Convertible notes are only issued to start-ups, hence it is important to understand the meaning of a start-up before addressing the term convertible note.

What is a Start-Up?

The meaning of the term Start-Up is not defined under the provisions of the Companies Act, 2013 or previous company law, 1956. However, the DPIIT has given a conclusive definition of the term Start-Up.

A start-up is defined as a company that is in its inception stage with a limited amount of resources and capital. The DPIIT has provided the meaning of the term start-up as a business that satisfies the following:

• Since its incorporation, the company has not completed ten years of business or operations; 
  
  
• If the turnover of the business is not more than 100 crores; and
  
  
• The services or products which are offered by the start-up are focused more on technology, innovation, and commercialization.

Hence if a company satisfies the above criteria then it is considered a Start-up.

What is a convertible note?

Convertible notes are those short-term debts that are issued to the investors during the early stages of the company and are later exchanged for shares or are repayable according to the option chosen by the holder.

This form of note is classified as an instrument that is issued by the entity. Such an instrument is considered as a debt or a debenture. An investor possessing such a note would have the option to convert the note into equity shares. Hence any form of instrument which is issued by a start-up and a mode of acknowledging debt is known as a convertible note. 

According to an amendment to the Companies (Acceptance of Deposits) Rules, 2014, a DPIIT recognized start-up is allowed to accept funds to the tune of INR 25 lakh or more in a single tranche from investors by issuing convertible notes to them. A convertible note is mandated to be repaid or converted into equity shares of a start-up company as per the terms and conditions agreed to in the process.

Convertible notes have to fulfill certain conditions and the terms related to maturity. When such conditions are fulfilled, then such notes are converted into equity shares or preference shares. If the above conditions cannot be carried out, then the holder can convert such note within 5 years of issuing the note or the maturity period whichever is earlier.

How do convertible notes work for start-ups?

Generally, all the early age start-ups need a certain amount of funding to expand their business. The complexity of capital raising compels the fund seekers to make use of convertible notes.

Generally, an investor provides early-stage capital to start-ups in the form of a loan with repayment terms of maybe a year or a two. Convertible notes contain the maturity date, interest, terms of conversion, and other such terms necessary for the execution. The note is repaid in the form of equity of the investee companies, usually with another round of funding.

If the maturity date has arrived and the Start-up is unable to repay the debt, the investor can choose to extend the maturity date of the convertible note, up to the statutory limit of five years or ask for an actual repayment of the note. All this depends upon the potential and the progress of the Startups.

What are the key parameters while considering a convertible note?

The evaluation of a convertible note involves the understanding of the following points:

• Valuation cap-This term is also known as ‘conversion cap or just cap’. The valuation cap defines the threshold limit at which the investor’s loan gets converted into equity. In short, the valuation cap provides a ceiling on the investment in the subsequent round of financing. The lower the cap, the better the deal for the investor.
  
  
• Discount rate– Discount rates define how much amount is owed to the investor as compensation for the additional investment risk. The earlier you invest the more reduction you get.
  
  
• Interest rate– In the case of convertible notes interest rate is not as significant as in the case of a traditional mortgage. The interest rates on the convertible notes are usually low, as the amount needs to be paid back in the form of equity and not as cash. Thus, the interest gets accrued to the principle, which in turn increases the number of shares that will be converted.

Important Clauses in a Convertible Note

• Interpretations and Definition Clause- This would have defined terms between the parties (start-up and investor). It would increase understanding between the parties.
  
  
• Conversion- In this clause, the date of maturity must be included. The terms of the conversion must be stated whether the note would be converted into equity shares or preference shares. Any rights related to termination must also be mentioned.

• Issuance of Conversion Shares- A clause related to the issue of shares must be also included in the convertible note.
  
  
• Lock-in Period- A period which states that investors would not sell or pledge the shares, encumber or dispose of the shares. Usually, convertible notes have lock-in periods of two to three years.

• Anti-Dilution Rights of the Holder- This clause would specify all the rights and obligations of the holder in the agreement.

• Event of Default (EOD) – This clause must mention the situations for any form of default that causes loss to either of the parties. 

What are the advantages of using a convertible note?

• Convertible notes do not require a valuation of the start-up which helps avoid the hassles of taxing and option pricing. Valuation is utilized for other forms of shares and securities which include equity shares and preference shares.
  
  
• Any start-up can issue a convertible by just doing the minimal formalities and that too in a short duration. However, the company must satisfy the requirements of a start-up as per the DPIIT.
  
  
• One of the significant advantages of using convertible notes is that they enable deals to close faster.
  
  
• Issuing a convertible note defers the dilution of the shareholding of the existing shareholders until such note is converted into equity.

• Convertible notes offer quite a quicker and safer solution to raise funds for new start-ups which are growing.

This option may not be the best for all the start-ups, but you can choose among the various options available for raising funds, by exploring all alternatives chalking down your preferences, and analyzing the procedure, you can handpick the fundraising method that suits your company’s needs.

Conclusion

A convertible note is a new form of instrument which is used by a start-up. When issuing a convertible note, there are a few conditions to be adhered to by the holder. There is a statutory maturity period for the holder of the convertible note. The holder of the convertible note has the option to convert it into equity shares.

All start-ups can use this form of financing the transactions that occur in their business due to the advantages which are offered by this instrument.