Govt. of India issued Consolidated FDI Policy in 2017. The thrust of the policy is to make India an attractive investment destination for foreign investors. A key feature of these policy announcements has been to boost fundraising options for home-grown startups by permitting startups to raise funds through issuance of Convertible Notes which was earlier not allowed. Convertible Notes are extremely popular investment instrument in advanced startup ecosystems such as Silicon Valley, Tel Aviv, Singapore etc.
What is Convertible Notes?
Convertible notes are debt instruments that are convertible into equity at the option of the holder or upon specific trigger events, most typically the company’s next equity fund-raising round. Under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, a convertible note issued by a qualifying startup to a non-resident investor is initially a debt instrument that may, at the option of the note holder, either be repaid or converted into equity within five years from issuance. Such notes also have the advantage of being redeemable at maturity if the startup fails to perform as expected.
What is the situation in India prior to January, 2017?
In India, issuing Convertible Notes (CN) to foreign investors was earlier forbidden since the Reserve Bank of India (RBI) allowed Foreign Direct Investment (FDI) permitted only in equity instruments and instruments that are compulsory convertible into equity shares like Compulsorily Convertible Preference Shares (CCPS) or Compulsorily Convertible Debentures (CCD). All other instruments, including those that are optionally convertible into equity, are treated as debt and have to comply with the External Commercial Borrowings (ECB). Before the new F.D.I policy, it was difficult for startups to raise funds from foreign investors, who are habituated to investing in startups through a convertible note issuance. In addition to that, such notes were not allowed to be issued because they would be considered as ‘Deposits’ under the Companies Act, 2013 and the Companies (Acceptance of Deposits) Rules, 2014.
R.B.I January, 2017 Notification
In one of many steps being taken for Ease of Doing Business (EODB) and promote F.D.I in start-ups, the R.B.I has permitted “recognized startups” to raise funding through the convertible note route. The RBI has amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, w.e.f January 10, 2017, to allow “recognized startups” to issue convertible notes to foreign investors.
Unlike other FDI instruments, like Equity Shares or CCPS, pricing guidelines need not to be complied with at the time of issuance of a convertible note. However, the conversion of the convertible note into equity as well as the transfer from a non-resident to a resident investor must be in accordance with the pricing guidelines. The price of shares issued upon conversion must be at or above fair market value, determined by a certified chartered accountant or merchant banker.
How Convertible Note works?
Mr. Dhaval Gusani has just started his start-up providing corporate law & start-up consultancy services. People of India still prefer to take law advisory from his local consultants. His product and business model is not very much popular in India and is undergoing changes along with his technology. However, due to quality services at lower cost, entrepreneurs and businessman now slowly and gradually prefer his services.
After some time, some angel investors from abroad shown interest in his start-up but they find valuing his company tough as revenue is not reached at break-even point and may be they are not much sure about the success of start-up so they prefer to wait and watch how startup performs without taking immediate equity exposure. They want to fund in the form of debt where the debt should get converted into equity shares before the next round of funding at some discount so that they get to benefit as early investors. So, what we did is as follows:
Company (Dhaval Gusani’s Start-up) is looking to raise Rs. 1 crore at a valuation of Rs 10 Crore (Founder’s value). The potential investors do not understand the basis of this valuation since the company is still trying to stabilize its business model so they decided that Company will issue Rs. 1 crore convertible notes to the investors with a condition that this money shall be converted into equity at a 20% discount to the next round of funding, which ought to take place within 24 months. If Company is unable to raise the money, it has to return the notes along with interest at 10% immediately upon the expiry of the 24th month or any other time that the investors demand.
1 year later, Company raises Series A funding Rs. 10 crore at a valuation of Rs. 30 crore. Now, the first investors will get to convert their investment of Rs. 1 crore at a valuation of Rs. 24 Crores (20% discount to the Rs 30 crore valuation). In other words, the first investors will get more shares for their money and get compensated for investing early in Company.
Conditions to issue Convertible Notes by Recognized Start-up
India estimated to house the third-highest number of tech startups in the world after the United States and England. This policy relaxation will help innovative startups raise seed capital in their initial (but critical) phase and explore funding opportunities with both domestic and foreign investors. While the pricing guidelines still act as a hamper with the restrictions on price of such instruments to be determined at fair market value, it is hoped that the RBI proactively exempts issuance of convertible notes by startups from the pricing guidelines for it to bring about the desired impact.
The author of this article is founder of DVG & Associates, Corporate Law & Start-up consultancy based at Mumbai. He can be reached at firstname.lastname@example.org