ISSUANCE OF CONVERTIBLE NOTES IN STARTUPS PERMITTED
Vide a notification
dated 10 January 2017, the Reserve Bank of India (RBI), has amended the
Foreign Exchange Management (Transfer or issue of Security by a Person
Resident outside India) Regulations, 2000 (FEMA 20/2000),
implementing a key change in the foreign exchange policy by allowing
startup companies to issue convertible notes to foreign investors.
A convertible note is an instrument given as a debt and convertible to equity at the option of the holder, upon a future contingency taking place, usually when start-ups get an additional round of investments. Therefore convertible notes allow investors to invest in start-ups without worrying about their valuations which are difficult to determine at inception, as convertible notes are merely an instrument advanced as a loan, and converted to equity at a later stage, when the startup is better established.
Following are the salient features of the Notification:
Definition of convertible note: The notification defines a convertible note as 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 5 years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.
The notification however, is applicable only to companies defined as start-ups, in the applicable government circular, which defines an entity as a startup, if 5 years have not elapsed from the date of its incorporation, its turnover for any of those years does not exceed Rs 25 crores and it is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property. Therefore entities which fall outside this definition shall be unable to avail of the benefits of this notification.
Persons eligible to purchase convertible notes: 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 Rs 25 lacs or more in a single tranche. A person resident outside India may acquire or transfer, by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. However, a startup company engaged in a sector where foreign investment requires Government approval may issue convertible notes to a non-resident only with approval of the Government. NRIs may acquire convertible notes on non-repatriation basis in accordance with the applicable FEMA Regulations.
Other formalities: A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time.
The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.
A convertible note is an instrument given as a debt and convertible to equity at the option of the holder, upon a future contingency taking place, usually when start-ups get an additional round of investments. Therefore convertible notes allow investors to invest in start-ups without worrying about their valuations which are difficult to determine at inception, as convertible notes are merely an instrument advanced as a loan, and converted to equity at a later stage, when the startup is better established.
Following are the salient features of the Notification:
Definition of convertible note: The notification defines a convertible note as 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 5 years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.
The notification however, is applicable only to companies defined as start-ups, in the applicable government circular, which defines an entity as a startup, if 5 years have not elapsed from the date of its incorporation, its turnover for any of those years does not exceed Rs 25 crores and it is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property. Therefore entities which fall outside this definition shall be unable to avail of the benefits of this notification.
Persons eligible to purchase convertible notes: 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 Rs 25 lacs or more in a single tranche. A person resident outside India may acquire or transfer, by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. However, a startup company engaged in a sector where foreign investment requires Government approval may issue convertible notes to a non-resident only with approval of the Government. NRIs may acquire convertible notes on non-repatriation basis in accordance with the applicable FEMA Regulations.
Other formalities: A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time.
The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.
MHCO COMMENT:
The notification is an encouraging step towards promoting a conducive
environment for start-ups in the country and shall be instrumental in
boosting both investor sentiment and promoting entrepreneurship in the
country.
The views expressed in this update are personal and should not be
construed as any legal advice. Please contact us directly on +91 22
40565252 or legalupdates@mhcolaw.com for any assistance.
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