What are Convertible Notes?
Convertible Notes is a type of financial instrument which contains an option of conversion into equity on a future date. This means that the holder of the convertible note has the option to exchange the note for a specified number of equity shares of the company. These notes are often used by early-stage companies which allows them to raise capital without having the need to immediately value their company, which can be difficult to do when the company is in its early stages.
Initially, convertible note holder subscribes to a note at a fixed rate of interest. When the funds are raised in the future through a funding round, the principal amount along with interest will get converted into equity shares.
Convertible Notes have a maximum validity period of 5 years.
General Terms:
Conversion Price: This is the price at which the note gets converted into equity shares.
Valuation Cap: This refers to maximum valuation of the company at which the investor will receive the shares on conversion. This clause works in favour of the investor by ensuring that they do not pay more than a certain price per share when converting their notes into equity shares.
Valuation Floor : This refers to minimum valuation of the company at which the investor will receive the shares on conversion. This clause works in favour of the company by ensuring that the investors do not pay less than a certain price per share when converting their notes into equity shares.
Discount Rate : This refers to the discounted price at which the note holder will receive the equity shares at the time of conversion when funds are raised by the company in the future.
A draft Convertible Note Agreement can be viewed using this hyperlink
Eligibility:
The following pre conditions need to be fulfilled in order to issue and raise funds through a convertible note in India:
1. The Company should be recognized as a startup by the Department for Promotion of Industry and Internal Trade (DPIIT) and have a registered startup certificate accordingly.
2. The minimum amount of investment required to be made through convertible notes is INR 25 Lakhs in a single tranche.
Comparison between Convertible Debt & Compulsorily Convertible Debentures (CCD’s)
Compulsorily Convertible Debentures ( CCD’S) are another popular form of debt instruments for fund raising.
The major differences between convertible notes and CCD’S are as under:
| Convertible Notes | Compulsorily Convertible Debentures (CCD) |
| Convertible notes can be converted into equity shares at the note holder’s option and discretion | CCD’s are compulsorily convertible into equity or preference shares at a given date as per the agreement |
| The Minimum amount of Investment required is Rs 25 lakhs. | CCD’S can be issued at any amount. There is no minimum amount criteria. |
| Convertible Notes can be issued without prior valuation. | Valuation Report is required to issue CCD’S, if conversion ratio is pre -determined |
| The company raising funds should be recognized as a Startup Company by the government. | The company raising funds can be any type of private limited company. |
Pros & Cons of Convertible Notes
| Pros of Convertible Notes | Cons of Convertible Notes |
| Convertible Notes can be issued without doing the valuation exercise | Convertible Note Holders may not see a return on their investment if the company does not reach the conversion price |
| Good Option for Companies who are not ready to give up equity stake but are in need of funds | Convertible Note Holders have no say in the decision making process until conversion |
| Tax Implications of Equity Instruments can be avoided until the conversion | Conflict among parties if the convertible note agreement is too complex |
| Note Holders normally get higher number of shares as compared to outside investors at conversion. | Too much debt gets reflected in books if the period of conversion is too long |
Conclusion:
Convertible Notes provide investors with the opportunity to participate in the growth of a company and offer a degree of flexibility for both the company and the investors. Even the pre and post filing compliance procedures are considerably easy and simple. However, they also carry some risks, and companies and investors should carefully consider the potential downsides before using convertible notes.
Authors:
Varsha Dhake | Manager | +917039178008 | varsha.dhake@masd.co.in
Anuj Pai | Associate Consultant | +918291090833 | anuj.pai@masd.co.in
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