As a sweetener to the convertible debt investor, Notes have a conversion discount feature by which the convertible debt holder will exchange the debt for Qualified Shares at a price per share equal to 80% (this amount can vary per deal) of the price per share paid by the Qualified Financing investors, so the Noteholder gets more shares for his or her money.
RBI ushers in a golden era for Startups
Coming into action from January 10, 2017, the RBI has amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, to allow “startups” to issue convertible notes to foreign investors. The regime was very different before this amendment.
Foreign investors in the past were allowed, foreign direct investment (FDI) ONLY by way of equity and other instruments that were at par with equity e.g. compulsorily convertible preference shares/debentures. Convertible promissory notes were not allowed until this notification was passed.
‘Convertible note’ has been defined-
- 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 not 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.
Illustration of Indian scenario
A Company is looking to raise funds. A pre - money valuation is a term widely used in private equity or venture capital industries, referring to the valuation of a company or asset prior to an investment or financing. If an investment adds cash to a company, the company will have different valuations before and after the investment. Hence a Convertible Promissory Note is a pre-money instrument or tool. The company has come up with a pre-money valuation of Rs. 100 crore. They are looking to raise Rs. 50 crore by way of Convertible Promissory Notes, guaranteeing the investor's preference shares upon the maturity of the loan period. Here the investors have the all-encompassing control over the situation as these notes are nothing but a loan or a debt, hence they are bound to receive the principal amount plus interest regardless.
The problem comes on the grand yet abstract valuation of Rs. 100 Crore. The potential investors will generally not agree or understand the basis of this valuation since the company is still trying to stabilise its business model in the pre-money initial stages.
Let's assume that after deliberation and checking the systems in place the investors put in their trust in the team of people and the business idea. The investors decided to go ahead with providing Rs. 50 crore in the form of convertible notes. This will always come with a mandatory condition of claiming equity upon maturity of the loan period as well as a discount in the next rounds of funding.
Let's say the founders of the business and investors agree at a 25 percent discount to the next round of funding for their generous initial funding which might be the make or break point for the business. They will also negotiate on the time for the next round of funding which would mostly be within 24 months.
Now if the Company is unable to raise the money, it has to return the loan along with interest at 10 percent immediately upon the expiry of the 24th month or any other time that the investors demand. Twelve months later, Company plans to raise Rs 100 crore at a pre-money valuation of Rs 200 crore from a seed fund. Now, the first investors will get to convert their investment of Rs 50 crore at a pre-money valuation of Rs 150 crore (that is 25 percent discount to the Rs 200 crore valuation). In other words, the first investors will get more shares for their money and get compensated for investing early in Company A.
Benefits of Notification
For the purpose of this Regulation, a ‘startup company’ means a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 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 (DIPP) , Ministry of Commerce and Industry. The RBI has only allowed “startups”, as defined by the MoCI vide its notification GSR 180(E) dated February 17, 2016, to issue convertible notes to foreign investors.
Certain regulations of the notification are restrictive for the time being. A caveat has been added which states that the “startup” seeking the funding through convertible notes must also be working towards “innovation, development, deployment or commercialisation of new products or processes or services driven by technology or intellectual property” whose certification has to be procured from one of the agencies mentioned in the February 17, 2016 notification.
Valuation not a problem, Notes deal with pre-evaluation stage
One of the key advantages of Notes is that the valuation issue is kicked down the road until the Qualified Financing- when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round). Again, a Note is a loan (debt, not equity). A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing. With startups and small companies, investors may not be financially savvy enough to properly value a company. By using Notes, investors can forgo valuation until a later date when more sophisticated investors value the company and inject additional equity. Therefore, a Note allows companies to access potential equity financing with the lower upfront costs and efforts of debt.
Recently a lot of startups have been using more Notes in angel rounds as they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest. Notes allow more flexibility in price as valuation caps for startups aren’t actual valuations, and Notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate Note with a different cap for each investor.
The effective way to raise funds
Notes have a maturity date upon which the company can be forced into bankruptcy if it hasn’t closed a financing round. Convertible equity eliminates that threat. This is true in theory but extremely rare in practice. Unless the startup has been hoarding cash or investing it in hard assets in some unusual way, calling the notes won’t yield any proceeds to the investor. Sometimes aggressive investors will ask to control the board of directors or other things upon a payment default.
Notes accrue interest from the date(s) they are issued. This adds cost and administrative complexity, especially with multiple closings on different dates. Yet startups have cranked out thousands of Notes for startups over the past several years, without any signs of the apocalypse (yet). Convertible equity strikes largely as a solution in search of a problem. The primary reason is that investors have every incentive to work with the startup to extend or renegotiate the terms of the notes because that represents their best shot at seeing any return on their investment.
Minimum Issue Size & Who can buy the same
A person resident outside India (other than an individual who is the 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 can buy these promissory notes.
The minimum issue size per investor must be at least Rs 25 lakh or more in any transaction. A “startup” cannot issue a convertible note to an investor looking to invest less than Rs 25 lakh. The government, perhaps, wants only “serious” investors to benefit from a note. NRIs may acquire convertible notes on the non-repatriation basis in accordance with Schedule 4 of the Principal Regulations.
Compliance and reporting
The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.
Tricky issues that founders must address with respect to the Promissory Note
Situation 1- The startup is acquired prior to the note’s conversion (and prior to the note’s maturity date). The following are ways to deal with such a scenario-
Founder Friendly Technique - The note can be made with a provision that requires the startup to pay-off the loan along with interest. Hence in case of a merger or any other situation where effectively there is a change in the control of the startup business or sale of substantially all the assets then simply the maturity date of the note is termed to be accelerated. The amount which was given as funding plus the interest that has accrued will be paid to the investors. However, such a proposition may not be appealing to sophisticated investors because their return on a high-risk investment would get limited only to the extent of interest on the loan.
- Fixed Premium - This is a resolution which can be said to be a win-win scenario for both investor and founders. In the above situation, a provision for granting the investors a right to get their money back with interest, plus a premium could help secure various investors who might be deterred with the over simplistic founder friendly technique. The Note can be drafted with a provision that provides premium as a multiple of the principal amount of the loan (generally in the 0.25x to 1.50x range).
- Conversion Right/ Right to share proceeds- This can be said to be the most investor-friendly approach to the situation at hand. A provision can be added to the note to secure the most sought-after investors permitting them (noteholders) to convert the notes into equity if and when such a situation arises or otherwise which grants them a certain percentage of the sale proceeds, based on an agreed-upon valuation of the startup.
Situation 2- The Maturity Date is reached Prior to the Note’s Conversion to Shares of Preferred Stock. Investors loan money to a startup and rather than getting their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.
In the Master notification, “Note” has been defined as an instrument issued by a “startup” evidencing a debt which is either (i) repayable at the option of the holder or (ii) convertible into equity within a period of five years (from the date of issue) upon occurrence of certain events mentioned in the note.
In this situation for any reason whatsoever if the date for the maturity of the loan expires and the conversion to stock as per terms is yet to happen then the following negotiations must be held-
- Loan Extension- The founders of a startup need to be careful in negotiating an extension of the promissory note. This method to deal with the situation of notes maturing before the note could be converted to shares is very common but not a given that the investors will agree to the same. Some factors which affect the negotiations can be the startup’s financial condition and prospects, the market conditions, the relationship between the founders and the investors etc.
- Automatic Conversion - Founders can often convince “friends and family” and less-sophisticated investors to agree on an automatic conversion into shares of common stock in the event that there hasn’t been a Series A round prior to the maturity date. Sophisticated investors, however, will push back hard against such a provision. From their perspective, requiring the loan (plus interest) to convert automatically into shares of common stock (or a new series of preferred stock) upon a default arguably rewards the founders and removes the significant leverage and rights the noteholders would have as creditors of the startup.
Proceed with Caution
Convertible notes work well for start-up companies when the value of the company increases between the time of the debt financing and a preferred stock financing. However, if the value of the company falls, investors who purchased convertible notes may end up owning more equity in the company then the company anticipated at the time of the debt financing. This occurs because the price discount feature often included in the notes enables the investors to purchase equity at a price below what they would have paid at the time they purchased the convertible notes.
Moreover, because the purchased equity often contains a liquidation preference, in addition to obtaining a larger equity position in the company at the expense of the founders, investors will also likely obtain an increased preference over the founders to the cash of the company in the event of a sale, dissolution or winding up of the company. Another downside of convertible notes is that in the event, a convertible note is not converted into equity prior to its maturity, investors could demand that the note is repaid with principal and interest, or potentially force the company into bankruptcy if the loans cannot be restructured.
Hence issuance of convertible promissory notes can be an effective means for start-up companies to raise capital. However, before raising capital through the issuance of promissory notes, investors and companies need to carefully evaluate the risks associated with the issuance of promissory notes in comparison to other financing alternatives.
Legistify connects you with the best lawyers in India and top Chartered Accountants in India with simple telephonic conversation or email. Call us at 011-33138123 or send us an email at firstname.lastname@example.org to get started.