Issue Of Convertible Notes By Start Up Companies

Introduction

The concept of “Convertible Notes” was first introduced vide Ministry of Corporate Affairs’ notification dated June 29, 2016 by way of amendment to the definition of Deposits. It is basically aimed to provide financing to a start-up company till it raises Series-A funding, with a simple and easy compliance procedure and without the requirement of valuation report.

As per Companies (Acceptance of Deposits) Rules, 2014 as amended:“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 start-up company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.

As per amended Deposits Rules, an amount of twenty-five lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person is not covered under the definition of Deposits.

Key points for issue of Convertible Notes

1. Company should be recognized as a start-up company with Department for Promotion of Industry and Internal Trade (DPIIT).
2. Minimum amount of issue of convertible note in a single tranche is Rs.25 lakhs.
3. An agreement shall be in place stating the terms and conditions of issue, maturity, conversion etc.
4. Maximum period of conversion or repayment allowed is five years.
5. Only equity shares shall be issued on conversion, and not any other instrument.

Analysis – The introduction of the concept of Convertible notes has allowed start-up companies to raise funds in its initial years of formation, without having to go through valuation. Prior to this concept, any start-up intending to raise funds had to go through valuation of the shares of the company. Further if the investors were persons resident outside India, start-up companies had only two modes of raising funds from them:

1. Issue of equity shares or Compulsorily Convertible Preference shares or Compulsorily Convertible Debentures under Foreign Direct Investment (FDI) route.

2. Partially convertible instruments or loan through External Commercial Borrowings (ECB) route.

With the objective of simplifying the procedure for raising funds from Abroad for start-up companies, Reserve Bank of India (RBI) amended Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2016 (“FDI Regulation”) to allow issue of convertible notes by recognized start-up companies.

1. Unlike issuance of shares by private placement or preferential allotment, the procedure for issuance of a convertible note is comparatively easier.

2. As it is a debt instrument, the issuing Company is required to seek approval of its members by way of a Special Resolution at the General Meeting. This must be notified to the Registrar of Companies by filing of eForm MGT-14 within 30 (Thirty) days of the General Meeting.

1. The Company issuing convertible notes to a person resident outside India shall report such inflows to the Authorised Dealer Bank in Form Convertible Note (CN) within 30 (Thirty) days of such issue.

2. A person resident in India, who may be a transferor or transferee of convertible notes issued by the Company shall report such transfers to or from a person resident outside India, as the case may be, in Form Convertible Note to the Authorised Dealer Bank within 30 days of such transfer.

Conclusion – It is pertinent to note here that at the time of conversion of convertible notes into equity shares, pricing guidelines and other conditions applicable under FDI Regulations have to be followed and necessary reporting to be done. This may act as a deterrent as the holders of convertible notes may be interested to convert their notes into equity shares at a discount to the fair value or to the value invested by series-A investors. In which case, the company may have to issue equity shares to series-A investors at a price higher than fair value, to offer discount to holders of convertible notes.

Further, Section 56(2)(viib) of Income Tax Act, 1961 provides for taxability in case the company issues shares at a consideration which is higher than fair value to residents. However, the section talks only about issue to “residents”. Thus, it may be inferred that non-residents are outside the purview of Sec. 56(2)(viib). Also, start-up companies meeting the criteria as prescribed shall be eligible for exemption from the applicability of Sec. 56(2)(viib) on an application made in this regard.

Overall, the recognition of Convertible Notes as a capital investment instrument is definitely a positive move to make the process of investments into Indian start ups swifter, easier and less expensive and will greatly benefit them.