The definition of a ‘convertible note’ first came in through a notification dated 29 June 2016 that amended the Companies (Acceptance of Deposits) Rules, 2014 (the “Rules”). A convertible note is defined under the Rules as an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the start-up company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument (“Convertible Note”). The notification dated 29 June 2016 effectively excluded any amount of 25 lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person, from the ambit of ‘deposit’. However, the Rules define start-up as a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 (the “Act”) and recognised as a start-up under the notification on start-ups issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”).
Read as such, post this 2016 amendment, a DPIIT recognised start-up company is allowed to accept money from investors by issuing Convertible Notes and without having to comply with the stringent provisions of the Rules.
Prior to this amendment, if a start-up (whether recognised by DPIIT or not) wanted to raise funds by way of any compulsorily or optionally convertible capital instruments, the start-up had to go through valuation of its shares (at least for the floor value). Valuation at early stages is always difficult, irrespective of the method of valuation adopted.
Only equity shares; fully, compulsorily & mandatorily convertible preference shares; and fully, compulsorily & mandatorily convertible debentures are treated as ‘capital’ under the existing Foreign Direct Investment Policy. Therefore, subject to certain specific exemptions under the FDI Policy, investments from foreign investors by way of any other instrument or optional conversion or repayment like a loan, fall under the ambit of External Commercial Borrowings regulated under the Foreign Exchange Management (Borrowing and Lending in Foreign Exchange Regulations), 2000 (“ECB Regulations”).
With the objective of simplifying the process of foreign investments into Indian recognised start-ups and in consonance with the 2016 notification discussed above, the Reserve Bank of India (“RBI”) issued a notification on 10 January 2017 amending the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2016 (“RBI Regulation”). By virtue of this, recognised start-ups are now allowed to issue Convertible Notes to foreign investors without having to arrive at valuations.
Conditions to be fulfilled for issuance of Convertible Notes to non-resident or foreign investors:
- A person who is resident outside India (other than an individual who is a citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), can purchase Convertible Notes issued by a recognised start-up company.
- The minimum amount to be invested for subscription to Convertible Notes is INR 25 lakhs in a single tranche.
- If the start-up is engaged in a sector which requires government approval for foreign investment, Convertible Notes shall be issued only with prior approval of the government. Also, the issue of shares against such Convertible Notes has to be in accordance with Schedule 1 of the RBI Regulation.
- The start-up issuing the Convertible Notes shall receive the consideration amount by inward remittance or by debit to the NRE/FCNR (B)/ escrow account maintained by the investor in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. In the event an escrow account is maintained for the above purposes, it shall be closed immediately after the requirements are completed or within a period of 6 months, whichever is earlier. However, in no case, continuance of such escrow account shall be permitted beyond a period of 6 months.
- NRIs may acquire Convertible Notes on non-repatriation basis in accordance with Schedule 4 of the RBI Regulation.
- A person resident outside India can acquire or transfer, by way of sale, Convertible Notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the Government shall be obtained for such transfers in case the start-up company is engaged in a sector which requires Government approval.
- Compliance with the reporting requirements prescribed by the RBI is also required.
Recognition of Convertible Notes as a capital investment instrument is definitely a positive move to make the process of investments into Indian companies’ swifter, easier and less expensive.
However, it is pertinent to note that the advantage is available only for recognised start-ups, which means that non-recognised start-ups are still not allowed to issue Convertible Notes as a capital instrument under the RBI Regulation or as a non-deposit under the Rules.
Further, a Convertible Note has to be repaid or converted into equity shares of a start-up company within 5 years from the date of issuance of the Convertible Note upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument. In case of conversion, the instrument would be converted into equity shares as per Section 62(3) of the Act.
Also, there is a minimum requirement to invest atleast Rs. 25 lakhs. It might be better if there is no threshold as such.
Another important aspect to be considered is with respect to the terms of conversion of the Convertible Notes. If the Convertible Notes are being converted into equity shares at the time of a subsequent investment, the conversion will be based on a valuation arrived at the time of such conversion. Whether such conversion will be at a discount to the shares being issued to the new investors and other terms will have to be carefully evaluated, so that the same is in compliance with the applicable laws, including the pricing guidelines, in case the Convertible Notes are held by non-resident investors.
Authors: Paul Albert and Ashwin Bhat
 Rule 2 (1) (xvii) of the Companies (Acceptance of Deposits) Rules, 2014.