Issue Of Convertible Notes To Indian Startups

The Narendra Modi led government has always shown keen interest and support in promoting entrepreneurship in India. With the idea of easing businesses in India, “Startup India, Stand -up India policy was legislated and then amended the exchange control regulations in January 2017. The notification now allowed startups to issue convertible notes, which was immediately after an amendment rolled out under the Indian company law excluding convertible notes from the purview of deposits to ease compliances for start-ups. The present article only provides a general idea of the subject matter and the opinions are purely personal and expert’s advice should be sought in special circumstances where the application of the discussed laws could vary. 

Relevant Terms and Concepts
  1. Convertible Notes: An instrument issued by a start-up company evidencing receipt of money which is initially treated as debt and then it is convertible into such number of equity shares of such start-up 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. 
  2. Start-up: Start-up companies include a company wherein 5 years have not elapsed from the date of its incorporation and its turnover for any of those years does not exceed Rs. 25 crores. 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. 
  3. Persons Eligible To Purchase Convertible Notes: Individuals / Entities resident outside India may purchase convertible notes issued by an Indian start-up, for an amount of Rs. 25 lakhs or more in a single tranche. However, a start-up company engaged in a sector where foreign investment requires government approval can issue convertible notes to a non-resident only with the 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.
  4. 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. A start-up company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time. The start-up company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank. 
  5. Reporting Convertible Notes: Start-ups issuing convertible notes are required to file Form CN within 30 days of issue. Residents buying or selling convertible notes are also required to file Form CN within 30 days of the transfer. Format of Form CN has not yet been prescribed.
Prior to this notification; start-up would raise funds by way of any compulsorily or optionally convertible capital instruments, the start-up had to go through the valuation of its shares which was unfair and difficult to its unknown profit and actual assets and liabilities along with the method of valuation adopted. Traditionally, it was an established rule that ambit of “capital” extended to equity shares, fully and mandatorily convertible preference shares and fully and mandatorily convertible debentures under the existing Foreign Direct Investment Policy. This FDI policy was further subject to certain exemptions where investments from foreign investors by way of any other instrument or optional conversion or repayment like a loan, fall under the purview 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, the Reserve Bank of India 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, recognized start-ups are now allowed to issue Convertible Notes to foreign investors without having to arrive at valuations. 

India is a developing nation with home to the third-highest number of tech start-ups in the world. With this new policy, is the emerging hope and support in establishing these start-ups in their initial and critical phase. It is a way to help them venture out for new opportunities with domestic and foreign investors. Convertible debts was initially a limited concept and were treated as ECBs which was only available to specific companies for effective interaction with RBI approved and enrolled non -resident companies. With the coming of this new notification, issuance of convertible notes is considered as foreign direct investment resulting in better networking for funds. 

Acknowledgment of Convertible Notes as a capital investment instrument is certainly a positive move to make the procedure of speculations into Indian companies is a boon. Though, it is relevant to take note of that the favorable position is accessible just for perceived startups, which implies that non-perceived new businesses or companies which are not recognized startups are as yet not permitted to issue Convertible Notes as a capital instrument under the RBI Regulation or as a non-deposit under the Rules. Along with this, the minimum requirement of 25 Lakhs becomes quite a burdensome and discriminatory in nature and such threshold should be done away with.

Another major drawback is that, at the time of conversion of the convertible notes to equity shares, the investment would be dependent on the valuation of shares at that time. The ambiguity of converting it at a discounted rate is tough in order to keep it in the purview of relevant laws and guidelines regulating convertible notes by non -resident investors/companies. 

Lastly, the notification regarding the amendment to the principal regulation of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000  permitting issuance of ‘Convertible Note’ by start-up companies to a person resident outside India (i.e. other than individuals who are citizens of Pakistan or Bangladesh or an entity which is registered/incorporated in Pakistan or Bangladesh) continue to have a lot of grey areas. It is silent on the question of the receipt of the foreign investment in lieu of the issuance of a new instrument of convertible notes. Since convertible notes play as a debt for the next five years and thus vital to the subscribers as the option of not converting to equity shares and keeping it for future purposes, unlike the other capital instruments. 

In my opinion, another amendment would be carried out in the External Commercial Borrowing Policy to answer these questions for the desired and greater effect. 



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