As per the Consolidated FDI Policy, 2017 startups have now been allowed to raise 100 percent funding from overseas investors via issuance of convertible notes. A convertible note is an optionally convertible instrument giving investors the option (on maturity i.e. when the startup raises next round of funding) to convert their investment into equity at a pre-determined discount on the amount paid by the investor in the next round of funding. If the startup’s valuation does not increase as per the expectations of the investors, they can choose not to convert and instead redeem the note at an interest rate subject to the terms & conditions contained therein. This reduces the risk for the investor, while at the same time allows the possibility of conversion into equity if the startup performs well.

Convertible notes are extremely popular investment instrument in advanced startup ecosystems such as Silicon Valley.

Until now, only equity and equity like instruments (such as CCDs and CCPSs) were recognized as foreign direct investment. Optionally convertible instruments were subject to the RBI’s guidelines on External Commercial Borrowings (ECBs), which are:

1. That the investor must have a minimum 25 per cent direct equity holding in the Indian borrower (or an indirect holding of 51 percent) – This requirement would commercially defeat the purpose of the seed stage investment as the majority of investors intend to wait and watch how the startup performs, without taking immediate equity exposure.
2. That there will be caps on the amount of interest paid, which makes it unviable for the kind of commercial returns expected by a venture capital investor – The guidelines lay down All-in-Cost requirements which cap the amount of interest that can be paid out on the loan (over a standard, called the London Interbank Offered Rate or LIBOR). Note that globally, interest rates are much lower than the domestic interest rates in India so this amount will come up to around 5-8 percent or so, which is much lower than the kind of return that an investor expects. Usually, an investor is a fund which has taken on contributions from other investors, to whom it has promised a high rate of return. Usually, in the investment documents, investors attempt to specify that they will make a 25 percent return over their investment which indicates the commercial intention behind such an investment, and the same would be impossible to achieve owing to the above mentioned limitations in the ECB requirements.

The exact all-in-cost requirements are

1. ECB with minimum average maturity period of 3 to 5 years – 300 basis points per annum over 6 month LIBOR or applicable benchmark for the respective currency.
2. ECB with average maturity period of more than 5 years – 450 basis points per annum over 6 month LIBOR or applicable benchmark for the respective currency.

Hence, before the new policy, the above situation made it difficult for startups to raise funds from foreign investors, who are habituated to investing in startups through a convertible note issuance. In the domestic market too, such notes were not allowed to be issued because they would be considered as ‘deposits’ under the Companies Act, 2013 and the Companies (Acceptance of Deposits) Rules, 2014.

The above rule was first inserted through the RBI’s notification dated 10th January, 2017 amending the Foreign Exchange Management (Transfer or issue of Security by a Person Resident outside India) Regulations 2000. RBI further clarified that its pricing guidelines will be applicable (on the conversion into equity), but no interest rate ceilings have been specified in case it is redeemed. The caps in the ECB guidelines will not be applicable here.

Another important issue that arises is whether amounts invested towards issuance of convertible notes will be treated as deposits under Companies Act. One of the challenges involved in raising corporate finance or investment is the risk that the amount raised may be considered a deposit, in which case the company raising funds must comply with other requirements governing deposits, making the exercise very cumbersome. Further, if it is a private company, it may not be able to raise deposits as private companies are not permitted to raise any money through deposits. You can find out whether the amount qualifies as a deposit or not by referring to the Companies (Acceptance of Deposits) Rules, 2014. Other than the definition of ‘deposit’ look at the list of exceptions to see if the method by which you are raising finance is specifically excluded or not.

In this case, there already is a specific exclusion. As per Rule 2 (1) (c) (xvii) of the Companies (Acceptance of Deposits) Rules, an investment of an amount of twenty-five lakh rupees or more received by a startup, 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 will not qualify as a deposit. This exception was made in 2016 and the Companies (Acceptance of Deposits) Rules do not limit this exception, so it is applicable both to convertible note issuances to domestic and foreign investors.

To be eligible to issue a convertible note within the purview of this clarification, the issuer (or investee) must qualify as a ‘startup’ within the meaning of Start Up India Action Plan. It must, therefore, satisfy the following criteria (as amended on 25 May 2017):

1. The corporate entity must be incorporated or registered in India not prior to seven years (for startups in the biotechnology sector, the period is ten years), with an annual turnover not exceeding Rs.25 crores in any preceding financial year, working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property; and
2. Such entity should not be formed by splitting up, or reconstruction, of a business already in existence.

There is still no clarity on whether issuance of convertible notes has commenced pending issuance of RBI’s clarification. Some advantages of convertible note issuance from the perspective of venture capital investment are:

• Investors and startups do not need to undertake an expensive valuation exercise at an early stage can wait to see the performance of the startup
• There can be a huge saving on legal and documentation costs, as convertible note templates do not involve complex shareholder rights. See the document provided separately. Any protective rights as shareholders are included only once a subsequent round of investment is raised and the investor has chosen to convert the investment into equity.  This saves a huge volume of documentation work, negotiation costs and legal fees. In comparison, a CCD issuance has comprehensive shareholder protection which makes the exercise more exhaustive.