Overseas investors looking to invest in Indian companies through the foreign direct investment (FDI) regime have traditionally had to do so either through equity shares or through instruments that are compulsorily convertible into equity shares, namely, compulsorily convertible preference shares (CCPS) or compulsorily convertible debentures. All other instruments, including those that are optionally convertible into equity, are treated as debt and have to comply with the more onerous regulations applicable to external commercial borrowings (ECBs). In January 2017, however, an amendment to the regulatory framework permitted eligible startup companies to issue convertible notes to non-resident investors under the FDI regime.
Convertible notes are debt instruments that are convertible into equity at the option of the holder or upon specific trigger events, most typically the company’s next equity fund-raising round. In jurisdictions such as the US and Singapore, convertible notes are an attractive option for venture capital funds investing in early-stage companies when determining the valuation can be a tricky process. Such notes also have the advantage of being redeemable at maturity if the startup fails to perform as expected.
Under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, a convertible note issued by a qualifying startup to a non-resident investor is initially a debt instrument that may, at the option of the note holder, either be repaid or converted into equity within five years from issuance. The time limit suggests that convertible notes in India, as elsewhere, are intended to be short-term instruments for seed funding or for a bridge round, enabling note holders to either be repaid or receive equity shares at the company’s subsequent equity fund-raising round.
Unlike other FDI instruments, such as equity shares or CCPS, pricing guidelines do not need to be complied with at the time of issuance of a convertible note. Thus, no valuation is required prior to issuance. However, the conversion of the note into equity as well as the transfer from a non-resident to a resident investor must be in accordance with the pricing guidelines. Accordingly, while the time and hassle of a valuation can be avoided at the time of issuance of a convertible note, the price of shares issued upon conversion must be at or above fair market value, determined by a certified chartered account or merchant banker.
How do convertible notes compare with CCPS, the most tried and tested route for FDI in India, and with the ECB regime applicable to startup companies? The absence of a valuation requirement makes the process for issuance significantly faster for convertible notes than for CCPS. Convertible notes also provide greater flexibility for startups than raising funds through ECBs, even though amendments to the ECB framework have given startups relaxations from certain of the regime’s more onerous requirements. For example, there are restrictions on the types of lenders who can extend loans through ECBs, while convertible notes are available to all non-resident (and resident) investors. Convertible notes are also freely transferable between resident and non-resident investors (subject to compliance with the pricing guidelines), while transfer of an ECB from one lender to another requires the approval of an authorized dealer bank and can only be made to another entity that is an eligible lender under the ECB regime.
At the same time, limitations and ambiguities in the regulatory framework around convertible notes may prevent them from replacing CCPS anytime soon. First, convertible notes are available only to startups that meet the specific criteria set out by the central government and so are only available to a limited universe of companies. Second, while the absence of an upfront valuation may allow for a quick fund-raising, investors have little visibility on the price at which the convertible note would convert into equity shares at the time of investing in the note. Finally, the regulations are silent on various features of a convertible note, such as whether it can continue as a debt instrument that accrues interest if not converted within five years, the types of trigger events that could result in conversion and whether the interest rate that could be charged on a convertible note is subject to any regulation.
It remains to be seen whether some of these ambiguities will be resolved and if convertible notes will become the popular instrument that they have become for seed rounds in other jurisdictions. However, foreign venture funds looking to invest in Indian startups through debt-like instruments that are convertible into equity now have an avenue for doing so through the FDI regime.
Aparna Ravi is a partner at the Bengaluru office of Samvad Partners.
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