Convertible Notes:- Understanding Convertible Notes: A Comprehensive Guide for Investors and Startups
Introduction
For any early-stage startup, the valuation is a major issue that can hinder the process of raising funds from investors. Convertible notes can be a great instrument for early-stage startups to raise funds without determining the valuation of the company.
Convertible Notes
As per Rule 2 of the Companies (Acceptance of Deposits) Rules, 2014, Convertible Notes 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.
In simple words Convertible notes are a type of financial instrument that is commonly used by early-stage startups to raise funding from investors. They are a hybrid security that combines elements of debt and equity, offering investors the option to convert their debt investment into equity shares at a later date, usually at a discount to the valuation of the company.
Startup Company
“start-up company” means a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognised as such in accordance with notification number 16[ G.S.R. 127 (E), dated the 19th February, 2019 issued by the Department for Promotion of Industry and Internal Trade];
Pre-Condition for Issuing Convertible Notes
- Only startups registered with the Department for Promotion of Industry and Internal Trade can issue convertible notes; otherwise, it will be considered as deposits under section 73 of the Companies Act, 2013.
- The amount to be raised should be 25lac or More is single tranches
- As per Amendment Notification Dated 07th September, 2020. Companies (Acceptance of Deposits) Amendment Rules, 2020 Convertible note is required to be converted into equity or repayble within a period of 10 years from the date of issue.
- As per Section 62(3) of the Companies Act, 2013 Shareholders Approval by way of Special Resolution is required for issuance of Convertible Notes
How the Concept of Convertible Notes work ?
When an early-stage startup is looking for funds, the startup does not have a valuation of the company or any revenue, making it very difficult to decide the real value of the company.
Convertible notes can be used Instrument in form of debt, which is issued to an investor at a fixed rate of interest and which will be convertible into equity shares of the company at a later stage valuation.
Investor gets more equity at discounted valuation of the Company.
How Discounted Valuation work??
For example Mr. A investing Invest 1Cr in Convertible notes at 20% discounted valuation and at the time of Conversion the valuation of company is 10Cr. and Mr B Investing in Equity shares 1 Cr in Financing Round.
Let’s see How the convertible Notes Investor get Benefits of discounting:
| Mr. A Convertible Notes Investor | Mr. B |
| Investment Amount = 1Cr | Investment Amount = 1Cr |
| Valuation = 10Cr | Valuation = 10Cr |
| Discounted rate = 20% | Discounted rate = 20% |
| Equity = Investment Amount/Valuation- Discount | Equity = Investment Amount/Valuation- Discount |
| 1cr/10cr-20% = 12.5% | 1cr/10cr = 10% |
| Investor will get 12.5 % of Equity Shares at the time of Financing Round | Investor will get 10 % of Equity Shares at the time of Financing Round |
Here Mr. A is getting more equity at discounting because he take the risk at the time when there was no worth of company.
Notes:- Interest on Convertible notes can also be convertible on Equity shares
Benefits of Startups for raising funds by way of Convertible notes :-
- Flexibility: Convertible notes offer a high degree of flexibility for both startups and investors. They provide a way for startups to raise funds without having to determine the valuation of the company.
- Raise Quickly Fund:- Startups get early money without following the lengthy procedure of funding rounds.
- Low upfront cost :- The Cost and time of raising of Convertible notes is less then issuance of CCPS or CCDs as Its don’t require the startup to issue new shares of stock, which can be expensive and time-consuming. Further no Valuation Report is required for issuance of Convertible notes.
- Reduced dilution: By raising funds through convertible notes, startups can delay the issuance of equity until a later date. This can help to reduce dilution for existing shareholders, including founders, early employees, and other investors.
- Attractive Term:- Convertible notes often come with attractive terms for investors, such as a discount on the future valuation of the company or the ability to convert their investment into equity at a lower price than later investors.
In summary, convertible notes can provide startups with a flexible, low-cost, and efficient way to raise funds while minimizing dilution and attracting investors with attractive terms.
Benefits of Investors for investing into Convertible notes :-
- Potential for high returns: Convertible notes typically offer a higher potential return on investment than traditional debt instruments. This is because investors have the option to convert their investment into equity at a later date at discounting rate.
- Valuation:- Investor get equity shares at later stage valuation which help to get shares at true valuation of Company
- Less Risky: – Convertible Notes is kind of debt if startup fail to raise additional funds or dose not achieved the decided valuation the convertible note may convert into equity at a lower valuation or may be repaid with interest.
- Attractive terms: Convertible notes often come with attractive terms for investors, such as a discount on the future valuation of the company or the ability to convert their investment into equity at a lower price than later investors.
- Support for startups: By investing in convertible notes, investors are providing support for startups and helping to drive innovation and economic growth.
Convertible Notes vs Debentures
Issuance of Convertible Notes is easy process then Issuance of Debentures as it required less time less Compliances and Less legal Fee in same time the cons of Convertible notes is that it can only issued by Startups Companies for maximum 10 year period and Minimum investment amount is 25Lac on other hand Debentures doesn’t have those restriction
Convertible Notes vs Safe Notes
Convertible notes convert into equity at a future date or event, such as a qualified financing round or an initial public offering (IPO), while SAFE notes convert into equity at a future financing round or event, but not necessarily at a fixed valuation. The terms of Convertible notes is pre decided.
Notes :- In India Safe Notes is not legally Considered however Safe notes can be issued in form of CCPS or CCDs.
Treatment of Convertible Notes under Various Laws
Companies Act, 2013
- Section 62(3) :- A Company may Issue Convertible Notes by passing Special Resolution in General Meeting and Term and Condition for Conversion should be approved by the shareholders.
- Section 73 read with Rules 2 of Companies (Acceptance of Deposits) Rule 2014:- Convertible Notes should not be considered as Deposits if such CNs is issued by the Startup Company with minimum investment of 25 Lac.
Foreign Exchange Management Act, 1999
Foreign Exchange Management (Non-debt Instruments) Rules 2019
- A person resident outside India (other than an individual who is a citizen of, or an entity registered / incorporated in, Pakistan or Bangladesh), may purchase convertible notes issued by startups for an amount of Rs. 25,00,000 or more in a single tranche
- Startups engaged in a sector where foreign investment requires Government approval may issue convertible notes to a non-resident only with Government approval;
- Startups issuing convertible notes to a non-resident must receive the consideration by inward remittance through banking channels or by debit to the NRE / FCNR (B) / escrow account maintained as per the Foreign Exchange Management (Deposit) Regulations, 2016.
- Company shall file Form CN with RBI with in 30 days from the receiving of remittance
Income Tax Act, 1961
Convertible Notes being debt initially, there are no tax implication at the time of issuance of Convertible notes however at the time of Conversion
However, conversion price of such instruments shall have to be at fair market value. In case if the conversion price is above the fair market value, then the difference between the conversion price and fair market value may be taxable in the hands of the company under section 56 (2) (viib) of the Income Tax Act, 1961.
If the conversion price is lower than fair market value, the difference between the conversion price and fair market value may be taxable in the hands of holder of convertible note under section 56 (2) (x) of the Income Tax Act, 1961.
Process of Issuance of Convertible Notes
Step-1 :- Convene Board Meeting for issuance of Convertible notes and decide the term & Condition and take Board Approval.
Step-2 :- Convene General Meeting for issuance of Convertible notes and decide the term & Condition and obtain shareholders’ Approval by way of special resolution.
Step:-3 Incorporate the Term and Condition in Convertible notes Agreement duly stamped and Notarised
Step-4:- File e-form MGT-14 with Registrar of the Company with in 30 days from passing of Special Resolution
Step-5:- Receipt Investment amount from investor and take note the same and issue Convertible Notes Certificates
Step-6 :- In case of Investment received from outside india file Form CN with RBI with in 30 Days from receipt of funds.
Process of Conversion of Convertible Notes into Equity Shares
Step-1 :- Convene Board Meeting for Conversion of Convertible notes and take Board Approval.
Step-2 :- File e-form PAS-3 for allotments of Equity shares with is 30 days from Allotment
Step-3 Issue Share certificates with in 60 days from the date of allotment of securities
Step-4 :- Complete Stamping of Share certificates with in 30 days from the date of issuance of share certificates
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