“Dive into the world of startup financing with insights on convertible notes and SAFEs – the emerging trend in India and abroad. Discover their significance for startups and investors, their role in fundraising, and key considerations for choosing between convertible notes and priced equity. For expert guidance on implementing convertible notes, contact CS Kanchan Gupta, Corporate Lawyer, and Company Secretary.”
In today’s startup world, convertible notes and SAFEs (Simple Agreements for Future Equity) have emerged as trending financial instruments in India and abroad, respectively. Convertible Notes and SAFEs are gaining popularity as a straightforward and expedient method of raising capital with minimal conditions and restrictions.
As an investor or a startup, you might have considered these financial instruments as a means to assure the maintenance or increment of shareholding in a startup ahead of the next financing round.
During their initial stages, startups often look to raise funds from angel investors for various reasons:
1. Startups often provide discounts to angel investors who show faith in their business plans, aiding in fulfilling working capital requirements and promoting company growth.
2. Using these financial instruments can speed up the fundraising process while keeping noteholders away from any effective control.
3. They can strategically increase a company’s valuation by utilizing the funds effectively, generating more traction and revenue.
4. They can serve as a bridge for the company until the next financing round, without necessarily setting a valuation.
Furthermore, angel investors are prepared to invest in Convertible Note (CN) Rounds for reasons such as:
i. To act quickly ahead of investors competing for equity, thereby retaining or increasing their shareholding.
ii. In ‘bridge round’ scenarios where a startup shows promise but hasn’t achieved product-market fit yet, these financial instruments provide more time to attract the next round of investors.
One common question from startup founders is whether they should raise investment through convertible notes, priced equity, or SAFE notes. The brief answer is that while one can raise investment through a SAFE note overseas or a convertible note in India, certain restrictions might apply in India when raising funds through convertible notes.
1. In India, the minimum investment required for a convertible note is twenty-five lakhs Rupees in a single tranche. However, there are typically no such restrictions in overseas countries.
2. Under the regulatory framework, convertible notes in India are mandated to be converted into equity shares, which removes the liquidation preference right from the note holder.
Let’s delve into how convertible notes work:
1. A convertible note is simpler than a priced equity round mainly because it postpones the need to agree on a pre-money valuation of the company before investment. Rather than offering shares, the startup offers a convertible note, which is essentially a loan to the company.
2. This loan has a fixed term, along with an interest rate that accumulates over the term. The interest rate can be negotiated depending on the amount the investors are willing to invest and the company’s need for investment.
3. At the end of the term, investors can choose whether to take back their principal plus interest, or to have the loan converted into company shares. The convertible note usually contains terms specifying instances in which the loan automatically converts to shares, such as the completion of a priced equity round or the sale of the company.
The concept of a valuation cap and discounting also play a significant role in the functioning of convertible notes. While the former protects the investor against receiving only a small ownership amount due to high future valuations, the latter offers investors a discount on the conversion from debt to equity to compensate for the risk associated with investing in a startup.
By opting for these financial instruments, you eliminate the need to negotiate a pre-money valuation, and the paperwork is typically shorter, making the process cost-effective. Additionally, there’s no strict need to agree on the size of the round.
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Author – CS Kanchan Gupta, Corporate Lawyer and Company Secretary
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