There are instances where a seed or early-stage startup needs to raise money to fund hiring and operations, and one cannot be expected to ascertain a fair valuation at this stage of the process. This is where convertible notes come into the picture.

Convertible Notes

A short-term debt instrument, convertible note is typically employed by startups to raise funding. The holder of the convertible note is entitled to a future equity stake in the company in exchange for current debt. The principal advantage for early-stage startups in raising funds by the issuance of convertible notes is that they are not required to determine the value of the company at the time of issuance.

Unlike the sale of equity in traditional priced rounds of financing, a company can issue a convertible note quickly and efficiently, without multiple documents and the necessity of amendment to the charter documents. As a flexible, one-document security, without numerous terms to negotiate, the convertible note should save companies and investors money and time.

Until 2016, the convertible note was not a legally recognised debt instrument in India. An amendment to the Companies (Acceptance of Deposits) Rules, 2014 defined and recognised convertible notes as an instrument for fundraising by startups.

Now, DPIIT-registered startups can raise funding through the convertible note route. In order for such startups to receive funding through Convertible Note, the following additional conditions will have to be complied with:

  • The amount of investment will have to be at least INR 25 lakhs in a single note
  • The amount will have to be converted within 10 years
  • The terms of conversion will have to be determined upfront

In the simplest terms, the convertible note can be linked to the expected return rather than a valuation and percentage of ownership getting away from the valuation quagmire for a very early-stage investment.

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