Brief Note on compliance w.r.t issuance of Convertible Note

India is gradually on its mission to build a robust startup ecosystem. In order to promote and support startups, the government has formed a ministry (department) dedicated to helping new businesses. Furthermore, the Central Government of India has also introduced many schemes to bolster entrepreneurship in India and to assist emerging startups financially with their innovative initiatives.

One of the significant steps taken by the Government was the introduction of convertible notes under the Companies Act, 2013, specifically for start-ups. The Term Convertible Note (CN) was first introduced by the Ministry of Corporate Affairs (MCA) vide Notification dated 29^th June 2016, which amended the Rule 2 of The Companies (Acceptance of Deposits) Rules, 2014  wherein an amount of INR 25 Lakh or more received by a Start-up Company by way of Convertible Note was from thereon treated as an exempted deposit:

“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 five (now ten years) years from the date of issue) in a single tranche, from a person, shall not be treated as Deposits”

Further, Reserve Bank of India has also amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2016 vide Notification No. FEMA.377/2016-RB. to introduce the concept of convertible notes as an investment option for startup companies with effect from January 10, 2017.

A. What is Convertible Note?

1. Companies Act, 2013

According to Rule 2, in sub rule (1), in clause ©, in sub-clause (xvii) of The Companies (Acceptance of Deposits) Rules, 2014:

“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”

Explanation II – For the purposes of this sub-clause-

“Convertible note” means 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

Apart from above provision, there is no other provision in the Act which talks specifically about issuance of convertible note.

2.Foreign Exchange Management Act, 1999

‘Convertible Note’ 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 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.

B. Who can issue Convertible Notes?

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

The term ‘start-up’ or “start-up company” means a private company incorporated under the Companies Act, 2013 (18 of 2013) or the Companies Act, 1956 (1 of 1956) and recognized as start-up in accordance with the notification issued by the Department of industrial Policy and Promotion, Ministry of Commerce and Industry”

An entity shall be considered as a Startup as per DPIIT notification dated 19th February, 2019 (superseding the notification dated 11th April, 2018), as below:

• Should be Private Company or Limited Liability Partnership or Partnership Firm. However, it does include a Private Company which is a subsidiary of a Public Company. Further, Entity should not have been formed by splitting up or reconstructing an already existing business.
• Up to a period of ten years from the date of incorporation/ registration
• Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
• 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.

Point to be noted: An entity shall cease to be a Startup on completion of ten years from the date of its incorporation/ registration or if its turnover for any previous year exceeds one hundred crore rupees.

 C. What is the procedure for issuance of Convertible Notes?

1. to a resident person

2. to a person resident outside India

1. Companies Act, 2013

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.

a. Brief steps for issuance of Convertible Note to a resident person

1. Spot an Investor(entity/individual)

2. Finalize the Terms of Convertible Note agreement and procure Valuation Report

3. Convene a Board Meeting for approval of below:

• •  Execution of Convertible Note agreement
  •   Issuance of Convertible Note
  •   Check your articles, if alteration required
  •   Notice of General Meeting

4. Convene a Shareholder Meeting for approval of below:

• • Issuance of Convertible Note
  • Alteration of Articles, if required

5. File E form MGT14 within 30 days of passing the shareholders resolution

6. Issuance of Convertible Note Instrument.

There are no specific timelines as per Act. However, the Company can issue the Note as per the agreed Terms and Conditions in the Convertible Note Agreement

b.Conversion of Convertible Note

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.

2. Foreign Exchange Management Act, 1999

For issuing convertible notes, to a person resident outside India, the following FEMA laws shall be applicable in addition to other laws:

• Foreign Exchange Management Act, 1999;
• Foreign Exchange Management (Non-debt Instruments) Rules, 2019;
• Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019

RBI guidelines for an Indian startup company for the issuance of convertible notes:

1. A person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), is permitted to invest in convertible notes issued by an Indian startup company for an amount of twenty-five lakh rupees or more in a single tranche.

2. A startup company, engaged in a sector where investment by a person resident outside India requires Government approval, can issue convertible notes to a person resident outside India only with such approval. Further, issue of equity shares against such convertible notes shall be in compliance with the entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment.

3. A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance 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. The escrow account maintained for this purpose should be closed immediately after the requirements are completed or within a period of six months, whichever is earlier. Such an escrow account shall not be permitted to continue beyond a period of six months.

4. 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.

5. A NRI or an OCI may acquire convertible notes on non-repatriation basis.

6. 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, provided the transfer takes place in accordance with the entry routes and pricing guidelines as prescribed for capital instruments.

7. The convertible note may either be converted to equity shares or repaid within 5 years from the date of the issue at the option of the holder.

Reporting Requirements

1. The Indian startup company issuing Convertible Notes to a person resident outside India shall file Form CN within 30 days of such issue.

2. A person resident in India, who may be a transferor or transferee of Convertible Notes issued by an Indian startup company shall report such transfers to or from a person resident outside India, within 30 days of such transfer.

3. An Indian company which has received FDI shall submit Form FLA to Reserve Bank on or before 15th day of July of each year.

4. The price/ conversion formula of the instrument is required to be determined upfront at the time of issue of the instrument. The price at the time of conversion should not, in any case, be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the FEMA regulations.

5. Following documents are required for reporting of CN –

• • FIRC (if the investment is received by remittance through banking channels)/ Debit advice (if the investment is received by way of debit to NRE / FCNR / Escrow account) and KYC of the non-resident investor.
  • The details like name and address of the investor and AD bank.
  • Declaration and CS Certificate
  • Copy of MOA / AOA in case of Body Corporate
  • Certificate of Incorporation.
  • Start-up Registration Certificate.
  • PAN of the Company.
  • Valuation Report (issued by SEBI registered Merchant Banker / Chartered Accountant / Cost Accountant)

6.Upon Conversion of Convertible Note to Equity Shares, Form FCGPR shall be filed within 30 days from date of allotment of equity shares upon conversion.

In short, convertible notes are originally structured as debt investments but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This allows the original investment to get done more quickly with lower legal fees for the company at the time, but ultimately gives the investors the economic exposure of an equity investment.