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Issue of Convertible Notes by Indian Start-up Company

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Start-up ecosystem is always dynamic and volatile. They are always in search of innovative funding and that too in a cost-effective manner. In order to promote start-ups, the Government comes out with innovative initiatives, either they give exemption from regulatory requirements or provide cost-effective funding. One of the steps taken by the Government was the introduction of convertible notes under the Companies Act, 2013, specifically for start-ups. The Ministry of Corporate Affairs vide Notification[1] dated 29-6-2016, amended the Companies (Acceptance of Deposits) Rules, 2014[2], which provides that “an amount of twenty-five lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person” is considered as exempted deposits. Further, Reserve Bank of India also amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2016, to introduce the concept of convertible notes under FEMA.

Herein, I have prepared a detailed note on convertible notes which can be issued by start-up company to person resident outside India. But, before going into the nitty-gritty of the topic, let us see the current scenario of foreign funding coming into India. Herein is provided the total amount of foreign funding coming into India during January to March 2020[3]:

  1. Total FDI inflows into India (Equity inflows + Reinvested earnings + Other capital) : USD 18,325 million.
  1. FDI equity inflows into India: INR 95,549 crores
  2. Top three investing countries (FDI equity inflows) in Financial Year 2019-2020: Singapore: INR 103,615 crores, Mauritius: INR 57,785 crores and Netherlands: INR 46,071 crores.
  3. Top three sectors attracting highest FDI equity inflows in Financial Year 2019-2020: Services sector: INR 55,429 crores, Computer software and hardware: INR 54,250 crores and Telecommunications: INR 30,940.
  4. Top three States attracting highest FDI equity inflows in Financial 2019-2020: Maharashtra: INR 52,073 crores, Karnataka: INR 30,746 crores and Delhi: INR 28,487.

We have seen the total amount of foreign investors have invested in Reliance Jio i.e. INR 1,04,326.65 crores.

Application of Law

For issuing convertible notes, the following FEMA laws shall be applicable in addition to other laws:

a. Foreign Exchange Management Act, 1999[4] (hereinafter referred to as “FEMA”).

b. Foreign Exchange Management (Non-debt Instruments) Rules, 2019[5] (hereinafter referred to as “the NDI Rules”).

c. Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019[6] (hereinafter referred to as “Mode of Payment and Reporting Regulations”).

Regulatory Provisions

  1. What are convertible notes?

Convertible note means an instrument issued by a start-up company acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.

  1. Who can issue convertible notes?

A convertible note can be issued by an Indian start-up company.

  1. What is the meaning of start-up company?

Start-up has been defined by the Department of Industrial Policy and Promotion (hereinafter referred to as “DIPP”), Ministry of Commerce and Industry vide amended Notification dated 16-1-2019.

An entity shall be considered as a start-up:

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a “start-up”.

  1. To whom convertible note can be issued?
  1. How much amount of convertible notes can be subscribed?

Eligible subscriber can subscribe or purchase convertible notes for an amount of twenty-five lakh rupees or more in a single tranche.

  1. Through which mode of payment convertible notes can be purchased?

A start-up 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 the NRE/FCNR(B)/Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016[9].

A start-up company issuing convertible notes to a NRI or OCI on non-repatriation basis shall receive the amount of consideration by inward remittance through banking channels or out of funds held in NRE/FCNR(B)/NRO account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

  1. Through which mode repayment/sale proceeds of convertible notes can be remitted?
  1. What are the reporting requirements for convertible notes?

Conclusion

In the current scenario, convertible notes are one of the most common methods of funding for start-ups. If the start-up takes the external commercial borrowing (ECB) route then it would be burdened with too much compliance like ECB-2 return every month, filing of ECB Form with any changes in ECB loan, etc.

The Ministry of Finance (MoF) vide Notification dated 22-4-2020, amended Rule 6(a) of the NDI Rules[10]. The amended rule provides that investment by a country which shares land border with India or beneficial owner from any such country shall invest only with the Government approval. Now, the question is whether an entity which shares land border with India can invest in an Indian entity by way of convertible notes without the Government approval? As per my opinion, Rule 6(a) is specifically for investment by person resident outside India in equity instruments of Indian company. If person resident outside India shares land border with India it requires the permission of Government of India. The question here arises whether investment in convertible notes by Public Relations Organisation International (PROI) who shares land border with India would be considered as investment in equity instruments and will it be covered under the amended proviso of Rule 6(a)? In order to answer that question we need to read the definition of the “equity instruments” as defined in the NDI Rules meaning equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. Further, “convertible debentures” means fully, compulsorily and mandatorily convertible debentures. So, convertible note does not fit into the definition of equity instruments and more specifically convertible debentures. So, the amended proviso(s) to Rule 6(a) does not apply to an investment by PROI in convertible notes belonging to country which shares land border with India. However, this is my personal opinion. What is your opinion? Do share it on chirag@csahmedabad.com.

* Practising Company Secretary in Kular Chirag & Associates. Author can be reached at chirag@csahmedabad.com

[1]Companies (Acceptance of Deposits) Amendment Rules, 2016

[2] Companies (Acceptance of Deposits) Rules, 2014.

[3]Quarterly Fact Sheet on Foreign Direct Investment (FDI) from April 2000 to March 2020 available at https://dipp.gov.in/sites/default/files/FDI_Factsheet_March20_28May_2020.pdf

[4] Foreign Exchange Management Act, 1999.

[5] Foreign Exchange Management (Non-debt Instruments) Rules, 2019.

[6]Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019.

[7] Section 59 of the Partnership Act, 1932.

[8] Limited Liability Partnership Act, 2008.

[9] Foreign Exchange Management (Deposit) Regulations, 2016.

[10]Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Rule 6(a).

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