This article is written by Anand Gopal, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from lawsikho.com.

Introduction

India ranks 23 globally among 202 countries, based on the strength of its start-up ecosystem. The start-ups are very volatile so the Govt of India issued convertible notes as an instrument and another way to raise finance for start-ups as per consolidated FDI policy 2017. India being an attractive investment option and policy announcement has given a boost to the economy. Prior issuance of convertible note was not permissible as per the regulations. 

Ministry of corporate affairs for the first time introduced and recognised convertible instruments as Companies (Acceptance of Deposit) Rules, 2014 (“Deposit Rules”) to exempt money received by a company through issuance of CN from the definition of Deposit. The norms and practices have been recognised by the ministry so that relevant instruments can be in alignment and prevalent to current economic conditions.

Convertible Instrument is extremely popular in advanced start-up ecosystems. This becomes very feasible for start-ups to raise finance from UAE, Singapore, silicon-valley etc. Convertible Note is used as an instrument to raise finance for start-ups which is initially a debt and later on converted to shares within a period of  five years from the date of issue The other terms and conditions agreed to and indicated in the instrument.

Convertible Note can be used as an investment option by Indian start-ups so that  raising funds of funds apart from directors, relatives or shareholders of the Company becomes easily accessible for the company. This is another type of instrument for availing credit from a Foreign national or Foreign Entity. FEMA guidelines give detailed requirements and conditions for availing Convertible Note.

Requirements  for issue of Convertible note (CN)

A person who is resident beyond the territories of India  (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), is permitted to invest in Convertible Note issued by an Indian start-up company up to 25 lakh rupees or more in a single tranche.

1. If a start-up company is engaged in any business where investment by a person resident outside India requires approval of Government, can issue Convertible Note only if such approval is granted.
2. A Convertible Note issued by an Indian start-up company has to be converted into equity shares of the company in accordance with FEMA rules, regulations and guidelines within 5 years.
3. The person who resides outside Indian can acquire or transfer by way of sale, convertible notes, from or to, a person resides in India, provided that transfer takes place in accordance with the pricing guidelines and entry routes.
4. A Convertible Note can be issued on repatriation and non-repatriation basis both. NRI or an OCI may acquire CN on a non-repatriation basis in accordance with the instructions/guidelines of RBI.
5. The payment consideration can be received by a person resident outside India by –

• If it is inward remittance through normal banking channels.
• by way of debit to FCNR (B)/NRE.
• by way of debit to “Escrow account” maintained in accordance with FEMA regulations.

Note: If an escrow account is maintained for above purpose then it should be closed immediately after the requirements are completed or within a period of six months. The said account shall not be permitted if it continues beyond six months.

Advantages from investor’s perspective 

• Valuation Cap  

As an investor you can negotiate for the convertible note to include a valuation cap or discounting rate. For instance, if a company in the near future reaches maximum price then valuation cap will assist in converting those notes into shares of the company. If you don’t have valuation cap, you might receive very little shares for the investment you have done initially with the company so it is advisable to have valuation cap which will give some guarantees that you will receive a certain share of the company at predetermined price and rate. 

Examples for a valuation cap/ Discount 

For better understanding of Convertible Note, let’s talk about some of the examples of what this conversion into equity actually looks like. The most important variable associated with convertible notes is: 1. Valuation Cap 2. Discount Rate and then see how these two interact. 

In other words, we can ignore accrued interest in our calculations.

1. Example 1, We can imagine that company raised a seed round of funding by issuing convertible notes with a valuation cap of Rs 40,00,000 lakhs and no discount before raising its Series A round of Funding Rs 1,20,00,000 and Rs 10 per share. For calculating the valuation cap on the note, the valuation cap has to be divided by the pre money valuation of the subsequent round and apply that to the series A price per share. As per the example it comes around Rs 3.33 per series A share for convertible note holders. If the investment comes around Rs15,00,000 by that Rs 3.33 per share would grant the seed investor approximately 4,50,450 shares. If the investor investing in directly in the Series A Round @ Rs 10 shares would only be issued 15,00,000 directly in the series A round share @ Rs 10 per share would only be issued 1,50,000 shares
2. Let us understand another example where the company raised its seed round by issuing a convertible note that had no valuation cap but it has a discount of 20 % to the Series A Round. In this particular situation Series A round is not important since you are applying the discounting rate per share. If you apply a 20% discount to the price of Rs 10 per share it becomes Rs 8 Per share. If an investor wishes to invest Rs 15,00,000, it would receive 1,87,500 Series A Shares. Now here if the investor doesn’t apply for a discount it might end up taking only 1,50,000 shares.  

Investors can use whichever method for calculation for conversion to get the maximum shares and It will be dependent upon the type transaction, so whether it is Seed round of Investing or it is series round of Investing. So, every transaction has it’s on pros and cons for investment. It is advisable for the investors to conduct a proper due diligence before going for any investment.  

• Interest rates

The interest rate for such loans can be maximum upto 20%. Investors earn interest from these convertible notes so investors won’t have to depend upon the company to receive a value for their investment and if required the investors can include the interest rate to include as part of investment.

• Priority over shareholders 

In case of liquidation of a company, you have priority over investors since convertible note is another form of debt like CCDs. The tenure for the same is 5 years FDI consolidated policy 2017.

Disadvantages from Investor’s Perspective  

• Risk of financial loss

In an early-stage start-up, investing through convertible notes carries a degree of risk. There are many start-ups which have succeeded and there many start-ups which have gone for liquidation. If the company goes into liquidation and your CN is outstanding and if there are no funds left with the company to pay your debt,  so as per the Insolvency and Bankruptcy Code, the NCLT might resolve the loan of Banks then it might resolve your debt. 

Probably you can cover you risk through:

• By securing the loan by charging the company’s property (intellectual or real); or
• a personal guarantee of promoter. 

Generally, most start-ups won’t agree to this. As an investor, you might have to take on the risk yourself.

• Uncertainty

Start-ups are generally uncertain like a seed of Bamboo. Start-ups generally depend on the founder’s capacity and vision to make it successful so it is necessary to do proper due diligence of the business and then come to the proper decision of the same. 

• Conversion

It is mandatory after five years it has to be converted into Equity shares or CCPS as the case may be. If you have to make certain decision about the business of the company you will have to make in these five years

• Lack of control

The convertible note is a loan so you might have to forgo your shareholders right. Since you are not a shareholder of the company so you have no voting rights over the affairs of the company. This means you are not part of decision making and you might have less insights of the operation of the company than a shareholder or director. 

• Reporting to RBI

If any start-up company issues any CN to any person who is resident outside India shall report such inflows to the Authorised Dealer bank in Form CN which is a part of Single Master form within 30 days of such issue.

• Following documents are required for reporting –

1. FIRC and KYC of the non-resident investor.
2. The details like name and address of the investor and AD bank.
3. Copy of MOA / AOA.
4. Certificate of Incorporation.
5. Start-up Registration Certificate.
6. PAN of the Company. 
7. Certificate from Practising Company Secretary.

• Penalty for late submission

Penalty in filing Form CN will attract late submission fees as per RBI Master Directions: 

The estimated Amount involved in reporting (in Rs.)	Late Submission Fee (LSF) as % of amount involved	Maximum amount of LSF applicable
Equal to  10 million	0.05 percent	300% of amount involved  or Rs.1 million  of the amount involved , whichever is lower
Greater than 10 million	0.15 percent	300% of the amount involved or  Rs.10 million of the amount involved  , whichever is lower

• Execution aspect of convertible note 

1. Register with Start-up India from DPIT.  
2. Conduct and convene a Board Meeting for approving issuance of Convertible Note.
3. Conduct and Convene a Shareholders’ Meeting for approving issuance of Convertible Note.
4. Draft a Convertible Note Agreement. 
5. Draft a Convertible Note certificate.
6. If the Articles of Association do not allow the Board to borrow money, amend the Articles of Association to give the Board the power to borrow by passing board and shareholders resolutions.
7. Drafting board resolution for approving Convertible Note.
8. Drafting a shareholders’ resolution for approving Convertible Note.
9. Stamp the Convertible Note Agreement.
10. Procuring signature of all Parties concerned on the Convertible Note Agreement.
11. After the receipt of investment amount then issue Convertible Note Certificate which has to be  duly stamped and executed.
12. File Form MGT-14 within 30 days of Shareholders’ Meeting.
13. File Form DPT-3 by 30th June of every year.

• Taxation aspect 

• Before Conversion

When Convertible Notes are issued initially there are no tax implications at the time of issuance.

• After Conversion 

The fair market value has to be determined so that conversion price could be evaluated. There is a difference between conversion price and the market price which may be taxable in the hands of the company under 56(2) (viib) of Income Tax Act, 1961 to be read with Rule 11 UA and  Rule 11U  of Income Tax Rules. The income tax department has provided an exemption if the company is registered as a start-up.  

• Stamp duty requirements 

The stamp duty might vary from state to state. 

Key terms of convertible notes agreement 

• Definition Clause 

In the Definition clause you can include the list of terms which you used in the Convertible Notes Agreement like the definition of act, charter documents like AOA, MOA, Business Days, Confidential Information Qualified Value Round or any other terms which can be included as part of the agreement. 

• Investment Clause 

The investment amount shall be transferred to XYZ Company’s Current Account and the amount of Investment, basis of investment like Condition precedent, condition subsequent, closing and closing date.   

• Valuation cap clause for the investment 

The valuation of investment in terms of equity shares. In Finance there is a concept called Time Value of Money, this basically means what is the value of present investment in the future. This means you need to put a valuation cap so that the value of investment does not fall in the future even if the start-up company is not able to meet the required bench mark in terms of profits. 

• Terms of CN 

The terms of CN can include various terms like what would be interest rate of invested amount, when will the investment will be converted into Equity shares, when will be the qualified valued round shall commence, whether the investor shall be given access to books of Accounts of the company these are the general terms and condition which shall be included in CN.

• Redemption/Liquidation Clause

The investors should look out for an exit clause if their investors are not satisfied with the company’s performance. The redemption clause should be included if the investors wish to redeem their Convertible Note. 

• Termination

The termination shall also be included in convertible note. This will totally be dependent on other clauses if there is any breach of representation and warranties, covenants.

• Confidentiality

The promoters, Investors and the management of the company shall maintain confidential information with respect to the business of the company and with respect to investment. This is a standard clause which is mentioned in any agreement. 

Conclusion

The convertible note is a very good investment option for a person Resident Outside India for NRI since it is safe and tenure is fixed for 5 years, investment amount cannot exceed Rs 25,00,000 and you can also earn interest from the investment. It is better if you view the performance of the start-company before Investing huge amount of money. Investors can use any method like valuation cap or Discounting method for valuation of Convertible Note. 

Key takeaways 

1. It is a safe investment if it is an early stage start-up.
2. After 5 years you need to convert them into shares compulsorily. 
3. You can also earn interest from those convertible notes.
4. The value of investment cannot exceed Rs 25,00,000 (twenty-five lakhs). 
5. It is better to invest at an initial phase with convertible notes rather than investing a huge amount of money. 
6. The valuation cap can also be inserted at an initial level, so that you view the performance of start-up companies before investing a huge amount of money. 

Sample notice and board resolution and EGM which needs to be completed 

[.] PRIVATE LIMITED

Registered Address: [.] [.] [.] [.] [.] [.] [.] [.][.] [.] , email id: [.]

CIN: [.]

Shorter notice of the board meeting

Shorter notice is hereby given that the meeting of the Board of Directors of [.] will be held on [.], [.]at the registered office of the Company at [.] at [.] to discuss the business as set out in the Agenda attached hereto.

You are requested to make it convenient to attend the meeting physically or through video conference.

Further, if a Director will not be able to attend the said Board Meeting, then he may seek leave of absence for the same.

For [.]

___________

[.]

Director

DIN: [.]

Address[.],

[.],

[.]

Date: [.]

Place: [.]

Agenda for the board meeting

Agenda for the [.] meeting of the Board of Directors of [.] to be held on [.], [.] at the registered office of the Company at[.]at [.].

The following business will be transacted at the meeting:

1. To elect the Chairman of the meeting; 
2. To grant leave of absence, if any;
3. Confirmation of the minutes of the previous board meeting;
4. To give authority to Board of Directors to borrow money through issue of convertible note;
5. To call an Extraordinary General Meeting of the Company at shorter notice; and
6. Any other business with the permission of the Chair.

For [.]

________________

[.]

Director

DIN: [.]

Address[.],

[.],

[.]

Date: [.]

Place: [.]

Notes to the agenda

Agenda No. 4

Keeping in view the Company’s business requirements and growth plans, it is considered desirable by the Board of Directors of the Company to borrow money through issue of convertible note from [.] upto Rs. 25,00,000 (Rupees Twenty Five Lakhs Only) in a single tranche, subject to provisions of Companies Act, 2013 and Foreign Exchange Management Act,1999 on such terms and conditions as may be decided by the Board of Directors of the Company. The consent of the Board of Director is required for the same.

Agenda No. 5

In order to obtain shareholders’ approval for agenda No. 4, it is proposed that an extra-ordinary general meeting of the members of the Company be convened on [.], [.] at the registered office of the Company at [.] at [.]. at shorter notice.

For [.]

___________

[.]

Director

DIN: [.]

Address[.],

[.],

[.]

Date: [.]

Place: [.]

[.] PRIVATE LIMITED

Registered Address: [.] [.] [.] [.] [.] [.] [.] [.][.] [.] , email id: [.]

CIN: [.]

CERTIFIED TRUE COPY OF THE RESOLUTION PASSED AT THE MEETING OF BOARD OF [.] ON [.], [.] AT [.] AT THE REGISTERED OFFICE OF THE COMPANY AT [.].

Resolution No. 1

Authority to board of directors to borrow money through issue of convertible note

“RESOLVED THAT pursuant to section 62(3), 179 and 180 and all the other applicable provisions, if any, of the Companies Act, 2013 and the rules made there under (including any statutory modification(s) or re-enactment(s) thereof for the time being in force), and as per the Reserve bank of India (Notification No. FEMA.377/2016-RB) and Companies (Acceptance of Deposit rules), 2014 and subject to the approval of members by way of special resolution, the consent of the Board of Directors of the Company be and is hereby accorded to borrow money from [.] upto Rs. [.] ([.] Only) through issue of Convertible Note and on such terms and conditions as may be decided by the Board of Directors including conversion of such Convertible Note into equity in certain default instances if insisted upon by the lenders.

RESOLVED FURTHER THAT any of the Directors of the Company be and is hereby authorized to negotiate and execute the convertible note agreement (draft of which duly initiated by the Chairman be and is hereby placed before the board for  the purpose of identification) and do all such acts, deeds, things and to deliver such other additional documents on behalf of the Company in connection with the borrowings including modifications and amendments to each of the aforesaid additional documents and to take steps and to do all things including filing of required forms with the Registrar of Companies / Reserve bank of India or any other authorized dealers as required under applicable law and to do all such acts, deeds, matters and things as may be necessary to give effect to the aforesaid resolution.

RESOLVED FURTHER THAT the copies of the foregoing resolutions, certified to be true by any Director, may be furnished to any person(s) as may be required.”

!!Certified True Copy!!

For [.]________________

[.]

Director

DIN: [.]

Address: [.]

Date: [.]

Place: [.]

[.] PRIVATE LIMITED

Registered Address: [.] [.] [.] [.] [.] [.] [.] [.][.] [.] , email id: [.]

CIN: [.]

Notice of EGM

Notice of the Extraordinary General Meeting

Shorter Notice is hereby given that the Extraordinary General Meeting of [.] will be held on [.], [.] at [.] at the registered office of the Company at [.] to transact the following special business:-

Item No. 1: To give authority to Board of Directors to borrow money through issue of convertible note:

To consider and if thought fit, to pass with or without modification, the following resolution as a Special Resolution:

“RESOLVED THAT pursuant to section 62(3), 179 and 180 and all the other applicable provisions, if any, of the Companies Act, 2013 and the rules made there under (including any statutory modification(s) or re-enactment(s) thereof for the time being in force), and as per the Reserve bank of India (Notification No. FEMA.377/2016-RB) and Companies (Acceptance of Deposit rules), 2014 the consent of the members of the Company be and is hereby accorded to borrow money from [.] upto Rs. 25,00,000 (Rupees Twenty Five Lakhs Only) through issue of Convertible Note and on such terms as may be decided by the Board of Directors including conversion of such convertible note into equity in certain default instances if insisted upon by the lenders. 

RESOLVED FURTHER THAT any of the Directors of the Company be and is hereby authorized to negotiate and execute the convertible note agreement (draft of which duly initialled by the Chairman be and is hereby placed before the meeting for  the purpose of identification) and to do all such acts, deeds, things and to deliver such other additional documents on behalf of the Company in connection with the borrowings including modifications and amendments to each of the aforesaid additional documents and to take steps and to do all things including filing of required forms with the Registrar of Companies / Reserve Bank of India or any other authorised dealers as required under applicable law and to do all such acts, deeds, matters and things as may be necessary to give effect to the aforesaid resolution.”

RESOLVED FURTHER THAT the copies of the foregoing resolutions, certified to be true by any Director, may be furnished to any person(s) as may be required.”

For [.]

________________

[.]

Director

DIN: [.]

Address[.],

[.] 

[.]

Date: [.]

Place: [.]

Notes

1. A member entitled to attend and vote at the meeting is entitled to appoint a proxy to attend and vote in his/her place, and the proxy need not be a member of the Company. 
2. Member/Proxy, desirous of attending the Meeting, must bring the Attendance Slip (enclosed herewith) to the Meeting duly completed and signed, and hand over the same at the venue entrance.
3. The meeting has been called at shorter notice and consent from the members of the Company as required under the Companies Act, 2013 has been received.
4. Members are requested to send a duly executed Representation Letter, pursuant to Section 113 of the Companies Act, 2013, authorizing their representative to attend and vote at the Extraordinary General Meeting.  
5. Route map and landmark details for the venue of the general meeting are as below. 

Route map and landmark details for the venue of the general meeting

Google Map Snapshot  

Explanatory statement pursuant to section 102 of the companies act, 2013

The following explanatory statement pursuant to Section 102 of the Companies Act, 2013 sets out all material facts relating to the special business mentioned in the accompanying notice and should be taken as forming part of the notice. The board of directors of the Company (“Board”) accordingly recommends the above resolutions for approval by the shareholders of the Company. The Board has given its approval for the above resolutions at the meeting of the Board held on Thursday, [.] at [.].

Item no. 1

Keeping in view the Company’s business requirements and growth plans, it is considered desirable by the Board of Directors of the Company to borrow money through issue of convertible note from [.] upto Rs. 25,00,000 (Rupees Twenty Five Lakhs Only) in a single tranche, subject to provisions of Companies Act, 2013 and Foreign Exchange Management Act,1999 on such terms and conditions as may be decided by the Board of Directors of the Company.

The borrowing limit of the Company shall be limited upto Rs. 25,00,000 (Rupees Twenty Five Lakhs Only).

The Board of Directors, therefore, recommend the resolution proposed vide item number 1 to be passed as a special resolution by the members of the Company.

None of the Directors of the Company are interested in the above mentioned resolution.

For [.]

________________

[.]

Director

DIN: [.]

Address[.]

[.], 

[.]

Date: [.]

Place: [.]

[.] PRIVATE LIMITED

Registered Address: [.] [.] [.] [.] [.] [.] [.] [.][.] [.] , email id: [.]

CIN: [.]

CERTIFIED TRUE COPY OF THE RESOLUTION PASSED AT THE MEETING OF BOARD OF DIRECTORS OF [.] HELD ON [.] AT [.] AT THE REGISTERED OFFICE OF THE COMPANY AT [.]

Resolution No. 2

Convene of Extraordinary general meeting:

“RESOLVED THAT the approval of the Board be and is hereby accorded to convene an extraordinary general meeting of the members of the Company at shorter notice on[.] ,[.] at [.]. at the registered office of the Company at [.], to transact the business as provided in the draft notice and explanatory statement tabled before the Board and initiated by the Chairman for the purposes of identification, for convening the extra ordinary general meeting.

RESOLVED FURTHER THAT the draft of the notice (along with the explanatory statement) tabled before the Board and initiated by the Chairman for the purposes of identification, for convening the extra ordinary general meeting of the members of the Company be and is hereby approved.

RESOLVED FURTHER THAT any of the Directors be and are hereby authorized to sign and issue the notice (along with the explanatory statement) of the extra ordinary general meeting for and on behalf of the Board of Directors of the Company, to the members of the Company; and do all such actions, deeds, matters, writings and things as are necessary or expedient to give effect to the above resolutions, including, but not limited to, undertaking filing of requisite forms, returns and documents with the concerned jurisdictional Registrar of Companies/Ministry of Corporate Affairs.

RESOLVED FURTHER THAT the copies of the foregoing resolutions, certified to be true by any Director, may be furnished to any person(s) as may be required.”

!!Certified True Copy!!

For [.] PRIVATE LIMITED

________________

[.]

Director

DIN: [.]

Address: [.]

Date: [.]

Place: [.]

---

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