India has the second largest startup ecosystem in the world. The startup-funding ecosystem has reached an all time high in 2019. It is undisputed, that along with innovation and talent, the right mode of funding is one of the most important determinants of a startup’s growth. Thus, for a startup, it is important to ask the right questions such as: what is the right source of funding, what is the right time for raising funds, and what are the right instruments for raising funds.
Historically, the convertible note instrument was introduced as a tool to facilitate investment from early-stage investors into startups. It is an attractive tool as it allows an investor to make an investment, initially in the form of debt, and grants such an investor, an option to convert such debt into equity at a later stage. It also helps avoid the hassle of arriving at a valuation of the startup at an early stage. Simply put, raising funds through convertible notes is faster and simpler.
The ease of executing a convertible note makes it ideal for raising quick bridge rounds (i.e. a short term funding to meet the business expenses until a larger, long term funding is secured). In mature startup jurisdictions like the Silicon Valley, Tel Aviv, and Singapore, a convertible note is the preferred instrument for raising seed funds.
In 2017, India introduced convertible note as a permitted instrument for making foreign investment into a recognized startup. The introduction of the convertible note instrument, was a measure that was taken by the government to promote ease of doing business in India. This move sought to attract foreign investments to promote entrepreneurship in the Indian startup ecosphere. Initially there were not too many takers of this instrument. Perhaps, because the structure of this instrument had not been tested in India before. However, lately, in practice we are observing a steady increase in interest in the convertible note instrument amongst foreign investors. Therefore, we decided to write an explanatory memorandum to facilitate the understanding of this instrument, and to encourage the growth of the startup ecosystem in India.
Consider the following example:
Company X, a startup company, wants to raise seed money for its business and values its startup at INR 10 crores.
Investor Y likes the idea of Company X’s business. However, Investor Y is skeptical of the valuation of Company X.
Investor Y is more comfortable in giving the funds to Company X as a loan, as that will yield a regular interest income and give the startup more time to prove that its valuation is realistic.
Investor Y makes an investment of INR 1 crore into Company X, as a loan against the issuance of a convertible note. One of the primary conditions attached to the convertible note is that upon Company X receiving further investment, Investor Y will have the option of converting the loan amount into equity shares of Company X, wherein Investor Y will receive a 20% discount on the future valuation of Company X.
2 years later, Company X proves its concept in the market and raises a second round of funding with a valuation of INR 20 crores. In this case, while the future investors will receive their equity shareholding in Company X at a valuation of INR 20 crores, Investor Y will receive its shareholding at a valuation of INR 16 crores (20% discount on INR 20 crores). Had Investor Y received its equity shareholding at the same valuation as the other investors in the second round of funding, the total shareholding for Investor Y would have come to 5 % (1 cr/20 cr x 100). Instead, since Investor Y invested early in the startup venture, as per the terms of the convertible note instrument, it will now receive 6.25 % (1 cr/16 cr x 100) shareholding in Company X. The additional 1.25 % shareholding is the benefit an investor gets as a result of investing in the startup under a convertible note instrument.
This is one of the common examples of how convertible notes are structured across various jurisdictions in the world. However, in the Indian context, there are certain conditions and regulations that need to be kept in mind while making an investment or receiving investment through a convertible note instrument.
For a legal entity, making, or receiving, foreign investment in India through equity and equity-linked instruments (such as a convertible note), the Foreign Exchange Management (Transfer or Issue of Securities to a Person Resident Outside India) Regulations, 2017 (“FEMA 20R”) is the most important legislation. It lays down rules and procedures that need to be complied with, in relation to foreign investment. According to FEMA 20R, a Convertible Note is defined 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”.
One of the most basic requirements to issue a convertible note to a foreign investor is that the investee company must be a startup, recognized as such, by the Department for Promotion of Industry and Internal Trade (DPIIT). The nature of the investment made under this instrument is initially that of debt. This debt amount is optionally convertible into equity shares at a later date, either upon maturity or upon any trigger event as decided between the foreign investor and the startup company. However, it is important to understand that the foreign investor has three options in relation to the investment amount:
- It can either recall the whole investment amount as debt, or
- It can exercise the option to convert the debt amount into equity shares of the investee company, or
- It can recall part amount as debt and the remaining balance can be converted into equity shares.
It is stipulated by law that either of these options must be exercised by the foreign investor, not later than 5 years from the date of issue of the convertible note (maturity date).
Conditions for issuance of a convertible note
The following are certain important conditions to be kept in mind while issuing a convertible note:
- Minimum investment amount: A person resident outside India 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. However, it is pertinent to note that an individual who is a citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh is not permitted to purchase convertible notes issued by an Indian startup company.
- Automatic/ Government route: A startup company, engaged in a sector where investment by a person resident outside India requires government approval, may issue convertible notes to a person resident outside India only with such approval.
- Conditions for conversion into equity shares: The issue of equity shares to a person resident outside India against a convertible note shall take place in accordance with the pricing guidelines, any sector specific conditions, government approvals (if required), and any other conditions as may be prescribed for foreign investment.
- Transfer of convertible note: A person resident outside India may acquire or transfer by way of sale, convertible notes, from or to, a person resident in or outside India. However, the transfer should take place in accordance with the pricing guidelines and subject to any approvals that may be required from the government.
Features of a Convertible Note
Element of Interest
A convertible note is issued initially as an instrument of debt, which is optionally convertible into equity shares upon the occurrence of certain predefined events. The debt amount typically carries an element of interest with it. The interest amount accrues on the outstanding debt amount, until it is repaid back.
Maturity date here means 5 years from the date of issue of the convertible note. The applicable law requires the investor to: (i) either exercise its right to convert the outstanding debt amount into equity shares; and/ or (ii) recall the outstanding debt amount; before the expiry of the maturity date.
- Conversion mechanism
The right of conversion is really the heart and soul of a convertible note instrument. The right of conversion can be exercised in order to convert the outstanding debt amount into certain number of equity shares of the startup company. The conversion of the convertible note may be effected upon certain trigger events. These trigger events typically translate into further rounds of raising finance by the startup (generally referred to as qualified financing), or achieving certain performance targets. The interesting thing to note here is that, the parties can be creative in constructing the terms of conversion of the outstanding debt amount. The right of conversion is where the investor can really reap the benefits of investing early in a startup venture. As stated above, in the Indian context, the issue of equity shares as against a convertible note has to be done in accordance with the pricing guidelines as laid down by the RBI. The pricing guidelines give a price floor for the price of conversion. Having said that, there is still a lot of room for an investor to have different conversion structures to exercise its right of conversion.
Subject to applicable laws, a few different types of conversion structures that could be explored have been listed below:
- Discount on valuation of the investee company at the time of conversion
- Valuation cap at the time of conversion
- Discount on the price of equity shares at the time of conversion
- Discount on purchase price offered to other investors on further rounds of financing
2. Conversion Price
FEMA 20R provides for the minimum price at which equity shares can be issued to a foreign investor. The issuance of equity shares against a convertible note instrument must be in compliance with the pricing guidelines as laid down by FEMA 20R.
The pricing guidelines stipulate that the price of the equity shares issued by a company to a foreign investor must not be less than the valuation of the equity shares done as per any internationally accepted pricing methodology for valuation, on an arm’s length basis, duly certified by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant (“Fair Market Value”). Thus, this sets a price floor for the purpose of arriving at the conversion price in case the foreign investor decides to exercise its right of conversion.
3. Exemption from the pricing guidelines
It is pertinent to note here, that if a foreign investor gets registered as a Foreign Venture Capital Investor (FVCI), then such an investor gets a benefit in the form of exemption from compliance with the pricing guidelines. This implies that there will be no price floor for the issuance of equity shares against the convertible note. The foreign investor may also exit at a price that is mutually agreed to by the foreign investor and a third party transferee.
- Good for seed funding
One of the major benefits with a convertible note instrument is that there is no hassle of arriving at a valuation at the time of issuance of the convertible note. This makes the convertible note instrument an attractive option for a seed round. At the seed funding stage, a startup is typically just an idea in the nascent stages of execution. Delaying valuation, while still raising funds, ensures that at a later date, there are more facts and information with the parties, in order to arrive at a more realistic and accurate valuation of the startup. This acts as a point of attraction for both the startup and the investor.
- Good for bridge funding
Sometimes, startups may need a bridge round in order to meet their immediate cash requirements. Startups generally would like to raise a bridge round without having to arrive at a valuation, because the bridge funding will help in increasing the valuation at a later date. Given the ease of executing a convertible note, it proves to be an attractive option for raising money between successive equity rounds.
Written by Pritika Kumar and Parmeet Batra
[Disclaimer: The article is a general guide to the subject matter. Please seek specific legal advice based on the facts and circumstances of your case.]
[For more information on structuring a convertible note instrument, you could contact us.]
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