CONVERTIBLE NOTES
In India, in the recent years, there has been a huge start up growth. More people especially the youngsters come up with innovative ideas to start a business. There are many young people who have the potential and capability to initiate their own startup. Everyone is aware of the fact that one of the basic requirements to start a business is raising funds. The main question arises here is HOW TO RAISE FUNDS?
In most cases, one cannot however self-fund the whole amount required for the business so a person takes help from family and friends. But sometimes the amount requirement is so huge that even family and friends cannot come up with the fund needs. A person can also approach to banks for loans as bank can provide higher amount of money comparatively. But the major drawback is that, more is the loan amount more will be the interest to be paid and sometimes it becomes very difficult for a person to pay the principal loan amount with interest. Even if a person does all these things the short term fund requirements are full filed but what about long term requirement of funds? As a business works efficiently only when there is a continuous flow of funds.
Also, there are some restrictions and prohibitions imposed on a private company under The Companies Act, 2013. The shares of a private company are not freely transferable and only members of a private company can purchase its own shares. So if a person wants to invest in a private company by issuance of shares, he can only do after becoming a member of the company and after complying with all the membership procedure which becomes very tedious.
Due to lack of facilities and opportunities, Government of India initiated Startup India intending to build a strong eco-system for nurturing innovation and Startups in the country that will drive sustainable economic growth and generate large scale employment opportunities. The Government through this initiative aims to empower Startups to grow through innovation and design. One of the important feature of this policy has been to boost fund-raising options for startups by permitting startups to raise funds through issuance of convertible notes.
“Startup” means an entity, incorporated or registered in India not prior to Ten years, with annual turnover not exceeding INR 100 crore in any preceding financial year, working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.
However to enjoy the advantages of the scheme provided by the Government of India, the startup shall meet certain eligibility criteria.
A convertible note is a debt instrument which is repayable at the option of the holder, or which is converted into equity shares upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument. The definition of a ‘convertible note’ first came in through a notification dated 29 June 2016 that amended the Companies (Acceptance of Deposits) Rules, 2014 (the “Rules”).
A convertible note can be issued by only recognized start-ups. Recognized “Start-up company” means a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognized as such in accordance with notification number G.S.R. 180(E) dated 17th February, 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry.
It is to be noted that the advantage is available only for recognized start-ups, which means that non-recognized start-ups are still not allowed to issue Convertible Notes as a capital instrument under the RBI Regulation or as a non-deposit under the Rules. Convertible notes can be issued to only NRIs.
Convertible notes:
Convertible notes are a hybrid of debt and equity. 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.
Points to remember:
- A person who is resident outside India (other than an individual who is a citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), can purchase Convertible Notes issued by a recognised start-up company.
- The minimum amount of investment required for a convertible note is Rupees Twenty Five Lakhs in a single tranche.
- The company is required to issue shares or repay the debt, as the case may be, within a period not exceeding five years from the date of issue of the convertible note.
- NRIs may acquire Convertible Notes on non-repatriation basis in accordance with Schedule 4 of the RBI Regulation.
- If the start-up is engaged in a sector which requires government approval for foreign investment, Convertible Notes shall be issued only with prior approval of the government.
- Convertible notes are freely transferable and can be acquired/transferred by way of sale, provided the sale is in accordance with the pricing guidelines prescribed by the RBI.
- The amount of consideration should be received by inward remittance through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained by the person concerned.
- Compliance with the reporting requirements prescribed by the RBI is also required.
Under The Companies Act, 2013
The procedure to issue Convertible note is: –
- Pass a resolution in board meeting to issue CN
- Pass a special resolution
- File MGT -14
- Prepare convertible notes agreement
- Issue offer letter and agreement to investors
- File Form CN with RBI once funds received ( through Authorised Dealer Bank within 30 days)
The documents required for reporting to RBI are: –
- FIRC (Foreign Inward Remittance Certificate) and KYC of the non-resident investor.
- Name and address of the investor and Authorised Dealer bank.
- Copy of MOA / AOA
- Certificate of Incorporation
- Startup Registration Certificate
- Certificate from Practicing Company Secretary
Under Foreign Exchange Management Act, 1999
Foreign Exchange Management (Non-debt Instruments) Rules, 2019.
“Convertible Note” means an instrument issued by a startup company acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding five years from the date of the issue of the convertible note, upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument
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.
Purchase or sale of convertible notes of a LLP.
A Non-resident Indian (NRI) or an Overseas Citizen of India (OCI), including a company, a trust and a partnership
firm incorporated outside India and owned and controlled by NRIs or OCIs, may purchase or contribute, as the case may
be, on non-repatriation basis, convertible notes issued by a startup company in accordance with the rules.
Discount during conversion: When the convertible note turn into equity on the date of maturity or in any other event, the holder gets the benefit to buy the shares at a discounted price per share of the new equity. For example: – if A holds a convertible note, he will be issued 100 shares of 100INR each for 80INR per share if the discount is 20%.
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