Convertible Notes under Companies Act, 2013

The regulatory landscape for startups in India is a constantly evolving space due to the dynamic and volatile nature of the country’s startup ecosystem. Cost-effective and innovative fundraising opportunities are a necessity for startups to succeed.

The Indian government, being aware of the above fact, regularly updates regulatory norms in accordance with the economic conditions and market dynamics. One of the fairly recent introductions by the government is the concept of ‘convertible notes’.

Convertible notes act as an instrument that evidences receipt of money initially as a debt, which is repayable at the option of the holder, or which can be convertible into equity shares of the startup company. Convertible notes are a hybrid of equity and debt instruments.

Convertible notes are primarily targeted towards startups as valuing companies during the initial phase of operations is often difficult. Since there’s no actual valuation for the startup’s shares, convertible notes become an attractive investment option for investors.

Under the Companies Act, 2013, a ‘convertible note’ was introduced as an exempted deposit (with respect to startup companies) under Rule 2(1)(c)(xvii) of Companies (Acceptance of Deposit) Rules, 2014.

To issue convertible notes, the startup company must be recognized as a “Startup” by the Department for Promotion of Industry and Internal Trade. Further,  the investment amount per investor should not be less than Rs. 25 lakh in a single tranche, otherwise the same shall be considered to be a deposit under the relevant provisions of the Companies Act, 2013 and shall attract the necessary compliances relating to ‘deposits’. As convertible notes are debt instruments, startup companies can issue the same under the provisions of Section 62(3) of the Companies Act, 2013, with the shareholders’ approval at a general meeting, and by notifying the Registrar of Companies by filing eForm MGT-14 within 30 days of having held the said general meeting.

Convertible notes offer extensive flexibility compared to other instruments like compulsorily convertible preference shares, compulsorily convertible debentures, or equity shares. They involve minimal regulatory reporting while issuing and valuation hassles, thus promising substantial traction in the Indian ecosystem.

FAQs about Convertible Notes under Companies Act, 2013

1. What exactly are convertible notes? Convertible notes are a financial instrument that acts as a hybrid of debt and equity. They allow startups to raise money by issuing a promise to: (a) either repay the debt; or (b) convert it into equity shares in the company at a later stage.

2. Are there any pre-conditions to issue convertible notes in India? Yes, there are two pre-conditions for issuing convertible notes in India: (a) the company issuing the convertible note must be recognized as a “Startup” by the DPIIT; and (b) the investment amount per investor should not be less than Rs. 25 lakh in a single tranche.

3. How can startups comply with regulations while issuing convertible notes in India? Startups must obtain shareholders’ approval by way of a special resolution at a general meeting and shall notify the Registrar of Companies of the same by filing eForm MGT-14 within 30 days of having held the meeting.

4. How is a convertible note different from a traditional loan? Unlike most traditional loans, convertible notes are convertible into equity shares of the startup company upon the occurrence of specified events. The investor also gets a right to receive equity shares of the startup company at a future date in lieu of repayment.

5. What advantages do convertible notes offer startups? Convertible notes are an attractive investment option because of their hybrid structure. They allow flexible fundraising, and bypass the initial valuation hassles that startups usually face, thus making them a promising investment option.

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