Convertible Notes Developing Trends

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

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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