Start-up as a concept has gained lots of momentum in past 1 decade. With the emergence of technology and fast paced digital revolution, many start-ups have gained unicorn status in India, especially in last one year. Startups work under a constant need of working capital, as it is very important for any startups to raise capital with minimum dilution on founder’s stake. Under a startup ecosystem, setting up of legal entity and using appropriate instruments for raising capital becomes paramount important criteria if long term considerations are given.
Usually, the legal structures adopted in India are Limited Liability Partnership (“LLP”) and Company. Both LLP and company are internationally accepted legal structure given that both are governed under Ministry of Corporate Affairs.
LLP is formed under Limited Liability Partnership Act, 2008. LLP is a body corporate and a legal person separate from its partners, it provides benefits of corporate structure and flexibility of partnership form. LLP is a corporate business vehicle that enables professional expertise and entrepreneurial initiative to combine and operate in flexible, innovative and efficient manner.
Company is formed under the Companies Act, 2013. Company is a body corporate and legal person separate from its shareholders. as a legal entity is classified under 2 baskets, viz. (i) Private Limited Company; and (ii) Public Limited Company. Under private limited company structure, there are no public shareholders, whereas in public limited company structure, there could be public shareholders depending upon whether such public limited company is listed or not.
As startups are in constant need of raising capital, both LLP and Company can be an efficient structure for raising capital. However, when funding is raised from outside India, provisions under Foreign Exchange Management Act, 1999 (“FEMA”) needs to be considered. Under FEMA, there are various restrictions and conditions for raising capital from outside India.
One of the unique instruments for raising capital under the company structure is through convertible notes. Convertible notes is an equity instrument whereby upon receipt of capital funds, such receipts are acknowledged initially as debt, repayable at the option of the holder, or which is convertible into a such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon the occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.
Convertible notes or funds are those short-term debts which are issued to the investors during the early stages of the company and are later exchanged for shares or are repayable according to the option chosen by the holder. Convertible notes have characteristics that make them attractive to both issuers and investors (or holders). Investors find them attractive because of the potential equity upside, as well as the downside protection provided by coupon and principal payments. A convertible note may have additional contractual features such as call option and put option. Call option is the ability of the issuer to call a convertible bond at a predetermined price, which could be a function of principal and accrued interest. Put option is the holder’s right to redeem the convertible note at a predetermined price, which could also be based on the principal and accrued interest.
According to an amendment to the Companies (Acceptance of Deposits) Rules, 2014, a DPIIT recognised start-up is allowed to accept funds to the tune of INR 25 lakh or more in a single tranche from investors by issuing convertible notes to investors. Generally, concept of convertible notes is commonly adopted by early age start-ups as it provides quick access to funding. Generally, an investor provides early-stage capital to start-ups in the form of a loan with repayment terms of maybe a year or a two. Convertible notes contain the maturity date, interest, terms of conversion and other such terms necessary for the execution. The note is repaid in the form of equity of the investee companies, usually with another round of funding. If the maturity date has arrived and the start-up is unable to repay the debt, the investor can choose to extend the maturity date of the convertible note, up to the statutory limit of five years or ask for an actual repayment of the note. All this depends upon the potential and the progress of the Start-ups.
Startup for the purposes of raising capital in a form of convertible notes are required to fulfil following criteria:
- Up to a period of ten years from the date of incorporation/ registration, if startup is incorporated as a private limited company (as defined in the Companies Act, 2013) in India;
- Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
- 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.
Convertible notes can be raised by a Company operating in any sector freely except in a sector where government approval is required. Further, issue of equity shares against such convertible notes shall be in compliance with the entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment. Further, prior government approval is required to be obtained if such raising of capital is done from any citizen / entity incorporated in a country which shares land border with India, even if entry route is allowed to be under automatic route.
However, any investment by a NRI or an OCI to acquire convertible notes on non-repatriation basis, would be considered as akin to domestic investment and no approval mechanism or entry route considerations and pricing guidelines needs to be complied with. Any sales proceeds from sale of such convertible notes or equity shares pursuant to conversion of convertible notes needs to be credited to NRO Account and can only be repatriated under USD 1 million scheme.
A person resident outside India may acquire or transfer by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the entry routes and pricing guidelines as prescribed for capital instruments.
In a nutshell, convertible note is a hybrid model, where capital can be changed from debt to equity. Option of choosing convertible notes is easiest as compared to route of external commercial borrowings or equity instrument itself. It can be considered as short term debt having equity feature in it as generally it carries low-interest rates. Convertible notes are alternatives to straight debt securities, which can potentially provide extra profit for investors through the conversion feature.
For more detailed discussion on the above subject, please do not hesitate to connect at contact@devadhaantu.in
