Convertible Notes – Eligibility, Process and Requirements

Introduction

Startups that need pre-seed or seed funding use convertible notes to raise money before offering equity funding. Since founders can buy their shares when they’re incorporated at a price specified in the articles of incorporation, turning around a few months later and selling shares at a significant markup would look suspicious.

Convertible Notes allow startups to focus on growing their business before they have to start paying back debt. This is particularly important for tech companies that need to spend a lot of time fine-tuning their product. Convertible notes are a fast and straightforward way for startups to raise money. Issuing equity is a more complicated process, and convertible notes bypass that by using debt

Meaning of Convertible Note Convertible note means an

  • Instrument issued by a start-up Company acknowledging receipt of money (minimum Rs 25 lakhs from 1 investor)
  • Initially as debt,
  • Repayable at the option of the holder, or which is convertible into such number of equity shares of that company,
  • Within a period not exceeding five years from the date of issue of the convertible note,
  • Upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.
Who can issue convertible note
  • Convertible note means an instrument issued by a start-up company.
  • Convertible notes are the instruments through which the registered startups can raise money from the investors without the requirement of the valuation report.
Meaning of Registered Start up
  • Start-up registered under Start up Scheme, recognised as Start-up by Department for Promotion of Industry and Internal Trade (DPIIT).
Is your company a Start-up
What are the conditions to issue Convertible Notes?

 

  • Can be issued only to foreign investors, NRI and resident Indians
  • Minimum amount to be invested in one tranche by one investor is Rs 25 lakhs
  • The maximum tenure of CN should be 5 years.
  • (That means it should be converted into equity or should be repaid within 5 years of issue)
  • The company that wants to issue CN should be registered under Start-up India Scheme
Whom can Convertible Note be issued to?

 

Convertible notes can be issued only to:

  • Foreign investors
  • NRI
  • Resident Indians
  • Indian companies and Indian investors
Steps / Procedure and documents required to issue Convertible notes in India:

 

  1. Decide the amount to be raised and the terms of conversion of convertible notes
  2. Prepare a convertible note agreement. This is the most important document and should have all the terms and conditions to avoid future dispute.
  3. Pass a board resolution to approve the convertible note agreement.
  4. Pass the EOGM to approve the issue of notes.
  5. Get the amount in the bank account. It should be more than Rs 25 lakhs.
  6. Issue convertible note to the investor.
What are the laws that govern Convertible Notes?

 

In India, convertible notes are regulated by the Reserve Bank of India vide notification number FEMA 20 (R)/ 2017-RB and the Companies Act, 2013

Under RBI only if the investors are foreign nationals (FEMA 20(R)/2017-RB)- File Form CN with RBI once you receive the funds (this is applicable only if funds are received in foreign currency):

  • Creation of Business User account and Entity Master account on FIRMS portal
  • Filing form CN within 30 days from the date of receipt of payment in bank account.
  • A certificate from CA, CS and the FIRC and KYC from bank is required.
  • Convertible notes agreement is also required when filing form CN
  • The Company issuing convertible notes to a person resident outside India shall report such inflows to the Authorised Dealer Bank in Form CN within 30 (Thirty) days of such issue.

Under Companies Act, 2013:

  1. Unlike issuance of shares by private placement or preferential allotment, the procedure for issuance of a convertible note is comparatively easier.
  2. As it is a debt instrument, the issuing Company is required to seek 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 e-Form MGT-14 within 30 (Thirty) days of the General Meeting.

The process to issue Convertible Notes is as follows:

Approval of board to approve the issue of convertible notes

  • Approval of shareholder in EOGM to issue convertible notes
  • Filing of MGT 14 with relevant terms and conditions of the convertible notes
  • Preparation of the convertible notes agreement with all important terms
Is valuation report required to issue Convertible Notes?

 

No the valuation report is not required to issue the convertible notes.

It is required only when the notes are converted into equity shares at the later date.

What is the valuation at which the convertible notes can be converted in to the equity shares? The notes can be converted into equity share at the valuation on the date of conversion or based on the predefined formula for calculating the value of the company.
Pros/ Advantages of Convertible Notes

 

  • The primary advantage of issuing convertible notes is that it share valuation is not required. Thus it makes it very easy for startups to raise funds.
  • The investors do not have any control or voting power when they subscribe to convertible notes.
  • Generally a Private Limited Company is not allowed to take loan from any other person other than its directors. So by way of convertible notes a start-up can take a loan from any investor for period of 5 years.
  • At the end of the 5 years the Convertible Note will be repaid and not converted.
  • The interest can be paid to the holder of Convertible Note.
  • The process can be completed within a week.
Cons/ Disadvantages of Convertible Notes

 

  • If future financing rounds are not completed, the investors may opt not to convert the notes into equity and the Convertible Notes will remain as debt and thus require redemption, potentially pushing still fragile companies into bankruptcy.
  • Further, a Convertible Note has to be repaid or converted into equity shares of a start-up company within 5 years from the date of issuance of the Convertible Note. Since the maturity period is less, the risk involved becomes high.
  • The threshold to invest minimum INR 25 Lakhs for one tranche also becomes a hurdle for start-ups to seek from angel investors.
  • One has to decide the Floor Valuation and Valuation cap for convertible notes which may become a hinderance.

The valuation cap sets the maximum possible valuation at which the convertible security derives its conversion price. Valuation cap applies regardless of how much higher the actual valuation of the financing round is above the cap.

A valuation floor sets the minimum possible valuation at which the convertible security derives its conversion price. Valuation floor applies regardless of how much lower the actual valuation of the financing round is below the floor.

Conclusion

Convertible notes can be an excellent option for the right company and the right investor. The high-risk, high-reward model can offer a way for startups to obtain seed funding before they have the resources to get to Series A funding. However, having a clear plan for all eventualities is imperative for both sides to benefit from the arrangement.

Companies that aren’t comfortable giving away so much equity can explore other options. It’s never wise to issue convertible notes without exploring all of your options. Other possible funding sources include SBA loans, SAFE notes, KISS notes, grants, bank loans, or lines of credit. Before deciding which is the best fit for your company, run through the possibilities and how they can play out positively or negatively in different scenarios. Securing the right funding is vital to the success of any startup.

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