Issue of Convertible Notes by Indian Startup Company

Issue of Convertible Notes by Indian Startup Company. Startups often issue convertible notes as a way to raise capital without giving up equity ownership or diluting existing equity holders. Convertible notes provide a flexible financing option for startups that are seeking growth capital but are not yet ready to go public or do not have a clear valuation.
What are Convertible Notes?
Convertible notes are a means of instrument through which registered start-ups can raise capital from investors without any valuation report. These are types of debt security, repayable at the discretion of the holder or which can be converted into equity stock at some future date not exceeding 10 years from date of issue of such convertible note under conditions stated in the instrument.

Convertible notes can be issued to any eligible investor, regardless of their nationality or residency status. This means that convertible notes can be issued to foreign investors, NRIs (Non-Resident Indians), resident Indians, Indian investors, and Indian companies.

Convertible notes are a type of debt instrument that can be converted into equity shares of the issuing company at a later stage, usually during a future funding round or at the maturity of the notes. They are often used by start-ups and early-stage companies as a way to raise funds without having to immediately determine a valuation for the company.

The terms and conditions of convertible notes, including the conversion price and the conversion mechanism, are typically negotiated between the issuing company and the investor at the time of issuance. These terms may vary depending on the investor's profile and the amount invested, among other factors.

Who can issue convertible notes?
Only startups which are recognised by the Department for Promotion of Industry and Internal Trade (DPIIT), can issue convertible notes. 
Convertible notes are a type of debt instrument that can be converted into equity shares of the issuing company at a later stage, usually during a future funding round or at the maturity of the notes. They are often used by start-ups and early-stage companies as a way to raise funds without having to immediately determine a valuation for the company.
In recent years, convertible notes have become a popular way for start-ups and early-stage companies to raise funds from angel investors, venture capitalists, and other types of investors. Companies such as Airbnb, Dropbox, and Y Combinator have used convertible notes to raise funds in their early years.
Who is a Start-up company in India?
Start-up company means any company incorporated under Companies Act, 2013 or Companies Act, 1956 and as recognised by the Department of Industrial Policy and Promotion, (DPIIT) Ministry of Commerce and Industry vide amended Notification dated 16-1-2019. Learn more about Startup India Recognition- DPIIT.
The Department of Industrial Policy & Promotion was renamed to Department for Promotion of Industry and Internal Trade (DPIIT) after internal trade was added to its mandate on 27 January 2019.
An entity shall be considered as a start-up:

Company age and type: Up to a period of 10 years from the date of incorporation/registration, if it is incorporated as a private limited company under the Companies Act, 2013 or registered as a partnership firm under Section 59 of the Partnership Act, 1932 or a limited liability partnership per the Limited Liability Partnership Act, 2008 in India.

Annual Turnover: Turnover of the entity for any financial years since incorporation has not exceeded INR 100 crores.

Innovative and scalable: Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Original entity: The entity should not have been formed by splitting up or reconstruction of a business already in existence.

Note: A foreign subsidiary cannot be registered under the startup India scheme. However, companies with foreign shareholders and directors can be registered under the startup India scheme.
Whom can convertible notes be issued to?

Foreign investors

NRI and resident Indians,

Indian investors and Indian companies.

Conditions to issue convertible notes?
Convertible notes can be issued to any eligible investor, including foreign investors, NRIs, resident Indians, Indian investors, and Indian companies. The eligibility of the investor to invest in convertible notes may be subject to compliance with applicable regulations and foreign exchange laws, but there is no restriction on the type of investor who can invest in convertible notes.
Key Notes
The minimum amount to be invested in one tranche by one investor may vary depending on the issuing company's policies and the applicable regulations.
In India, the Securities and Exchange Board of India (SEBI) has set certain guidelines for private placement of securities, including a minimum investment amount of Rs. 20,000 per investor per transaction. This means that if an issuing company is raising funds through private placement, each investor must invest a minimum of Rs. 20,000 in one tranche.
Further, for other types of securities such as convertible notes or equity shares, the minimum investment amount may be higher and can be determined by the issuing company. In general, start-ups and early-stage companies may set a higher minimum investment amount to attract serious investors who are committed to the company's growth and success.
The maximum tenure of convertible notes should be 10 years, which means it should be converted into equity or repaid within a period of 10 years of issue.
For investors convertible notes are better as it has the option to convert into equity unlike Compulsorily Convertible debentures (CCD), which has to mandatorily be converted into equity shares.
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.
Issue of Convertible Notes under Companies Act, 2013
Start-up companies can issue convertible notes under the provision of Section 62(3) of the Companies Act, 2013 by passing a Special Resolution and file the form MGT-14 with ROC within a period of 30 days.
Process for issuance under Companies Act, 2013

Board meeting – Approval of the board to approve the issue of convertible notes, notice of EGM, check if article amendment is required and execute the Convertible Note Agreement.

Extra Ordinary Meeting (EGM) – Approval of the shareholder in EGM held to pass Special Resolution and approval to issue the convertible notes and alteration of articles if needed.

MGT-14 – Filing of e-form MGT-14 on MCA portal having relevant terms and conditions of the convertible notes within 30 days of passing of the special resolution.

Issuance – Preparation of the convertible notes agreement which should have all the important terms and issuance of the convertible note instrument.

Conversion of Convertible Notes after maturity

Conversion – Upon completion of the maturity date or 10 years per the terms and conditions of the instrument whichever is earlier, start-up companies shall convert the note into equity or preferred stock at the conversion rate as agreed upon.

PAS-3 – Filing of e-form PAS-3 within 30 days of allotment of such share on MCA portal for ROC to approve.

Issue share certificates – Issue the share certificate maintaining the register of members as per the regulations of the Act.

Issue of convertible notes under Foreign Exchange Management Act, 1999 
The convertible notes can be issued to a person resident outside India other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh by an Indian startup company for an amount of twenty-five lakh rupees or more in a single tranche.
Repayment or the sale proceeds can be remitted outside India or credited to the NRE/ FCNR (B) account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. Also, NRI or an OCI may acquire the convertible notes on non-repatriation basis (transfer to NRO account)
FEMA guidelines comes into picture and following laws governing the issuance shall be followed

Foreign Exchange Management Act, 1999;

Foreign Exchange Management (Non-debt Instruments) Rules, 2019;

Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019

Reporting requirement under FEMA Act and RBI for such inflow

Creation of Business User and Entity Master account on FIRMS portal

Filing of Form CN within 30 days of such issue from the date of receipt of payment in bank account. Following documents need to file Form CN:

A declaration certificate from CS

the FIRC and KYC from bank is required

Convertible notes agreement

Copy of MOA / AOA in case investor is a Body Corporate

Certificate of Incorporation.

Start-up Registration Certificate.

PAN of the Company.

Valuation Report (if requested by investor and prepared)

Upon Conversion of Convertible Note to Equity Shares, Form FC-GPR shall be filed within 30 days from date of allotment of equity shares upon conversion.
Tax exemption can be availed by following steps
It usually takes 6 months to 1 year to get this approval.
1) Apply for startup recognition on www.startupindia.gov.in
2) After getting DIPP certificate for startup recognition apply for exemption under section 80 IAC on www.startupindia.gov.in
Issuing convertible notes can also provide startups with more time to develop their business and reach key milestones before having to issue equity. Additionally, the interest payments on convertible notes are tax deductible, which can reduce the issuer's taxable income.
However, it's important to consider the potential downsides of issuing convertible notes, such as the possibility of dilution if the company performs well and the stock price increases, or the potential for conflict if the noteholders and existing equity holders have different expectations for the future of the company. It's also important to carefully consider the terms and conditions of the convertible notes, including the conversion price, conversion ratio, and any restrictions or limitations on conversion. For help, reach out at info@ccoffice.in

Startups often issue convertible notes as a way to raise capital without giving up equity ownership or diluting existing equity holders. Convertible notes provide a flexible financing option for startups that are seeking growth capital but are not yet ready to go public or do not have a clear valuation.

What are Convertible Notes?

Convertible notes are a means of instrument through which registered start-ups can raise capital from investors without any valuation report. These are types of debt security, repayable at the discretion of the holder or which can be converted into equity stock at some future date not exceeding 10 years from date of issue of such convertible note under conditions stated in the instrument.

Convertible notes can be issued to any eligible investor, regardless of their nationality or residency status. This means that convertible notes can be issued to foreign investors, NRIs (Non-Resident Indians), resident Indians, Indian investors, and Indian companies.
Convertible notes are a type of debt instrument that can be converted into equity shares of the issuing company at a later stage, usually during a future funding round or at the maturity of the notes. They are often used by start-ups and early-stage companies as a way to raise funds without having to immediately determine a valuation for the company.
The terms and conditions of convertible notes, including the conversion price and the conversion mechanism, are typically negotiated between the issuing company and the investor at the time of issuance. These terms may vary depending on the investor's profile and the amount invested, among other factors.

Who can issue convertible notes?

Only startups which are recognised by the Department for Promotion of Industry and Internal Trade (DPIIT), can issue convertible notes.

In recent years, convertible notes have become a popular way for start-ups and early-stage companies to raise funds from angel investors, venture capitalists, and other types of investors. Companies such as Airbnb, Dropbox, and Y Combinator have used convertible notes to raise funds in their early years.

Who is a Start-up company in India?

Start-up company means any company incorporated under Companies Act, 2013 or Companies Act, 1956 and as recognised by the Department of Industrial Policy and Promotion, (DPIIT) Ministry of Commerce and Industry vide amended Notification dated 16-1-2019. Learn more about Startup India Recognition- DPIIT.

The Department of Industrial Policy & Promotion was renamed to Department for Promotion of Industry and Internal Trade (DPIIT) after internal trade was added to its mandate on 27 January 2019.

An entity shall be considered as a start-up:

Company age and type: Up to a period of 10 years from the date of incorporation/registration, if it is incorporated as a private limited company under the Companies Act, 2013 or registered as a partnership firm under Section 59 of the Partnership Act, 1932 or a limited liability partnership per the Limited Liability Partnership Act, 2008 in India.
Annual Turnover: Turnover of the entity for any financial years since incorporation has not exceeded INR 100 crores.
Innovative and scalable: Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
Original entity: The entity should not have been formed by splitting up or reconstruction of a business already in existence.

Note: A foreign subsidiary cannot be registered under the startup India scheme. However, companies with foreign shareholders and directors can be registered under the startup India scheme.

Whom can convertible notes be issued to?

Foreign investors
NRI and resident Indians,
Indian investors and Indian companies.

Conditions to issue convertible notes?

Convertible notes can be issued to any eligible investor, including foreign investors, NRIs, resident Indians, Indian investors, and Indian companies. The eligibility of the investor to invest in convertible notes may be subject to compliance with applicable regulations and foreign exchange laws, but there is no restriction on the type of investor who can invest in convertible notes.

Key Notes

The minimum amount to be invested in one tranche by one investor may vary depending on the issuing company's policies and the applicable regulations.

In India, the Securities and Exchange Board of India (SEBI) has set certain guidelines for private placement of securities, including a minimum investment amount of Rs. 20,000 per investor per transaction. This means that if an issuing company is raising funds through private placement, each investor must invest a minimum of Rs. 20,000 in one tranche.

Further, for other types of securities such as convertible notes or equity shares, the minimum investment amount may be higher and can be determined by the issuing company. In general, start-ups and early-stage companies may set a higher minimum investment amount to attract serious investors who are committed to the company's growth and success.

The maximum tenure of convertible notes should be 10 years, which means it should be converted into equity or repaid within a period of 10 years of issue.

For investors convertible notes are better as it has the option to convert into equity unlike Compulsorily Convertible debentures (CCD), which has to mandatorily be converted into equity shares.

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.

Issue of Convertible Notes under Companies Act, 2013

Start-up companies can issue convertible notes under the provision of Section 62(3) of the Companies Act, 2013 by passing a Special Resolution and file the form MGT-14 with ROC within a period of 30 days.

Process for issuance under Companies Act, 2013

Board meeting – Approval of the board to approve the issue of convertible notes, notice of EGM, check if article amendment is required and execute the Convertible Note Agreement.
Extra Ordinary Meeting (EGM) – Approval of the shareholder in EGM held to pass Special Resolution and approval to issue the convertible notes and alteration of articles if needed.
MGT-14 – Filing of e-form MGT-14 on MCA portal having relevant terms and conditions of the convertible notes within 30 days of passing of the special resolution.
Issuance – Preparation of the convertible notes agreement which should have all the important terms and issuance of the convertible note instrument.

Conversion of Convertible Notes after maturity

Conversion – Upon completion of the maturity date or 10 years per the terms and conditions of the instrument whichever is earlier, start-up companies shall convert the note into equity or preferred stock at the conversion rate as agreed upon.
PAS-3 – Filing of e-form PAS-3 within 30 days of allotment of such share on MCA portal for ROC to approve.
Issue share certificates – Issue the share certificate maintaining the register of members as per the regulations of the Act.

Issue of convertible notes under Foreign Exchange Management Act, 1999

The convertible notes can be issued to a person resident outside India other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh by an Indian startup company for an amount of twenty-five lakh rupees or more in a single tranche.

Repayment or the sale proceeds can be remitted outside India or credited to the NRE/ FCNR (B) account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016. Also, NRI or an OCI may acquire the convertible notes on non-repatriation basis (transfer to NRO account)

FEMA guidelines comes into picture and following laws governing the issuance shall be followed

Foreign Exchange Management Act, 1999;
Foreign Exchange Management (Non-debt Instruments) Rules, 2019;
Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019

Reporting requirement under FEMA Act and RBI for such inflow

Creation of Business User and Entity Master account on FIRMS portal
Filing of Form CN within 30 days of such issue from the date of receipt of payment in bank account. Following documents need to file Form CN:

A declaration certificate from CS
the FIRC and KYC from bank is required
Convertible notes agreement
Copy of MOA / AOA in case investor is a Body Corporate
Certificate of Incorporation.
Start-up Registration Certificate.
PAN of the Company.
Valuation Report (if requested by investor and prepared)

Upon Conversion of Convertible Note to Equity Shares, Form FC-GPR shall be filed within 30 days from date of allotment of equity shares upon conversion.

Tax exemption can be availed by following steps

It usually takes 6 months to 1 year to get this approval.

1) Apply for startup recognition on www.startupindia.gov.in

2) After getting DIPP certificate for startup recognition apply for exemption under section 80 IAC on www.startupindia.gov.in

Issuing convertible notes can also provide startups with more time to develop their business and reach key milestones before having to issue equity. Additionally, the interest payments on convertible notes are tax deductible, which can reduce the issuer's taxable income.

However, it's important to consider the potential downsides of issuing convertible notes, such as the possibility of dilution if the company performs well and the stock price increases, or the potential for conflict if the noteholders and existing equity holders have different expectations for the future of the company. It's also important to carefully consider the terms and conditions of the convertible notes, including the conversion price, conversion ratio, and any restrictions or limitations on conversion. For help, reach out at info@ccoffice.in