Raising of funds by issuance of Compulsorily Convertible Debentures (“CCD”), also known as convertible notes in common parlance, is one of the ways that start-ups can raise money during the early stages of investments and bridge round investments. Primarily because of the flexibility that such an instrument offers with respect to conversion into shares, at a later point of time, without having to fix a valuation of the investee company straight away.
Debenture, as defined under the Companies Act, 2013 (the “Act”), means any instrument of a company evidencing debt, whether constituting a charge on the assets of the company or not. Further, the Act empowers a company to issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of redemption. Under the Reserve Bank of India (“RBI”) guidelines, CCD is considered as equity for all the reporting purposes and under financial statements, till the time CCDs are converted into equity they are not considered as part of the share capital of a company.
Following is a broad overview of some of the important factors to be taken into consideration before choosing CCDs as the instrument for raising funds by a private limited company:-
Pricing and Discount
- Generally at a discount to the valuation of the next round of investment, since an investor is investing prior to arriving at the valuation through institutional investors and at very early stages;
- Discount rates may either be flat or staggered, varying over a period of time, typically in the range of 6 to 18 months;
- If the next round of investment is not obtained during the timelines specified, then the CCD has to compulsorily convert within a period of 5 years (for Indian residents) and within 20 years (for non-Indian residents) at a floor-value, which has to be determined by the parties at the time of entering into the transaction.
- As per RBI pricing guidelines, investment has to be subject to minimum lock-in period of one year or sector specific minimum lock-in period as prescribed under FDI Regulations, whichever is higher. The lock-in period shall be effective from the date of allotment of CCDs or as prescribed for any particular sector under FDI Regulations;
- Pricing has to be worked out as per any internationally accepted pricing methodology on arm’s length basis;
- After the lock-in period, the non-resident investor can be eligible to exit without any guarantee on any assured exit price in equity shares of the investee company;
- Disclosure for the financial year, in which the transaction took place, is required in the balance sheet of the investee company, with the details of valuation of CCDs, the pricing methodology adopted for the same as well as the agency that has given/certified the valuation (necessarily a chartered accountant in practice for 10 or more years);
- Upon investment, the allotment details, pricing, valuation certificate have to be intimated to RBI within 30 days of allotment.
- To accrue upon conversion of CCDs into shares in the capital of the investee company;
- From the investor’s perspective, same rights shall be available as offered by the investee company to the next round of investors, provided the next round happens within a pre-determined time period. If not, detailed rights may be discussed and negotiated upon expiry of the pre-determined time period.
- The Companies Act 2013 requires that securities shall be issued through private placement process by issuance of a Private Placement Offer Letter (“PPOL”). The PPOL has to be approved by the board and the shareholders of the investee company and filed with the Registrar of Companies;
- Upon investment, the Board will allot and issue CCD and CCD certificates to each investor;
- For guidance on the detailed process reference may be made to Section 42 read with Section 71 of the Act and Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014.
- Payable under Article 5 of Schedule 1 of the Indian Stamp Act, 1899 (“Stamp Act”), on the agreement evidencing subscription;
- Issuance of CCDs in India may also attract stamp duty under Article 27 of Schedule I of the Stamp Act. However only debentures, which are in the nature of marketable securities fall under the ambit of Article 27. Marketable security, as defined under the Stamp Act, means a security of such a description as to be capable of being sold in any stock market in India or in the United Kingdom. As CCDs issued by a private limited company are not freely transferable or tradable on the stock markets, they do not qualify to be marketable securities.
While CCDs are opted by the founders in scenarios where valuation is difficult to ascertain, the statutory requirements such as private placement under Companies Act and RBI filings, does require valuation reports. The advantage however, is the ability to push the discovery of actual market driven valuation to a later date.