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
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.
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.
- A person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), may purchase convertible notes issued by an Indian startup company for an amount of twenty five lakh rupees or more in a single tranche.
- In case company is covered under sector which requires Government approval, convertible notes shall be issued only with such approval.
- At the time of conversion, entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment shall be complied.
- The amount of consideration shall be received by inward remittance through banking channels or by debit to the NRE/ FCNR (B)/ Escrow account maintained by the person concerned.
- A NRI or an OCI may acquire convertible notes on non-repatriation basis in accordance with Schedule 4 of these Regulations.
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.
ConclusionIt 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.
Article contributed by:
Shilpa Agarwal & Deepika Gupta, R&A Associates Team