October 22, 2019

Convertible Notes Developing Trends

- Manish Gupta, Partner, M&A and Private Equity [ Link Legal India Law Services ]
- Pratyush Khurana, Principal Associate, M&A and Private Equity [ Link Legal India Law Services ]


Since convertible notes are only permitted to be converted into ordinary equity, foreign investors continue to prefer instruments such as CCPS or CCDs which can be designed to carry preferred rights and returns...

Start-ups in India have traditionally bootstrapped their seed funding, relying on angel investors to bolster their initial operations. Seasoned financial investors, be it individual angel investors or institutional investors, usually seek preferred securities, such as compulsorily convertible preference shares (“CCPS”) and compulsorily convertible debentures (“CCDs”). Preferred securities carry a predetermined coupon, liquidation preference, pre-emptive rights, and other protective and participative provisions such as veto right and board representation in the start-up.

However, these investments through CCPS and CCDs tend to consume time and cost for parties at both ends. Further, a lot of complex shareholder rights may not have any value within smaller companies looking to jumpstart their business. In this context, convertible notes may be able to solve some of these issues for both - the investors’ target of deploying capital and a start-up’s aim of raising funds.

Legal Framework

The Companies Act, 2013 (“Companies Act”) read with the Companies (Acceptance of Deposit) Rules, 2014 (“Deposit Rules”)1 provides an exemption to a private company registered as a start-up in accordance with the Start-up Indian Policy (“issuer”) from receiving a deposit by way of convertible notes. Convertible note is defined as 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 specified events and as per the other terms and conditions agreed to and indicated in the instrument”.2

In similar vein, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FEMA 20-R”) issued under the Foreign Exchange Management Act, 1999 (“FEMA”) has also identified convertible notes as a class of instruments available to the issuer to raise funds from non-resident investors. Regulation 2(vi) of FEMA 20-R includes a definition for convertible notes which is consistent with the one prescribed under the Deposit Rules.


Fundraising through convertible notes

The process of raising funds by way of convertible notes would typically involve: (a) convening a meeting of the board of the issuer to record the funding requirement of the issuer, which is sought to be fulfilled by way of issuance of convertible notes;3 and (b) seeking shareholders’ special approval to issue the convertible notes, which shall carry an option to convert into equity4.

It should be noted that a convertible note can be considered as a short term unsecured debt, and not an instrument in itself; therefore, the processes required for issuance of securities can be said to be not applicable.5

Conversion events

The terms of conversion, as discussed below, can be negotiated differently in different cases. The issuer and convertible note subscriber (“investor”) may execute an agreement recording the same.

Convertible notes may be converted into equity on the occurrence of event(s) such as next round of equity financing (“Funding Round”), or the issuer reaching predetermined business goals (each a “Conversion Event”).

Alternatively, parties may also agree on pre-term termination and repayment of the convertible notes in contingencies (similar to what liquidation preference rights) which include not only traditional insolvency scenarios, but business specific events such as failure of the issuer to acquire a patent, or failure to reach certain sale / revenue thresholds or business goals which were agreed as Conversion Events (“Event of Default”), essentially matters more indicative of the issuer’s inability to continue carrying on the operations for which funding was sought. Convertible notes allow both the investor and the issuer to account for uncertainty which is unique to a start-up, offering flexibility which is otherwise missing in traditional securities.

Terms and conditions of conversion

The default conversion event, i.e. expiry of 5 years from the date of issuance, will apply in all cases, regardless of such pre-identified event occurring, unless redemption of the convertible note has been made as the default rule.

Upon the earlier of the occurrence of a Conversion Event or the default 5 years’ period expiring, the convertible note will convert on such terms which had been approved at the time of its issuance. The important ones amongst these terms are valuation cap and/or discount, and applicable shareholders’ rights.

Valuation Cap and/or Discount
Convertible notes are intended for use by businesses which are in such a nascent stage that ascribing any valuation may not be feasible. In such cases, deferment of the valuation exercise to the next Funding Round is considered more favorable to the parties as it avoids unnecessary discussion about the right valuation at the initial stage and allows the parties to move on with the investment in a time effective manner. The elimination of these steps contributes positively towards reducing the time spent between negotiations and the investment closing.

The conversion of the convertible note amount is generally linked with the valuation of the subsequent Funding Round, which may be subject to certain discount to accommodate time value of money and/or subject to a valuation cap, i.e., even after application of such discount, the valuation at which the conversion will take place will go beyond a specific amount. Alternatively, its conversion may be purely based on fair market value at the time of conversion, instead of it being linked with the valuation of a subsequent Funding Round.

Transfer of convertible notes
The relaxation in pricing requirements extended for issuance of convertible notes under FEMA 20-R cease in case such subscriber intends to transfer of the same. While FEMA 20-R allows for the convertible note to be freely transferrable, the transfer between a person resident in India and the person outside India will have to be priced in accordance with the pricing guidelines prescribed under FEMA 20-R.

Treatment of interest
Though neither the Companies Act nor FEMA prescribes for the convertible notes to carry any interest, if any interest is to be contractually agreed upon, such interest may better be included in the amount which is converted into equity in order to avoid questions on its repatriation in case of conversion of the principal amount.

Shareholders’ rights
While the convertible notes itself only assures economic participation; the investor may seek to enhance their position in the issuer by negotiating that it will acquire prorata rights in the issuer’s management and governance, at par with the rights granted to the new subscriber in the Funding Round. This will conserve the efforts which the parties need to otherwise apply upfront in negotiating shareholder rights. Alternatively, the investor may also ask for certain limited rights upfront, such as a pro-rata right to invest in any subsequent Funding Round.

Converted instrument

Instruments such as CCPS or CCD, are accorded the same treatment as equity share capital under the Companies Act and FEMA, while convertible instruments are a debt on the books of the issuer. Each of Companies Act and FEMA 20-R states that convertible notes are to be converted into “equity shares” of the issuer and thereby seems to take away the flexibility of the subscriber to get CCPS or CCD in the next Funding Round, when the new investor may be taking either CCPS or CCD.


The above analysis sought to bring forth the extensive flexibility (in terms of times, cost and process) available in structuring a convertible note. Given the uncertainty which surrounds an early stage business, convertible notes, unlike equity instruments require upfront resolution on only limited matters, thereby expediting the process from the negotiation table to infusion of capital into the issuer. However, since the convertible notes are only permitted to be converted into ordinary equity, investors continue to prefer instruments such as CCPS or CCDs which can be designed to carry preferred rights in terms of anti-dilution protection, liquidation preference and returns thereby cushioning their investments against risks which are inherent to ordinary equity shares. These are teething issues which are typical for any new change, which we believe will get resolved gradually. We do foresee a lot of traction for convertible notes in the Indian eco-system in the near future.

1 Rule 2(1) (xvii) Deposit Rules, read with notification number G.S.R. 180(E) dated 17th February 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry.
2 Rule 2(1)(xvii), Deposit Rules.
3 Section 179, Companies Act.
4 Section 62(3), Companies Act.
5 Section 42 read with Companies Act and the Companies (Prospectus and Allotment of Securities) Rules, 2014.

Disclaimer – This article does not consider the tax positions which convertible notes offer.


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