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CONVERTIBLE NOTE || Compliance, || Procedure || FEMA, RBI, ||

CONVERTIBLE NOTE

OVERVIEW

Convertible notes are hybrid debt-equity instruments issued by startup companies, offering the option to convert into equity and paying a percentage of interest on maturity, with a minimum duration of 18 to 36 months and a maximum term of 10 years, without set monthly payments. These notes are individually issued to investors in the minimum denomination of RS. 25 lakhs, prohibiting joint ownership, are typically targeted towards individuals such as angel investors who believe in the startup's vision. In the

event of default, the investor may require the company to liquidate or negotiate an extension of the loan's maturity date.

Here we are going to discuss everything about Convertable notes:-


Definition:

In accordance with the Reserve Bank of India, Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 ‘Convertible Note’ means an instrument issued by a startup company evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup company, within a period no


t exceeding five years from the date of issue of the convertible note, upon the occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument;

[Note: Definition of Convertable notes is not defined under the Companies Act 2013]


Start-up

Startup’ means an entity which complies with the conditions laid down in Notification No. G.S.R 180(E) dated February 17, 2016, issued by the


Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India; (reference from RBI)


Start-Up: Company

‘Startup company’ means a private company incorporated under the Companies Act, 2013 and recognised as such in accordance with notification number G.S.R. 180(E) dated February 17, 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India and complies with the conditions laid down by it; (reference from RBI)



Why a company shall choose a convertible note instead of a Compulsory convertible Debenture?

Convertible Notes

Convertible Debentures

Flexible Terms: Convertible notes often have more flexible terms and can be customized to suit the specific needs of the company and investors.

​Fixed Terms: Convertible debentures usually have fixed terms and conditions that may not offer as much flexibility.

Startup-Friendly: Convertible notes are commonly used in startup financing as they provide a simpler and quicker fundraising process.

Established Companies: Convertible debentures are typically more suitable for established companies that have a stable financial position.

Simpler Documentation: Convertible notes generally require less extensive documentation, making them quicker and more cost-effective to execute.

Comprehensive Documentation: Convertible debentures may involve more complex legal documentation, which can increase transaction costs and time.

Lower Interest Rates: Convertible notes often have lower interest rates compared to convertible debentures, making them more attractive to investors

Higher Interest Rates: Convertible debentures may have higher interest rates as they are considered a more secure investment.

Conversion Flexibility: Convertible notes allow for flexible conversion into equity at a later stage or upon specific triggering events as agreed between the company and investors

Fixed Conversion: Convertible debentures typically have fixed conversion terms and timelines, providing less flexibility for conversion.

​Investor Relations: Convertible notes provide an opportunity to build relationships with investors during the note stage, potentially leading to future investments and collaborations

Investor Protection: Convertible debentures may offer more robust investor protections, such as priority in repayment and security against company assets.


Eligible Company:-

Convertible notes (CN) in India can only be issued by Private Limited Companies that are registered under the Startup India scheme and hold a government-issued certificate. It is crucial to note that if a company was previously registered as a startup but no longer fulfils the eligibility criteria, it cannot issue convertible notes. Furthermore, for a newly incorporated company to be classified as a startup and be eligible to issue convertible notes, it must possess the government-issued certificate of startup status.

In India, convertible notes are comparable to the iSAFE (Simple Agreement for Future Equity) instrument used in the United States.

Note: Such a Private company must have share capital.


Eligible Investor:

  • Foreign Investors: Non-resident individuals or entities from outside India can invest in convertible notes issued by Indian companies.

  • Non-Resident Indians (NRI): Indian citizens residing abroad, commonly referred to as NRIs, are eligible to invest in convertible notes issued by Indian companies.

  • Resident Indians: Individuals residing in India can also invest in convertible notes issued by Indian companies.

  • Indian Companies and Indian Investors: Indian companies and domestic investors, including individuals, institutions, and other entities registered in India, can participate in convertible note investments.


Tenure

convertible notes (CN) have a maximum tenure of 5 years. This means that the conversion into equity or repayment of the convertible notes must be completed within 5 years from the date of issuance. This time limit ensures that the convertible notes are not utilized as long-term debt instruments and promotes their timely conversion into equity or repayment


Maximum Limit

In India, there is no specific maximum limit on the issuance of convertible notes for a startup company. A private company has the flexibility to issue unlimited convertible notes, provided it follows the necessary legal requirements. This typically involves passing a special resolution in a general meeting of the company, where shareholders approved the issuance of convertible notes.


Procedure:

  • Approval of Board: The board of directors of the company must approve the issuance of convertible notes.

  • Shareholder Approval: The issuance of convertible notes must be approved by the shareholders in an Extraordinary General Meeting (EOGM).

  • Preparation of Convertible Notes Agreement: A comprehensive convertible notes agreement should be prepared, incorporating all the important terms and conditions related to the convertible notes, such as conversion rights, interest rates, maturity dates, etc.

  • Filing of MGT 14: The company is required to file Form MGT 14 with the Registrar of Companies (ROC), providing the relevant terms and conditions of the convertible notes.

  • Filing Form CN with RBI (if applicable): If the funds received for the convertible notes are in foreign currency, the company must file Form CN with the Reserve Bank of India (RBI) after receiving the funds. This requirement is specific to foreign currency inflows.


Compliance with the issue of Convertable note.

  • Non-Resident Investors: People who live outside India (except citizens of Pakistan or Bangladesh and entities registered/incorporated in Pakistan or Bangladesh) can buy convertible notes issued by an Indian startup company. The amount they invest should be twenty-five lakh rupees or more in a single transaction.

Note: Joint holding is not allowed

  • Government Approval: If the startup operates in a sector where investment from non-resident individuals requires government approval, the company can issue convertible notes to non-resident investors only after obtaining that approval. When the convertible notes are converted into equity shares, the process must follow specific rules and conditions related to foreign investment

  • Receiving and Repaying Funds: When a startup company issues convertible notes to non-resident investors, they need to receive the investment amount through proper channels like banking channels or by debiting the investor's NRE/FCNR(B)/Escrow account. When it's time to repay or sell the convertible notes, the startup company can either send the money outside India or credit it to the investor's NRE/FCNR(B) account, as per the regulations specified in the Foreign Exchange Management (Deposit) Regulations, 2016.

  • NRIs and OCIs: Non-Resident Indians (NRIs) or Overseas Citizens of India (OCIs) have the option to acquire convertible notes on a non-repatriation basis, as per the guidelines mentioned in Schedule 4 of the regulations.

  • Transfer of Convertible Notes: People living outside India can buy or sell convertible notes from or to individuals or entities residing in or outside India. However, these transfers should adhere to the prescribed rules and guidelines related to entry routes and pricing for capital instruments.


FEMA Compliance: (If applicable)

Form Convertible Notes (CN): The Indian startup company issuing Convertible Notes to a person resident outside India shall report such inflows to the Authorised Dealer bank in Form CN within 30 days of such issue.


A person resident in India, who may be a transferor or transferee of Convertible Notes issued by an Indian startup company shall report such transfers to or from a person resident outside India, as the case may be, in Form CN to the Authorised Dealer bank within 30 days of such transfer.


The Authorised Dealer bank shall submit consolidated statements to the Reserve Bank. Provided, the format, periodicity and manner of submission of such reporting shall be as prescribed by Reserve Bank in this regard. Provided further that unless otherwise specifically stated in these regulations all reporting shall be made through or by an Authorised Dealer bank, as the case may be. (13)4


“Form InVi : An Investment vehicle which has issued its units to a person resident outside India shall file Form InVi with the Reserve Bank within 30 days from the date of issue of units.” Delays in reporting The person/ entity responsible for filing the reports provided in regulation 13.1 above shall be liable for payment of late submission fee, as may be decided by the Reserve Bank, in consultation with the Central Government, for any delays in reporting.



FAQ.

Question: Who is eligible to issue convertible notes?

Answer: Only startup companies registered under the Startup India scheme are eligible to issue convertible notes.


Question: How is a startup company defined?

Answer: A startup company is a private company incorporated under the Companies Act, 2013, and recognized as such in accordance with notification number G.S.R. 180(E) dated February 17, 2016, issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India. The company must comply with the conditions laid down by the notification.


Question: What is the minimum and maximum tenure for convertible notes?

Answer: The minimum tenure for a convertible note is 18 months, and the maximum tenure is 5 years.


Question: Who can purchase convertible notes?

Answer: Any investor, whether from India or outside the country, can purchase convertible notes.


Question: What compliance requirements are necessary for issuing convertible notes?

Answer: The compliance requirements for issuing convertible notes may vary depending on the jurisdiction and applicable laws. However, in the context of the Startup India scheme, it is important to adhere to the conditions and regulations specified by the Department of Industrial Policy and Promotion and other relevant authorities.


Question: What compliance requirements are necessary to receive funds from foreign investors?

Answer: The compliance requirements for receiving funds from foreign investors may vary depending on the jurisdiction and applicable laws. It is essential to ensure compliance with the regulations specified by the relevant authorities when dealing with foreign investments


Question: As a foreign resident, am I allowed to subscribe to a convertible note?

Answer: Yes, foreign residents are generally allowed to subscribe to convertible notes, but it is important to consider the compliance requirements specific to the jurisdiction in which the company is incorporated and the foreign resident is located.


Question: What compliance needs to be fulfilled when issuing a convertible note?

Answer: When issuing a convertible note, it is necessary to comply with the applicable laws and regulations of the country where the company is incorporated. This may include ensuring proper company registration and adherence to investor qualification requirements, which can vary depending on the jurisdiction.


Question: What are the procedures for issuing a convertible note?

Answer: The specific procedures for issuing a convertible note may vary depending on the jurisdiction and the company's legal requirements. It is advisable to consult with legal professionals or financial advisors who are knowledgeable about the regulations in the relevant jurisdiction to ensure proper compliance.


Question: What if an investor wants to exit before the maturity period of the convertible note?

Answer: The ability for an investor to exit before the maturity period of a convertible note depends on the terms outlined in the agreement between the company and the investor. If the agreement allows for early conversion or an exit mechanism, the investor may have the option to convert or exit the investment. However, if the agreement does not provide for such provisions, the investor may need to wait until the maturity period to exercise any conversion or exit rights.


Question: Under which act are convertible notes allowed?

Answer: While the Companies Act 2013 does not specifically define convertible notes, they can be issued in accordance with Section 62 of the Companies Act 2013. It is important to review the relevant sections and provisions of the act to ensure compliance when issuing convertible notes.


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