Decoding Convertible Notes: A Comprehensive Guide for Startups and Investors in India

Convertible Notes are a type of financial instrument that includes an option to convert into equity at a future date. This means the holder can exchange the note for a specified number of equity shares. Early-stage companies often use convertible notes to raise capital without immediately valuing their company, which can be challenging in early stages. Initially, the note holder subscribes to the note at a fixed interest rate. When the company raises funds in the future, the principal amount plus interest converts into equity shares. Convertible Notes typically have a maximum validity period of 5 years.

General Terms:

• Conversion Price: The price at which the note converts into equity shares.
• Valuation Cap: The maximum valuation of the company at which the investor receives shares on conversion, ensuring they do not pay more than a certain price per share.
• Valuation Floor: The minimum valuation of the company at which the investor receives shares on conversion, ensuring they do not pay less than a certain price per share.
• Discount Rate: The discounted price at which the note holder receives equity shares at the time of conversion when the company raises funds in the future.

Eligibility: To issue and raise funds through a convertible note in India, the company must be recognized as a startup by the DPIIT and have a registered startup certificate. The minimum investment required through convertible notes is INR 25 Lakhs in a single tranche.

Comparison with CCDs: Convertible Notes can be converted at the note holder’s option and discretion, while Compulsorily Convertible Debentures (CCDs) are compulsorily converted into equity or preference shares at a given date as per the agreement.

Pros & Cons:

• Pros: Can be issued without prior valuation, good option for companies not ready to give up equity, and note holders may get a higher number of shares at conversion.
• Cons: Note holders may not see a return if the company doesn't reach the conversion price, holders have no say until conversion, and there can be conflicts if the agreement is too complex.

Conditions to Issue Convertible Notes:

• Can be issued to foreign investors, NRI, resident Indians and Indian companies
• Minimum amount to be invested in one tranche by one investor is Rs 25 lakhs.
• The maximum tenure of CN should be 10 years, either converted into equity or repaid within this period.
• The company that wants to issue CN should be registered under the Startup India scheme.

Procedure to Issue CN:

1. Approval of board to approve the issue of convertible notes.
2. Approval of shareholder in EOGM to issue convertible notes.
3. Filing of MGT 14 with relevant terms and conditions of the convertible notes.
4. Preparation of the convertible notes agreement which should have all the important terms.
5. File Form CN with RBI once you receive the funds (this is applicable only if funds are received in foreign currency).

Difference between CCD and CN:

• CNs are optionally convertible whereas CCDs are mandatorily convertible.
• Process is simple to issue CN whereas the process to issue CCD is a bit complicated.

Laws Governing Convertible Notes in India: 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.

Reporting Requirements after the Convertible Notes is issued: Under RBI, if the investors are foreign nationals (FEMA 20(R)/2017-RB):

• 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 the bank account.
• A certificate from CA, CS and the FIRC and KYC from the bank is required.
• Convertible notes agreement is also required when filing form CN.

Under Companies Act, 2013:

• Seek approval of its members by way of a special resolution at the General Meeting.
• Notify to the Registrar of Companies by filing of eForm MGT-14 within 30 days of the General Meeting.

In conclusion, Convertible Notes offer flexibility for both companies and investors, with simple compliance procedures. However, they also carry risks, and careful consideration is necessary before using them.