Corporate Law Newsletter – All About Convertible Note And Its Benefits To Startups : May 2024

Introduction

As we know, early-stage businesses often encounter heightened risks of failure due to several reasons and factors, especially startups, which are operating on the risk of innovation in the market. In order to keep them afloat, it is significant for them to secure funding through various sources of channels such as debt, equity by means of venture capital, crowdfunding, etc. Among these, one of the common ways for raising funds by the startups is through the issuance of Convertible Note. 

Convertible Note have emerged as a prominent mechanism or tool for capital procurement by startups in today’s contemporary and dynamic market. In simpler terms, a Convertible Note is a financial instrument that provides an opportunity to startups to raise capital without immediate dilution of shareholding or the issuance of securities. It is a form of debt provided by the investors with the option of converting their indebtedness into equity at a subsequent juncture and while navigating the uncertainties of early-stage businesses. 

Let’s understand the legal requirements and thresholds involved in the issuance of a Convertible Note below. 

Definition of Convertible Note

As per Rule 2 (1) (c) (xvii) of the Companies (Acceptance of Deposits) Rules, 2014 (“Deposit Rules”), a company can accept a deposit or loan by way of a Convertible Note, for an amount of minimum INR 25,00,000 (Indian Rupees Twenty-Five Lakhs) or more in a single tranche from a person for a period of 10 (Ten) years. 

For this purpose, the term ‘Convertible Note’ 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 startup company upon occurrence of conversion events and in accordance with the terms and conditions as agreed and captured in the instrument”. 

Further, the Deposit Rules have specifically laid down the definition of startups as well. The Deposit Rules state that a startup shall mean a private limited company incorporated under the Companies Act, 2013 or the Companies Act, 1956, which is recognised as a startup by the Department for Promotion of Industry and Internal Trade (“DPIIT”). The additional criteria under the laws of India for a private limited company or registered partnership firm or limited liability partnership to be labelled as a startup are as follows:

1. Period of existence and operations shall not exceed 10 (Ten) years from the date of incorporation;
2. Requirement of an annual turnover exceeding INR 1,00,00,00,000 (Indian Rupees One Hundred Crores) for any of the financial years since its incorporation;
3. The business model of such an entity must work towards an innovation, development, or improvement of a product, process, or service, or it is a scalable business model with the potential of increasing employment or wealth creation.
4. The company has not been formed by splitting or reconstructing an already existing business/company.

Valuation of startups

As per the Rule 13 (xii) (h) of the Companies (Share Capital and Debenture) Rules, 2014, where convertible securities are offered on a preferential basis with an option to either opt for redemption of money or convert the debt into equity shares, the valuation of the startup issuing Convertible Note should be determined either:

1. upfront at the time of issuance of the convertible securities; or 
2. at the time when the convertible securities are being converted into equity shares. 

Benefits to the startups 

Issuance of Convertible Note offers several benefits to the startups:

1. Delayed equity dilution: By opting for Convertible Note, startups can delay the dilution of their equity share capital at an early stage. Instead of giving up ownership stake in the company immediately, they can choose to repay the debt or convert the Convertible Note into equity shares at a later date, typically during a future financing round when the company’s valuation is at a stable value.
2. Bridges fundraising rounds: Convertible Note act as a bridge between different funding rounds of a company, allowing the startups to extend their operations and achieve their business milestones. It is a more chosen way of fundraising by early startups post their seed rounds. 
3. Easy access to funding: It provides comfort to the founders who are seeking investment that they can access much-needed capital without diluting their shareholding in the company immediately.
4. Fast process: Issuance of Convertible Note is a faster process compared to issuance of equity shares by the company to the early investors. The legal documentation and procedure for the issuance of Convertible Note is less cumbersome and can be completed swiftly in comparison to the issuance of equity shares and allows the startups to procure an investment without losing management control in the company upfront. Further, conversion of Convertible Note into equity shares is also a more flexible process as it eliminates the necessity for the company to commence the fundraising procedure anew.
5. Discount Rates:  The increased trend of issuance of Convertible Note will make discount rates more founder-friendly in the future providing startups with more attractive conversion deals.
   

Conclusion

The various potential benefits of Convertible Note includes:

1. Convertible Note is a valuable financial instrument which keeps the company away from immediate equity dilution and provides flexibility in repayment terms;
2. Convertible Note can act as a catalyst for the growth of startups while allowing them to maintain ownership and management control.