Convertible Notes (CNs) and Compulsorily Convertible Debentures (CCDs)

For Indian startups, raising funds is often an unfamiliar and tedious process. In addition to pitching to investors with valuation, financial projections and business costs, startups are required to comply with multifarious rules and regulations. The entire process of fundraising requires a sense of intuition, diligence and trust from both ends - business owners and investors.

The preference to overcome these barriers has been to employ Convertible Notes. These debt-equity hybrids enable investors to invest in startups, while protecting their interests. 

Put yourself in the shoes of an investor, attracted by the potential of your startup. Your idea and enthusiasm may excite the Investor to be a part of your growth, but they will need assurance of protecting their investment. A convertible note can act as a bridge of assurance to overcome any hesitancy in such a situation.

What are Convertible Notes (CNs)? 

A convertible note acts like an instrument of debt-equity hybrid, with the funds provided amounting to a loan which may be payable back as per terms of contract (with interest) or further be converted into shares of the startup as stipulated by the conditions of investment (which may provide a discounted share price based on early commitment). The benefit of such an instrument is obvious to the investor who not only has a monetary guarantee towards his investment, but also can get in on the first floor as an early investor availing a discounted share or stock percentage in the start-up, on a Series-A valuation. 

Simply put, it allows for a preferential right to a dividend that can enable an investor to recover even if the startup should be forced into liquidation. For the startup, the most potent benefit is that it overcomes many of the compliance and evaluation hurdles that would discourage investor involvement in a company. By using a convertible note, the startup can avail the required funds to focus on business expansion and growth without having to spend excessive amounts of time and money just to ensure investor satisfaction.

Process of Issuing Convertible Notes

The Section 62(3) of the Companies Act, 2013 provides for the issuance of Convertible Notes in a simple manner - by the filing of eForm MGT-14 that would validate any Special Board Resolution passed for issuance of required Convertible Notes in favour of any domestic investors. Some basic conditions include:

• Investors may be domestic, NRI or foreign-based. There are special limitations for investors from countries that share a border with India.
• The minimum amount to be invested for subscription to a Convertible Note is INR 25 Lakhs in a single tranche.
• As per the notification by Ministry of Finance dated April 12, 2022, the amendment in FEMA (Non-Debt Instruments) Rules, 2019 has facilitated the CN to be converted to equity shares at a time limit of 10 years at a conversion price made and decided upon between investor and company at the time of issuance. This Conversion price cannot be made at lower than the relevant market price.
• For a foreign-based investor, The Foreign Exchange Act (FEMA) and other RBI directives would regulate any Convertible Notes issues in favour of startups. Various compliance checks are conducted, ensuring strict adherence to foreign investment regulations such as Sectoral Limitations, and Pricing Guidelines. An Escrow Account, or an NRE (Non-resident External) Account must be compulsorily used to transfer money both to and from the company, in accordance with Entry guidelines and exchange rules that are periodically notified

To summarize the positives:

• Cost-effective and time-efficient: Convertible Notes can be made effective through just a single document
• Ease the process of fundraising: Convertible Notes enables the startups that are unsure of their value and assets to raise funds and provides them with the time for growth and attaining clarity.

What are Compulsorily Convertible Debentures (CCDs)?

Compulsorily Convertible Debenture (CCD) is a type of security which is a hybrid of debt and equity. Unlike CNs, it is mandatory for CCDs to convert to equity. Due to this mandatory conversion, CCDs are often considered as deferred equity instruments. Upon conversion, a CCD holder - after CCDs convert to equity - automatically becomes a shareholder in the company and acquires all the rights of a shareholder as prescribed under the Companies Act, 2013.

CCDs being valuation-independent are helpful to nascent stage companies and startups while raising bridge rounds. 

Indian Legal Perspective

India, through a number of legal and administrative changes, has been moving towards encouraging Convertible Notes. The Companies Act, 2013 along with Companies (Acceptance of Deposit) Rules, 2014 have now been amended to preclude Convertible Notes to be counted as a ‘deposit’, helping small companies avoid several compliance burdens. Further, by existing as ‘equity investments’ and not a financial loan, Investments from abroad are easily facilitated. In the FDI context, Convertible Instruments had been non-permissible since a long time. But now, Convertible Instruments in the FDI context have become legal.

India, in 2017, embraced the use of Convertible Notes for Recognized Startups as designated by the government through an RBI circular that allowed even non-resident Angel investors to provide funds to Indian startups. This provided a right to transform equity investment into shares as per future funding provided.

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