We are in the golden age of seed financing. Venture capital funds, seed funds, super angels, angel groups, incubators and “friends and family” are all playing the seed financing game and investing early in startups.
The vast majority of high-growth startup companies rely on some form of outside financings such as funding from angel funds, traditional venture capital, high net worth investors, etc. Amongst all of the mode of investments, Convertible notes have become increasingly popular in the world of startup financing, particularly in seed stage companies.
A convertible note (CN) is a debt instrument that allows raising funds by granting the holder of the note the right to be repaid the amount or the right to convert the amount invested into equity shares of the issuing Company. In short, convertible notes are originally structured as debt investments but have a provision that allows conversion of the principal plus accrued interest into equity investment subsequently.
It also carry a unique characteristic among investments. Typically, investors can only cash out during a liquidity event, like the sale of the company, but convertible notes are technically debt, and as such if held to maturity, a note holder could demand payback. Convertible Notes usually include a provision in which the notes automatically convert to equity, at a discount or at a set valuation, on the maturity date.
The primary advantage of issuing convertible notes is that it does not force the issuer and investors to determine the value of the company when there may not be much to base a valuation on – in some cases the company may just be an idea. The valuation will usually be determined during the Series A financing, when there are more data points to base a valuation.
Another significant advantage of issuing convertible notes is to avoid giving the investors any control.
Finally, another advantage of issuing convertible notes is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round and also allow more flexibility in price. As Paul Graham competently noted in his post High Resolution Fundraising:
‘The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors wait to see who else is going to invest.
The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So, you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.’
Raising early-stage money through a convertible note is quite common in startup economies like Silicon Valley, Singapore, etc. making the funding process easier and quicker. India allowed foreign direct investment (FDI) only in equity instruments or such other instruments that were considered at par with equity (compulsorily convertible preference shares/debentures, etc.). However, with effect from January 10, 2017, the RBI amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, (superseded by Notification No. FEMA 20(R)/2017-RB of RBI dated November 07, 2017) to allow “startups” to issue convertible notes to foreign investors.
It has been defined as an instrument issued by a startup evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup upon occurrence of certain specified events, within 5 (five) years from the date of its issue and as per the terms and conditions set out in the instrument.
The minimum amount of investment for a convertible note is INR 25,00,000 (Indian Rupees Twenty-Five Lakhs) in a single tranche.
a person 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); and
a Non-Resident Indian (NRI), an Overseas Citizen of India (OCI), Company, a trust and a partnership firm incorporated outside India and owned and controlled by NRIs or OCIs. However, the investment will be deemed to be domestic investment at par with the investment made by residents.
RBI approval: A startup company, engaged in a sector where foreign investment requires Government approval, may issue convertible notes only with such approval. Further, issue of equity shares against such convertible notes shall follow the entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment provided in FEMA 20(R)/2017-RB.
Mode of payment: The amount of consideration by inward remittance shall be through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.
Remittance of sale proceeds: Repayment or sale proceeds may be remitted outside India or credited to NRE/ FCNR (B) account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.
Transfer: The convertible note may be transferred by way of sale to a person resident in or outside India, provided the transfer takes place in accordance with the entry routes and pricing guidelines as prescribed for capital instruments.
Pricing guidelines: While there are no pricing guidelines applicable at the time of issuance of a convertible note, the conversion of a note into equity must be in accordance with the pricing guidelines applicable to capital instruments.
The Company issuing convertible notes to a person resident outside India shall report such inflows to the Authorised Dealer Bank in Form Convertible Note within 30 (Thirty) days of such issue.
A person resident in India, who may be a transferor or transferee of convertible notes issued by the Company shall report such transfers to or from a person resident outside India, as the case may be, in Form Convertible Note to the Authorised Dealer Bank within 30 days of such transfer.
The Authorised Dealer Bank shall submit consolidated statements to the Reserve Bank.
Unlike issuance of shares by private placement or preferential allotment, the procedure for issuance of a convertible note is comparatively easier.
As it is a debt instrument, the issuing Company is required to seek approval of its members by way of a special resolution at the General Meeting. This must be notified to the Registrar of Companies by filing of eForm MGT-14 within 30 (Thirty) days of the General Meeting.
Issuance of equity or preference shares can only be through private placement or preferential allotment, which requires compliance with the valuation and extensive reporting requirements under the Companies Act, 2013. On the other hand, a convertible note has minimal reporting requirements and there is no hassle of valuation at the time of issuance. The ease of issuing convertible notes is the reason for its popularity among startup companies.
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 Companies (Acceptance of Deposit) Rules, 2014. The regulators need to make it easier for all companies, not just start-ups, to raise funding through convertible notes.