[The following guest post is contributed by Bhushan Shah & Neha Lakshman from Mansukhlal Hiralal & Company. The views expressed in the post are personal]
A convertible note is an instrument issued as debt and convertible into equity of a startup at the option of the holder, upon a future contingency taking place, usually when the startup obtains an additional round of investments. Therefore, convertible notes allow investors to invest in startups without concerns about their valuations, which are difficult to determine at the inception, as convertible notes are merely an instrument advanced as a loan and converted to equity at a later stage when the startup’s business model is more evolved.
In July 2016, the Ministry of Corporate Affairs (MCA) amended the Companies (Acceptance of Deposits) Rules, 2014 (Rules) exempting convertible notes from the ambit of deposits, and thereby allowing companies to issue convertible notes in tranches exceeding Rs 25 lakhs to prospective investors, without having to comply with the slew of requirements mandated by the Rules.
Now, the Reserve Bank of India (RBI) has by way of a notification dated 10 January 2017 (Notification), amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20/2000), implementing a key change in the foreign exchange policy by allowing startup companies to issue convertible notes to foreign investors. This is a marked change from the existing foreign exchange policy, where optionally convertible debentures are considered External Commercial Borrowings (ECBs) and are required to comply with the more stringent ECB Guidelines.
Following are the salient features of the Notification:
- Definition of convertible note: The notification defines a convertible note as follows:
- An instrument issued by a startup company evidencing receipt of money;
- This instrument is initially treated as debt;
- It is convertible into such number of equity shares of such startup company within a period 5 years from the date of issue, upon occurrence of specified events, as per the other terms and conditions agreed to and indicated in the instrument.
- Startup: This Notification is only applicable only to entities defined as startups. Startup companies includes the following:
- A company wherein 5 years have not elapsed from the date of its incorporation;
- Its turnover for any of those years does not exceed Rs. 25 crores; and
- The company is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.
Therefore, entities that fall outside this definition would be unable to avail of the benefits of the Notification of being able to issue convertible notes.
- Persons eligible to purchase convertible notes
- Individuals / Entities resident outside India may purchase convertible notes issued by an Indian startup, for an amount of Rs 25 lakhs or more in a single tranche. However, a startup company engaged in a sector where foreign investment requires Government approval can issue convertible notes to a non-resident only with approval of the Government.
- Holders of the convertible notes are allowed to transfer the same to third parties, provided, such transfer complies with the pricing guidelines issued by the RBI.
- Non-Resident Indians may acquire convertible notes on non-repatriation basis in accordance with the applicable regulations under the Foreign Exchange Management Act, 1999.
- Persons barred from purchasing convertible notes: Citizens of Pakistan or Bangladesh, or entities registered in/incorporated in these countries cannot purchase convertible notes in Indian entities.
- Other formalities: A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time. The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.
Comment: As mentioned earlier, convertible debt has been traditionally treated as ECBs and was required to comply with applicable ECB Guidelines, which permit only specific companies to access this route of financing from sources approved by the RBI as eligible non-resident entities, and that too for specific permitted end uses. With the issue of convertible notes being allowed, such convertible debt issued by startups shall now be considered foreign direct investment, thereby allowing the emerging companies to access to funds from foreign sources at a better valuation. However, this Notification is likely to have limited impact in increasing overall foreign investments as it is applicable only to specific types of entities.
- Bhushan Shah & Neha Lakshman