In the previous parts of this series, we gave you pointers on raising funds by way of debt and by the issuance of shares. In this part, we see the route startups can take in case they want to draw investors with promises of an assured annualized return while also giving them the upside of the appreciation of the share price of the startup. Convertible instruments provide both these comforts.
Convertible instruments include compulsorily convertible debentures (“CCD’s”) and convertible notes and are a bit more sophisticated than regular debt and equity. The money raised through both these instruments will be treated as debt on the books of the company and within a certain period, these instruments will convert into shares of the company. These instruments can also be interest-bearing, in which case the company will also end up making a certain interest payment on the dent every year, while at the end of the tenure of the instrument the principal will convert into shares of the company.
These instruments are an extremely lucrative investment for investors. Consider this: The instrument convert within a 5 year period, which is a long duration in the life of a startup and during which time the valuation may have skyrocketed. In case you had agreed to a 1:1 conversion ratio 5 years back on an INR 1000/- loan when the value of a share of the company was INR 10/- and after 5 years the price of the shares has skyrocketed to INR 100/-, the investor makes a 10x return on his investment.
With convertible instruments there come in concepts like “discount at the time of conversion” i.e. when the conversion happens at a discount to the future valuation of the company e.g. My convertible note will convert 5 years later. I have invested INR 1000 /- today and I will be getting shares worth the same amount. However, considering that I am taking a risk, I will get a 30% (Thirty percent) discount on whatever the valuation of the company may be after 5 years. Therefore after 5 years if the price of the shares of the company is INR 100/-, my conversion will be made considering assuming the price of the shares to be INR 70/-. These concepts are fairly complicated, can have tax implications and it is always recommended, that you seek professional advice before issuing these instruments.
While CCDs have existed for some time, convertible notes are a fairly new phenomenon that we have adopted from the western market. Convertible notes in India come with some simple principles of issuance:
They can be issued only by Startups recognized by DIPP;
The amount of investment will have to be at least INR 25 lakhs in a single tranche;
The amount will have to be converted within 5 years; and
The terms of conversion will have to be determined upfront.
Things to look out for: Terms of conversion: Considering that these instruments convert at a later date and the terms of conversion have to be fixed upfront, it is key to ensure that you do not give away a large chunk of equity as a result of conversion. Conversion is determined by a formula (which factors in revenue, profits, etc.) or on the basis of a ratio e.g. 1:1; where each CCD converts into an equity share of the company. Also, institutional or professional investors are wary of any existing instruments in the Company which will convert at a later date and can possibly dilute them.
With the Startup India series, we plan to answer the ten most commonly asked common legal questions which we get asked.
At LexStart we advise startups at various stages of growth on disclosure-related compliances and non-disclosure arrangements. You can reach out to anisha@lexstart.com with any specific queries that you may have.
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Disclaimer: Please note that the article above is for information purposes only and represents the views of the author and should not be construed as legal advice.
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