Convertible Note is introduced firstly by RBI and considered as a very welcoming option provided to early stage startups to raise funds by way of convertible notes which is prima facie a debt instrument with conversion terms.
Under FEMA and Rule 2(1)(c)(xvii) of Companies (Acceptance of Deposit) Rules, 2014, convertible note is been defined as follows:
”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.
So, it is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor is giving money as loan to a startup and instead of a return in the form of principal plus interest, the investor receives equity in the company.
The primary advantage of issuing convertible notes is that it does not force the issuing company and investors to determine the value of the company when there really might not be much to base a valuation on – in some cases the company may just be an idea. That valuation will usually be determined during the Series A financing, when there are more data points off which to base a valuation.
There are two pre-condition to issue Convertible Notes-
1. Company must be recognised as “Startup” by DPIIT
2. Investment amount per investor should not be less than Rs. 25 lakh in a single tranche.
Procedural Aspect and Challenges:
To issue any instrument by a company in India, provisions under Companies Act, 2013 (the Act) shall apply.
Under the Act, Convertible note was introduced as exempted deposit under Rule 2(1)(c)(xvii) of Companies (Acceptance of Deposit) Rules. Apart from above provision, there is no other provision in the Act which talks about issuance of convertible note.
There is a section 42 (private placement) under the Act where Company can issue share or securities but if convertible note is issued under section 42, it asks to provide the details of Valuer who performed the valuation and basis for the price [ref. Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014]
Also, exemption from valuation in convertible notes option is given by RBI under FEMA regulation however there is no such exemption under the Companies Act till date.
Companies are issuing Convertible Notes under the provision of Section 42 (i.e. Private placement) but they all are ignoring a mandatory provision under the aforementioned rule where they are required to disclose the name and address of Valuer who performed the valuation and the basis/justification for the price.
Further U/s 42, if company issue any securities/shares, it is required to submit a form PAS-3 for allotment of such securities. But, in case of issuance of Convertible Notes, form PAS-3 cannot be filed as there is no such option given in the form.
In view of above, it can be said that Convertible Notes shall not be issued u/s 42 of the Act otherwise it will be a violation of the rule 14 made there-under or else the company will have to obtain valuation report which make no sense to raise money through 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 form MGT-14 should be filed with ROC within a period of 30 days.
Also the company if raising money from foreign investors by way of convertible note, it must ensure the compliances to be done under FEMA regulations within 30 days of receipt of funds.
(Submitted by – CS Akash Goel; Mobile: +91-995-367-2781; Email-ID: firstname.lastname@example.org)
Disclaimer – This article is for the purpose of information and shall not be treated as solicitation in any manner and for any other purpose whatsoever. It shall not be treated as legal opinion and not to be used for rendering any professional advice.