Convertible Notes under Companies Act, 2013

The regulatory landscape for startups in India is bound to be ever-evolving, owing to the dynamic and volatile nature of India’s startup ecosystem. Startups are always on the lookout for innovative and cost-effective fund-raising opportunities, consequentially the government also upgrades regulatory norms and practices, in alignment with prevalent economic conditions and market dynamics. 

One of the steps taken by the government is the introduction of convertible notes, specifically for startups. The definition of a ‘convertible note’ was first introduced through a notification dated June 29, 2016[1] that amended the Companies (Acceptance of Deposits) Rules, 2014 (the “Rules”). A convertible note is defined under the Rules as an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the startup company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument (“Convertible Note”). 

Convertible Notes are a hybrid of debt and equity. They are originally structured as debt investments but unlike a typical "loan", an entrepreneur is not required to pay "interest" here. Instead, the investor gets a right to buy equity at a future investment round (typically series A, with a formal valuation of the company) at a discounted price (against the interest value of the debt funding). 

It is difficult to value a company during its initial stage of operation. This is the time when most of the investors are backing a startup for the mere reason of a strong and motivated team. In actuality, there is no real value behind the equity and that’s where convertible notes as an investment option come across as attractive.

The Rules define a startup company as a private limited company and recognised as a startup under the notification on startups issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”). A DPIIT recognised startup company is allowed to accept money from investors by issuing Convertible Notes and without having to comply with the stringent provisions of the Rules.

Under the Companies Act, 2013, a Convertible note was introduced as an exempted deposit under Rule 2(1)(c)(xvii) of Companies (Acceptance of Deposit) Rules. Apart from the above provision, there is no other provision in the Act that talks about the issuance of convertible notes.

There are two pre-condition to issue Convertible Notes-

1. Company must be recognised as “Startup” by DPIIT;

2. Investment amount per investor should not be less than Rs. 25 lakh in a single tranche.

As it is a debt instrument, the Company can issue Convertible Notes under the provision of Section 62(3) of the Companies Act, 2013 after seeking 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.

As the notification dated June 29, 2016, specifically excludes only that amount which is more than or equal to INR 25 Lakh with regards to Convertible Note, hence any amount received against Convertible Notes which is less than INR 25 Lakh shall be considered as a ‘Deposit’ and the startup company shall have to comply with all the provisions relating to deposits as stated in the Rules.

Convertible Notes are extensively flexible, as opposed to the other instruments like CCPS, CCD or equity shares due to minimal reporting requirements and no hassle of valuation at the time of issuance. Therefore, it is safe to say that convertible notes promise a lot of traction in the Indian ecosystem.

*[1] - Notification dated June 29, 2016 [G.S.R 639(E)] 

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