Convertible Note: Flexible funding options for Startups
The Indian startup landscape has seen a steep transformation since 2016 and is the third largest ecosystem for startups globally. We now have more than 99,000 startups in India, across 674 districts that have reported the creation of over 10.49 lakh jobs with an average of 11 jobs per startup.
Department for Promotion of Industry and Internal Trade (DPIIT) is constantly working to simplify regulatory frameworks for Startups. One such step taken by the government was the introduction of Convertible Notes for Startups.
The concept of Convertible Notes was introduced through a notification dated 29th June 2016 that amended the Companies (Acceptance of Deposits) Rules, 2014.
Convertible Note can be understood as a hybrid of debt and equity. At the time of issuing such a convertible note, it is structured as a debt instrument, but unlike a loan, where the loaner must pay interest, the investor gets the right to buy equity at a future investment round at a price agreed upon in the agreement between the parties.
Key Provisions on Convertible Note
1. Definition: A Convertible Note is defined 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.” Such a Convertible Note can be issued by a private limited company.
2. Preconditions for issuing convertible notes: There are two conditions that a company must meet to be able to issue convertible Notes:
- Private Limited Company must be recognised as a “Startup” by DPIIT
- Investment amount per investor should not be less than INR 25 lakh in a single tranche.
To get recognised as a DPIIT Startup, apply at: https://www.startupindia.gov.in/content/sih/en/recognition-page.html
3. Valuation requirements for convertible securities: The valuation of the Convertible Note is determined either upfront when the Convertible Note is being offered or at the time when the holder of the convertible securities becomes entitled to apply for shares. The decision – if the company will decide the price at the time of offer, or at the time of issuance– is determined at the time of offer of convertible securities itself. Such disclosure needs to be made in the convertible note agreement.
Convertible Notes are a beneficial way for Startups to raise debt. The flexibility of the valuation requirement further simplifies the process of issuing such instruments for Startups. This also makes Convertible Notes extremely flexible as opposed to other instruments.
Most often, it is difficult to value a company during its initial stage of operations. At this stage, investors are generally looking to invest in the team and the idea rather than on the basis of the valuation of shares. There is often no backable value behind the equity, and this is where Convertible Notes offer attractive investment options for Startups and investors.