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Issuance of Convertible Notes in India

‘Convertible Note’ in India is 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 ten years from the date of issue of the convertible note. The repayment or conversion is as per the other terms and conditions agreed to and indicated in the instrument or Agreement.

In India Convertible notes as an investment option was permitted for startup companies with effect from January 10, 2017.(FED-Master Direction No.11/2017-18 amended upto 17-Mar-2022). “An amount of twenty-five lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding ten years from the date of issue) in a single tranche, from a person, shall not be treated as Deposits”

So only a Start-up Company, recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can issue a Convertible Note.

Is your Company a Startup?

According to the DPIIT notification dated 19th February, 2019 (superseding the notification dated 11th April, 2018) an entity shall be considered a Start-up if it fulfills the following conditions:

If it is incorporated in India as a private limited company (as defined in the Companies Act, 2013) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) or registered as a partnership firm (registered under section 59 of the Partnership Act, 1932) for a period of 10 years from the date of Incorporation / registration

  1. Turnover of the entity has not exceeded INR 100 Crores for any of the FYs since incorporation / registration.

  2. It is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation. Notwithstanding the conditions mentioned above, if an entity is formed by splitting up or reconstruction of an existing business it shall not be considered a ‘Start-up’.

To whom can Convertible Notes be issued to:

Convertible notes can be issued only to:

  • Foreign investors

  • NRI

  • Resident Indians

  • Indian companies and Indian investors

The following steps need to be followed in case of issue of Convertible Notes to different types of Investors.

Issue of CN to Resident Indians, Indian Companies, and Indian Investors:

Issues of CN to a Non Resident:

Is Valuation Report Mandatory for Convertible Notes?

Convertible notes are the instruments through which the registered startups can raise money from the investors without the requirement of the valuation report. Valuation report is not required to issue the convertible notes. It is required only when the notes are converted into equity shares at the later date or when Convertible Notes are converted.

Procedure to Issue Convertible Notes:

Company can issue Convertible Note under the provision of Section 62(3) of the Act (i.e., raising money as convertible debt) by passing Special Resolution and accordingly file form MGT-14 with ROC within a period of 30 days.

Important points for consideration while issuing convertible Notes:

On completion of 10 years or upon occurrence of specified events as per the terms and conditions agreed to and indicated in the instrument or Convertible Note agreement, whichever is earlier, Company may convert the note into equity shares at the agreed conversion price

1. The Company is required to adhere with the terms and condition of conversion, if any, stipulated in the instrument or Convertible Note Agreement

2. File PAS 3 within 30 days of the allotment of equity shares upon conversion.

3. Include the name of the Holder as a shareholder in the register of members maintained by the Company and apply for stamping for shares within 30 days of issuance of share Certificate.

Exit for Investors is an important consideration. If future financing rounds are not completed, the investors may opt not to convert the notes into equity and the Convertible Notes will remain as debt and thus require redemption, potentially pushing still fragile companies into bankruptcy.

The objective of convertible notes is to allow startups issue convertible instruments without having to go through a lot of compliances. The procedure to issue convertible notes is simple and does not involve any filing.

An instrument like Convertible Note can definitely save the day as there are no statutory restrictions / limitations on the immediate utilization of funds. They are the most simple and flexible option for a startup to raise funds from angel investors. It is one way for Private Limited to take unsecured loan from person other than directors.

Early-stage startups struggle with limited traction, non-existing or limited revenues and difficulties with right company valuation which makes the negotiations with conventional lenders long-lasting and ineffective. In such a case, convertible note is a perfect solution, as it significantly accelerates the pace of closing a deal with investors and enables early-stage startups with no obvious valuation to obtain financing - often in a much cheaper and faster way than equity.

Convertible notes are a hybrid of equity and debt financing and as such are characterized by many of their advantages. This is also one of the reasons why they are quite common among early-stage startups. However, they may also have a serious impact on your business in the future – especially if things do not go as planned. Therefore, before deciding to use this financial instrument, make sure to understand all potential outcomes.

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Hemant Kothari
Hemant Kothari

Useful content. Funding is becoming a real challenge for growing economy. Banks have become stronger now and credit cycle has started, still lot of startups wouldnt qualify. Its good that CN is simplified and presented in lucid manner. Great going CS Sandhya.

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