If you are an early-stage founder or an investor who invests in early-stage companies, you've heard of 'convertible notes'. The popular version(s) of convertible notes in the Indian market are adaptations of Y Combinator's popular "SAFE" structure (Simple Agreement for Future Equity). As the name suggests, the SAFEs promise a simple, quick and process-light means to raise capital.
Under Indian corporate law and exchange control laws Indian companies are permitted to issue convertible notes if they satisfy the following conditions:
- Company should be registered as a startup with the DPIIT (Department for Promotion of Industry and Internal Trade, Ministry of Commerce).
- Each convertible note issued by the Company should be at least of an amount of INR 25 Lakhs.
- The convertible note should be converted into equity shares or repaid within 5 years.
An important attribute of Indian convertible notes is that they are not priced, i.e., the exact value/valuation at which the investment is made is not decided at the time of the investment. Exact pricing of the investment is usually deferred to the next institutional round (the notion here is that with the capital raised through convertible notes, the Company would have a chance to build out enough to generate valuation metrics). Accordingly, the convertible note is issued with an understanding that it will be converted to the Company's shares based on the valuation at which the next round of funding is raised by the Company. Usually, the conversion is at a discount to the next round valuation and is often subject to a valuation cap and/or a valuation floor. Thus, while the exact valuation is not decided, the investor and the founder make certain assumptions on the valuation range that the company has or is likely to achieve.
The general rule under Indian corporate law is that when a company raises external capital, it needs to justify the valuation at which the capital is raised with the support of the report of a valuer. Similarly, under our foreign exchange laws, when capital is raised from a foreign investor, the company has to justify the valuation at which the capital is raised with the support of the valuation report of a chartered accountant or a SEBI registered merchant banker. In contrast, for issuing convertible notes, the Company need not obtain such valuation reports. Similarly, the regulatory filings and processes for issuing convertible notes are simpler than those required for issuing equity shares, convertible preference shares, or convertible debentures.
Another significant attribute of convertible notes is that the investors usually take very limited rights in the company- in terms of reporting, consent requirements and other governance rights. This is recognizing the fact that the company is (usually) in very early stages, working with a lean team and limited resources, and can ill afford the costs associated with elaborate reporting and governance regimes. All this leads to contractual documentation which is simple and short (in contrast to 100+ pages of contractual documentation in a normal funding round).
The simplicity of documentation (and thereby minimized contract negotiations), and permissibility to defer the valuation, make a convertible note round usually quicker and more economical to close than a priced round (or even an unpriced round structured as a variably priced convertible preference share or convertible debentures round). No wonder, convertible notes have become a popular funding structure for infant startups.
Originally published 15 March 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.