Issue of Convertible Notes by Startups Permitted

[The following guest post is contributed by Bhushan Shah & Neha Lakshman from
Mansukhlal Hiralal & Company. The views expressed in the post are personal]

A convertible note is an instrument issued as debt and convertible into equity
of a startup at the option of the holder, upon a future contingency taking
place, usually when the startup obtains an additional round of investments.
Therefore, convertible notes allow investors to invest in startups without
concerns about their valuations, which are difficult to determine at the
inception, as convertible notes are merely an instrument advanced as a loan and
converted to equity at a later stage when the startup’s business model is more
evolved.
In
July 2016, the Ministry of Corporate Affairs (MCA) amended the
Companies (Acceptance of Deposits) Rules, 2014 (Rules) exempting convertible notes from the ambit of deposits, and
thereby allowing companies to issue convertible notes in tranches exceeding Rs
25 lakhs to prospective investors, without having to comply with the slew of
requirements mandated by the Rules.
Now,
the Reserve Bank of India (RBI) has  by way of a notification dated
10 January 2017 (Notification),
amended the Foreign Exchange Management (Transfer or Issue of Security by a
Person Resident outside India) Regulations, 2000 (FEMA 20/2000),
implementing a key change in the foreign exchange policy by allowing startup
companies to issue convertible notes to foreign investors. This is a marked
change from the existing foreign exchange policy, where optionally convertible
debentures are considered External Commercial Borrowings (ECBs) and are required to comply with the more stringent ECB Guidelines.
Following
are the salient features of the Notification:
– Definition of convertible note: The notification defines a
convertible note as follows:
– An instrument issued by a startup
company evidencing receipt of money;
– This instrument is initially treated
as debt;
– It is convertible into such number
of equity shares of such startup company within a period 5 years from the date
of issue, upon occurrence of specified events, as per the other terms and
conditions agreed to and indicated in the instrument.
– Startup: This Notification is only applicable only to entities defined
as startups. Startup companies includes the following:
– A company wherein 5 years have not
elapsed from the date of its incorporation;
– Its turnover for any of those
years does not exceed Rs. 25 crores; and
– The company is working towards
innovation, development, deployment or commercialization of new products,
processes or services driven by technology or intellectual property.
Therefore, entities that fall outside this definition would
be unable to avail of the benefits of the Notification of being able to issue convertible
notes.
– Persons eligible to purchase convertible notes
– Individuals / Entities
resident outside India may purchase convertible notes issued by an Indian
startup, for an amount of Rs 25 lakhs or more in a single tranche. However, a
startup company engaged in a sector where foreign investment requires
Government approval can issue convertible notes to a non-resident only with
approval of the Government.
– Holders of the
convertible notes are allowed to transfer the same to third parties, provided,
such transfer complies with the pricing guidelines issued by the RBI.
– Non-Resident Indians
may acquire convertible notes on non-repatriation basis in accordance with the
applicable regulations under the Foreign Exchange Management Act, 1999.
– Persons barred from purchasing convertible notes: Citizens of Pakistan or
Bangladesh, or entities registered in/incorporated in these countries cannot
purchase convertible notes in Indian entities. 
– Other
formalities:
A startup company issuing convertible notes to a person
resident outside India shall receive the amount of consideration by inward
remittance through banking channels or by debit to NRE / FCNR (B) / Escrow
account maintained by the person concerned in accordance with the Foreign
Exchange Management (Deposit) Regulations, 2016, as amended from time to time.
The startup company issuing convertible notes shall be required to furnish
reports as prescribed by Reserve Bank.
Comment: As mentioned earlier, convertible debt has
been traditionally treated as ECBs and was required to comply with applicable ECB
Guidelines, which permit only specific companies to access this route of
financing from sources approved by the RBI as eligible non-resident entities, and
that too for specific permitted end uses. With the issue of convertible notes
being allowed, such convertible debt issued by startups shall now be considered
foreign direct investment, thereby allowing the emerging companies to access to
funds from foreign sources at a better valuation. However, this Notification is
likely to have limited impact in increasing overall foreign investments as it
is applicable only to specific types of entities.
– Bhushan Shah & Neha Lakshman

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • Will it be considered as a private allotment under the Companies Act, if so, should we follow the procedure prescribed under the Act?

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