Who Can Issue Convertible Notes?

Only startups officially recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can issue convertible notes. To qualify as a startup, an entity must meet the following criteria:

• Incorporation Type: Must be a private company, LLP, or partnership.
• Age Limit: Must be within 10 years of incorporation.
• Turnover Cap: Annual turnover should not exceed ?100 crores.
• Innovation Focus: Must focus on innovation, improvement of products/services, or possess a scalable business model.

Conditions for Issuing Convertible Notes

1. Registration: Only registered startups can issue convertible notes.
2. Minimum Amount: The amount must be ?25 lakh or more in a single tranche.
3. Conversion/Repayment Period: Convertible notes must convert into equity or be repaid within ten years from the date of issuance.
4. Special Resolution: Requires shareholder approval via a Special Resolution.

Process of Raising Convertible Notes

Step 1: Register with DPIIT

The first step for any Indian company seeking to raise convertible notes is to register with the Department for Promotion of Industry and Internal Trade (DPIIT). This registration is essential for accessing funding through convertible notes.

Step 2: Understand Regulatory Guidelines

Startups must ensure they raise a minimum of INR 25 lakhs in a single tranche. Compliance with the Foreign Exchange Management Act (FEMA) is crucial when issuing notes to foreign investors.

Step 3: File Relevant Documents

File all necessary documents, including board meeting resolutions and shareholder agreements, with the Registrar of Companies (ROC).

Step 4: Review and Finalize the Convertible Note Agreement

The convertible note agreement outlines essential terms such as conversion triggers, maturity dates, discounts, and valuation caps or floors. It’s advisable to have a legal expert review this binding document.

Step 5: Negotiate with Investors

With legal documents prepared, pitch your startup to potential investors, such as family, friends, angel investors, or venture capitalists. Be ready to discuss your business model, growth potential, and exit strategies.

Step 6: Receive Funding

Once all formalities are completed and convertible notes are issued, the funds will be transferred to your company's bank account.

Step 7: Meet Reporting Requirements

As per RBI guidelines, Indian companies must report foreign investment within 30 days of receiving funds. Adhering to these regulations is vital to avoid compliance issues.

Key Terms Related to Convertible Notes

Before raising funds through convertible notes, it’s essential to understand some key terms that are integral to the process. Here’s a breakdown of the most important concepts:

1. Principal Amount

The principal amount refers to the initial investment received from the investor. This amount is either converted into equity during a future funding round or repaid to the investor at a mutually agreed date.

2. Maturity Date

The maturity date is the deadline by which the note must be converted into equity. Typically, this period ranges from 18 to 36 months.

3. Discount Rate

The discount rate is a benefit for early investors, indicating how much less they will pay for shares compared to new investors in later funding rounds. For example, if the next financing round occurs within six months of issuing the convertible note, the discount rate could be zero.

4. Valuation Cap

The valuation cap sets an upper limit on the company’s valuation at which the convertible note can convert into equity. This ensures that early investors receive a fair deal by limiting their conversion price per share.

5. Valuation Floor

Conversely, the valuation floor establishes a lower limit for the conversion, protecting the founders from significant downsides when offering deep discounts for conversion.

6. Conversion Price

The conversion price is the price at which the convertible note will convert into equity. It is determined by dividing the future round valuation, valuation cap, or valuation floor by the outstanding equity. A lower conversion price results in more shares per note and vice versa.

Why Do Convertible Notes Matter?

For startups with promising ideas, prototypes, or apps ready for market testing, securing funding can often be challenging. Traditional loans may not fit, and determining a valuation at an early stage can be tough. This is where convertible notes become invaluable.

Advantages of Convertible Notes:

1. Delayed Valuation: They allow startups to defer valuation until a later, more significant funding round. This gives you more time to demonstrate your business's value.
2. Founder-Friendly: Convertible notes enable you to secure funding without immediate equity exchange, maintaining greater control and ownership.
3. Flexibility: Founders can negotiate terms such as conversion discounts, allowing for tailored funding arrangements.
4. Simplified Process: The process for raising capital through convertible notes is simpler than equity financing. The regulatory requirements mainly involve filings and board resolutions, avoiding the need for detailed financial projections and extensive due diligence.

Potential Drawbacks:

• Dilution Calculations: Founders may miscalculate dilution percentages, leading to unintentional over-dilution in future rounds.
• Investor Expectations: Delays in hitting conversion triggers can lead to dissatisfaction among investors, potentially harming relationships.
• Bookkeeping Complexity: Poor bookkeeping can complicate future funding rounds, making compliance more challenging.

Utilizing a financial management platform can help mitigate these risks and provide essential compliance support.

Reporting Requirements Under FEMA

1. Entity Master Account: Create accounts on the FIRMS Portal.
2. Form CN: File this form within 30 days of issuing convertible notes.
3. Form FLA: Submit this form annually if applicable.

Tax Implications

The tax treatment of convertible notes can vary based on whether they are treated as debt or equity. Interest payments are generally deductible as an expense, while gains from conversion or sale of equity shares may incur capital gains tax.