Issue of Convertible Notes by STARTUPS

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By: Laxmi Joshi, Riya Dutta & Aditi Rani

2016 was a tough year for the Indian startup ecosystem with the funding crunch, among other issues, plaguing them for most part of the year. The launch of the government’s action plan ‘Start-up India, Stand-up India’ made all the right noises to incentivize the set up, growth and expansion of startups in India. It was also followed by tax exemptions and a relaxed compliance regime for startups. This year began on a positive note with the Reserve Bank of India (“RBI”) amending the Foreign Exchange Management (Transfer or issue of securities by a person resident outside India) Regulations, 2016[1] (“Amendment”) on January 10, 2017 to permit startups to raise funds through issuance of convertible notes. This move is further aided by the Ministry of Corporate Affairs’ amendment of the Companies (Acceptance of Deposits) Rules, 2014 (the “Rules”) last year, whereby convertible notes (were excluded from the purview of deposits under the Rules. Consequently, the issuance of convertible notes for an investment amount of INR 2.5 million (USD 37,000 approximately) by startups stands excluded from being construed as deposits under the Rules, providing a relief to startups saddled with compliances relating to deposits under the Rules.

Present Foreign Direct Investment (FDI) Regime:

Under the current FDI regime, FDI through fully convertible instruments is treated as equity, while non-convertible and optionally/partially convertible instruments are treated as debt instruments governed by the policy on external commercial borrowings.

Issuance of Convertible notes by Startups:

Pursuant to the Amendment, a private company being a start up enterprise within the meaning of the notification issued by the Department of Industrial Policy and Promotion (the “Notification”)[2] can raise foreign funds by issuing convertible notes in accordance with the conditions set out in the Amendment.

The definition of the term “startup” under the Notification is three fold. It defines a “startup enterprise” as an entity (i) being in existence for not more than five years; (ii) working towards innovation, development, deployment, and commercialization of new product, processes or services driven by technology or intellectual property; and (iii) having earned an annual turnover of not more than INR 250 million in any of the financial years.

A convertible note under the Amendment refers to an instrument evidencing receipt of money by the issuer initially as debt repayable at the option of the holder, which may also be converted into equity shares of the issuer company upon occurrence of certain specified events, within a period not exceeding five years from the date of its issue as per the terms and conditions stipulated in the instrument. Further, the price for conversion must be determined as per the applicable pricing guidelines prescribed by the RBI (“Pricing Guidelines”) As per the Pricing Guidelines, the pricing/conversion formula of such convertible notes should be determined upfront at the time of issuance of such notes. In any case, the conversion price should not be lower than the fair market value worked out (as per any internationally accepted pricing methodology on arm’s length basis) at the time of issuance of these convertible notes.

Some of the conditions for issuance of convertible notes set out in the Amendment are as follows:

  • Minimum amount of investment: A startup can issue a convertible note for an amount equal to or not less than INR 2.5 million (USD 37,000 approximately) payable in a single tranche.
  • Government approval: Where the startup is engaged in any business/activity falling under the government approval route under the extant foreign direct investment guidelines, convertible note can be issued by such startup only after obtaining prior government approval.
  • Inward remittance methods: Inward remittance of consideration towards convertible note is permitted through normal banking channels or through NRE/FCNR (B)[3] account or escrow account maintained in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. However, such escrow account must immediately be closed after the requirements are completed or within a period of six months, whichever is earlier. However, in no case continuance of such escrow account shall be permitted beyond a period of six months.
  • Transferability: Convertible notes issued by startups may be freely transferred by the holder by way of sale for a price determined as per the Pricing Guideline.
  • Reporting compliances: All issuances and transfer of convertible notes must be reported to RBI in accordance with the applicable reporting requirement.
  • Approval of the terms of issuance: The terms of issue of convertible notes must be approved by the shareholders at a general meeting by a special resolution before the issuance of such notes.

Our Observations:

Given the growth of startups in India and challenges faced by them in raising capital, this is a welcome policy relaxation. Globally convertible notes are the preferred mode of seed investment for startups; the main reasons being the flexibility they provide to the investors in terms of returns. It is also advantageous to the promoters who do not have to immediately dilute their stake to secure funding. While it is no doubt a positive development for startups, it may have a limited impact in the immediate short term given the practical challenges faced by startups in getting registered as a “startup” under the Notification.

[1]https://rbi.org.in/Scripts/BS_FemaNotifications.aspx?Id=10825

[2] http://dipp.nic.in/English/Investor/startupindia/Definition_Startup_GazetteNotification.pdf.

[3] Non-Resident (External) Rupee Account – (NRE) Account / Foreign Currency Non Resident (Bank) Account – FCNR (B) Account

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