Individuals (NRIs).

      Thus, RBI compliances will be applicable as if convertible notes are issued to a person resident outside India i.e. Form FC-GPR shall be filed within 30 days of allotment. (If the investment is on non-repatriation basis)

      Also, the amount of consideration should be received by inward remittance through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained by the person concerned.

      Hence, OCI holder can only transfer money through above stated modes of payments and not from Indian Saving Bank Account.

  4. Can Indian startup issue Compulsory convertible notes to raise funding in place of just convertible note agreement? Please help

    1. No, a convertible note cannot be issued to a domestic investor. As per extant RBI regulations, a person 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), may purchase convertible notes issued by an Indian start-up company for an amount of twenty five lakh rupees or more in a single tranche.

      1. First of all, really great article on convertible notes. However, RBI issues regulation only for foreign funds. It may not have say in domestic funding. Hence their regulation is quite about issue to domestic investor. Hence, according to us we can issue convertible notes to domestic investors too, as companies act do not impose any restriction here

        1. Thanks for the appreciation. We feel great when we receive such remarkable comments.

          As per Regulation 8 of Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (Notification No. FEMA 20(R)/ 2017-RB dated November 07, 2017), only person resident outside India may purchase CN issued by an Indian startup company.

          Therefore CN cannot be issued to a person resident in India.There are no regulations under CA, 2013 governing the issuance of CN. CN is mentioned only in deposit rules.

        2. Good evaluation. However, did have a view on whether it can be issued to domestic investors. You mentioned that the CN is mentioned only in deposit Rules – but inclusion of CN in these Rules was done in 2016 whereas FEMA 20 was amended in 2017. Wouldn’t this imply that it could be issued to domestic investors too?
          Also, another query was on interest – is it mandatory for CN to carry interest? What is the industry practice for the rate of interest on CN?

        3. Yes, CN can be issued to domestic investors. But before notification of Companies (Acceptance of Deposits) Amendment Rules, 2014, issue of CN was considered as deposits. After the amendment, only a recognised start-up company can issue CN and the same shall not be considered as deposits. Unrecognised start-up companies are still kept outside the ambit of this exemption and issuance of CN by them will be treated as deposits.

          CN being a debt instrument and debt in essence always carries interest. CN carries a very nominal rate of interest.

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