In a recent move, the Reserve
Bank of India (RBI) vide Notification dated 10th January, 2017
introduced a new instrument for Start up companies named as ‘Convertible Notes’
by amending the Foreign Exchange Management (Transfer or Issue of Security by a
Person Resident Outside India) Regulations, 2000 (Regulations) through issue of
Foreign Exchange Management (Transfer of Issue of Security by a Person Resident
Outside India) (Fifteenth Amendment) Regulations, 2016 (Amendment). It is an
instrument issued as debt and convertible into equity of a startup at the
option of the holder.
Background
A convertible note is one of the
most preferred instruments for early stage funding of start ups in Silicon
valley and other ‘advanced startup ecosystems’- represents a debt which
converts into equity only upon the occurrence of a contingent event (for
instance, the issuing startup receiving the next round of funding). If such an
event does not take place, the Note continues to represent the debt, which is
repayable by the issuing startup. Under the Regulations, until now, foreign
direct investment (FDI) in Indian startup companies could only be made by persons
resident outside India (Foreign Investors) by subscribing to equity instruments
and other instruments that were considered on par with equity instruments (such
as mandatorily and fully convertible debentures / preference shares and
warrants) of such investee companies.
The amendment came into effect
post the Ministry of Corporate Affairs (MCA) exempted the convertible notes
from the ambit of deposits, and thereby allowing companies to issue convertible
notes in tranches exceeding Rs 25 lakhs to prospective investors, without
having to comply with the slew of requirements mandated by the Rules.
Key changes
The Amendment permits Indian
startups to raise funds from Foreign Investors by issuing Notes, with the
following key features:
Definition:
A 'Convertible Note' has been
defined as an instrument issued by a startup evidencing receipt of money
initially as debt, which is either: (a) repayable at the option of the holder;
or (b) convertible into equity shares (within a period of 5 years from the date
of issue) upon occurrence of specified events according to the terms of the
Note.
‘Start up’ – this notification is
only applicable to entities defined as startups. Startup companies includes the
following –
‾
A company wherein 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
‾
The company is working towards innovation,
development, deployment or commercialization of new products, processes or
services driven by technology or intellectual property.
‾
Therefore, entities that fall outside this
definition would be unable to avail the benefits of the notification of being
able to issue convertible notes.
Persons
Eligible To Purchase Convertible Notes
‾
Individuals / Entities resident outside India
may purchase convertible notes issued by an Indian startup, for an amount of
Rs. 25 lakhs or more in a single tranche. However, where the startup company is
involved in the sector where foreign investment requires Government approval
can issue convertible note to non-residents only with the approval of the
Government.
‾
Citizens of Pakistan or Bangladesh or entities
registered in/incorporated in these countries cannot purchase convertible notes
in Indian entities.
Minimum
purchase amount:
Foreign
Investors are required to invest at least Rs. 25,00,000/- or more in a single
tranche to subscribe to the Notes, and issuance of equity shares against such
Notes needs to comply with the Regulations. In addition, non-resident Indians
are permitted to acquire Notes on non-repatriation basis in accordance with the
Regulations.
Other
Procedures to be followed:
Escrow for
remittance of consideration:
In addition to
the usual permitted modes of remittance, escrow arrangements have also been
permitted for making remittance of consideration for subscription to Notes.
Such escrow account needs to be closed upon the earlier of: (a) the allotment
of the Note and the remittance of consideration to the issuing startup; and (b)
the expiry of 6 months from the account opening date.
Transferability
Investors are
also permitted to acquire / transfer the Notes by way of sale, so long as the
sale takes place in accordance with the pricing guidelines prescribed by the
RBI.
Government
Approval
Where startups
are engaged in sectors requiring government approval for foreign investment,
government approval needs to be obtained before issue / transfer of the Notes
to Foreign Investors.
Compliances
Startups
issuing Notes are required to furnish reports as prescribed by the RBI.
Observations
The Amendment
opens up an important avenue of fund raising for Indian startups and is likely
to make them more attractive to early stage Foreign Investors who are
accustomed to invest by way of Notes. The redemption feature of the Note is also
expected to make startups more accountable. In a way, the Amendment permits a
certain minimum guaranteed return to Foreign Investors, which the Regulations
do not otherwise permit. Though the definition seems reasonable but ‘start ups’
have to keep the five year period in mind. Once this period lapses, the money
received against the note will continue to be a debt and have to be re-paid.
Thus, this point needs to be clarified by RBI whether the investor and investee
can mutually determine the interest rate at which the convertible note may be
repayable. Also, the present Foreign Direct Investment (FDI) policy in force
restricts and regulates issuance of debt instruments to foreign investors.
Thus, in order to put this notification in force the Department of Industrial
Promotion & Policy (DIPP) need to amend the FDI policy accordingly.
Despite the
major features set out above, the Amendment is expected to have limited impact
on the overall foreign investment into India, as it is applicable only to
entities defined as 'startups' by the Department of Industrial Policy and
Promotion (i.e., an entity which is not more than 5 years old and the turnover
of which has not exceeded INR 25,00,00,000 for any financial year). Despite the
uncertainties in the Amendment, the positive impact of the Amendment on the
overall foreign investment sentiment and India's image as a progressive
ecosystem for startups cannot be undermined.
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