CONVERTIBLE NOTE IN INDIA
Simply put, a convertible note (debentures) is debt that converts into equity at the time of a future financing. In other words, convertible note (debenture) investors are lending you money with the understanding that when you raise a Series A (typically the next step in financing a start-up), you’ll convert the note into the same equity shares that your Series A investors are getting. Of course, seed round investors want to be compensated for taking more risk than Series A investors, so often there are provision that allow seed investors to convert their note into Series A equity at more favourable prices than the Series A investors get.
A recent notification dated June 29, 2016 amended the Companies (Acceptance of Deposits) Rules, 2014, defining the ‘all American term’ convertible note. Per this amendment a convertible note, which was earlier not defined means, “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 start-up company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.” With the above amendment finally being notified, not only does it clear ambiguity regarding issuance of convertible notes, but makes it easier for start-ups to access funds via the coveted convertible note route. The amendment seems to be part of the all-round initiative planned by the government to strengthen the start-up ecosystem in India. In addition to the above, funds received by a start-up amounting to Rs 25 lakh or more by way of a convertible note, in a single tranche from a person, will not be treated as a `deposit’. The convertible note is to be either converted into equity or repaid within a period of five years.
START-UP DEFINED
A start up on the other hand has also been defined vide notification dated Feb 17, 2016 G.S.R. 180(E) issued by DIPP to mean, “an entity which is – a) up to five years old, from the date of its incorporation; b) its turnover for any of the financial years has not exceeded Rupees 25 crore; and c) is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property. Any such entity formed by splitting up or reconstruction of a business already in existence shall not be considered a stat-up”. If a tax holiday is to be availed, the entity is required to be set up between April 1, 2016 and March 31, 2019 and an approval of an inter-ministerial board set up by DIPP is required. The tax holiday is available for a period of three years in a block of initial five years.
WHY DO COMPANIES RAISE MONEY USING A CONVERTIBLE NOTE?
The most commonly cited reason is that convertible notes kick the can on valuation to a later date. It’s incredibly difficult (and arguably impossible) to slap any sort of meaningful valuation on a business at this early stage (i.e. two smart people with a great idea), and convertible notes allow you to delay that valuation to a future date when the company and investors have more data with which to value the business. This also prevents the company from inadvertently setting an inflated valuation and thereby an inflated strike price on options being used to attract talent to the company. Control is another important benefit for many founders as convertible notes constitute debt, not equity, so they don’t come with voting rights and rarely come with board seats or other control provisions.