Understanding Convertible Notes as an Investment in Startups

Understanding Convertible Notes as an Investment in Startups. Do you imagine being a startup founder or owning a business? If so, you would inevitably need funding. A crucial choice before a startup founder is choosing whether to take on debt or dilute equity, for obtaining funds. Convertible notes are a mix of both debt and equity, and are ideal for early stage businesses. In this article, Compliance Calendar outlines which businesses are ideally suited for issuing convertible notes, understanding the compliance requirements and the risks involved.
What is a convertible note and does your business benefit from it?
A convertible note is a type of debt instrument commonly used by startups to raise funding. It is a short-term debt that can be converted into equity at a later date, usually during a subsequent funding round or at the time of an exit event.
In India, convertible notes are a popular form of fundraising for startups, particularly for those in the early stages of development. This is because convertible notes offer several advantages over other forms of funding, such as equity financing or traditional debt.
Who can issue convertible notes?
All startups recognised by the DPIIT, Ministry of Commerce can issue convertible notes. This includes private companies, limited liability partnerships etc. In order to be eligible to issue convertible notes, the entity must not only be recognised by DPIIT as a ‘startup’ but also remain within the definition. This means, the entity should neither have completed ten years from date of incorporation, nor should it have crossed INR100 crores in turnover.
Tracing advantages of convertible notes

Quick and easy - One advantage of convertible notes is that they are typically quicker and easier to execute than other forms of financing.

Troubles of fixing valuation are not needed - Convertible notes do not require the startup to agree on a valuation with investors, which can be a time-consuming and difficult process.

Offers flexibility in pricing, valuation - Unlike shares issued at fixed price valuations or debt issued at fixed rates of interest, an advantage of convertible notes is that they offer more flexibility for both the startup and the investors. For example, issuing a convertible note may allow the startup to delay setting a valuation until a later funding round. It also allows investors to convert their debt into equity at a discount to the valuation of the subsequent funding round.

Who can invest in convertible notes?
According to RBI guidelines, both residents and non-residents can issue convertible notes. However, the following additional information must be adhered to:

For non-resident applicants to convertible notes, the provisions of the Foreign Exchange Management Act as well as Foreign Exchange Management (Non-debt Instruments) Rules, 2019; Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019 are applicable. This means all sectoral caps for FDI, pricing guidelines must be abided.

A company must report issuing convertible notes to non-residents via Form FLA to the Reserve Bank of India, within 30 days of such issue.

The amount must be INR 25 lacs or more in a single tranche.

Upon completion of ten years, or occurrence of specific events (as mentioned in the agreement) that lead to conversion of the Convertible Note, the debt portion, along with interest accrued must be converted into equity shares.

Documents required for before issuing Convertible Notes:
»Start-up registration certificate
»Certificate of Incorporation
»Copy of Memorandum of Association, Articles of Association, authorising the issue
»PAN
»Certificate of CS and Valuation Reports
»KYC, Escrow or NRE debit details, for non resident investors
»Agreement with investor for convertible note
»Requisite Board Meeting and Shareholder Meetings, and filing Form MGT14 within 30 days.
Convertible Notes - Challenges and Precautions
Here are some of the risks associated with convertible notes in India:

Uncertainty regarding conversion value : The terms of convertible notes may allow for conversion into equity at a future date or at a future funding round. As per the applicable Indian laws, the conversion price and terms are not fixed at the time of the initial investment. This may create a situation of uncertainty for both the startup and the investor. If the conversion price is not favourable for the investor, they may not convert their investment into equity, which could result in a loss for the startup.

Lack of liquidity for an investor: Convertible notes are a form of debt. While investors can transfer their debt investment until the note matures or is converted into equity, it is harder to find immediate buyers. This lack of liquidity could be a disadvantage for investors who may need to liquidate their investment quickly.

Dilution risk in future, at the time of conversion: Convertible notes may result in dilution for existing shareholders, including founders (who may own equity as promoters and founders) and employees (who may hold ESOPs). This dilution of shares happens typically in cases of lower valuation in subsequent funding rounds. As a result, the conversion of the notes into equity would result in the issuance of more shares, which dilutes the ownership of existing shareholders.

Loss to investor/holder of convertible note: If the startup is not able to raise additional capital or achieve a successful exit, the convertible notes may end up being converted into equity at a lower valuation than the investors anticipated.

Does not offer certain benefits available only to shareholders: Every shareholder, along with their equity acquires a certain bouquet of rights granted under the Companies Act, 2013. This includes voting rights, board representation, right to receive notices, examine books etc. A holder of a convertible note may not possess these rights, until formally agreed to or until conversion to equity is exercised.

Overall, convertible notes can be a useful tool for startups in India looking to raise funding quickly and easily. Compliance Calendar has assisted hundreds of startups and investors in evaluating risks, drafting convertible note agreements and end-to-end filing procedure. Connect with us to make sure all your convertible note compliances are taken care of.

Understanding Convertible Notes as an Investment in Startups

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