Early-stage start-ups face two problems when it comes to raising funds. They cannot approach banks because they do not possess collateral for a loan, and the interest rates are higher. Second, if they get an angel investor, a PE, or a VC firm to invest in the start-up in its nascent stage, they will face problems regarding the company’s valuation. Also, issuing equity to the early investors shall mean dilution of the equity held by the founders which most founders are wary of. Startups have the option of issuing hybrid instruments such as Convertible Notes and Convertible Debentures to overcome these challenges and still raise much needed capital.

Convertible Notes

The Government of India, with an intent to help start-ups with fewer regulations and ease in raising money for their enterprises, amended and introduced the idea of convertible notes.

Under the Foreign Exchange Management Act, 1999 (FEMA) and Rule 2(1)(c)(xvii) of Companies (Acceptance of Deposit) Rules, 2014, convertible note has been defined as follows:” Convertible Note” means an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the start-up as may be agreed depending on the valuations.

Meaning, money is provided as a short-term debt which can be convertible into equity, unlike general debt, where a person has to pay principal plus interest. This conversion is generally either during the subsequent financing round or after the completion of the maturity period.

Some of the features and advantages of Convertible notes are as follows:

a. Does not force valuation upon the company since the money raised is a debt.

b. Convertible notes can be issued for amount >= INR 25,00,000/-.

c. The start-up needs to get DPIIT recognized. To understand how to become a DPIIT recognized start-up, follow us.

d. Converts into equity at the option of the investor.

e. No Valuation report or certificate is needed to issue a Convertible Note.

Compulsory Convertible Debentures (CCD)

CCDs are a form of convertible debentures which are compulsorily convertible into equity upon the end of their tenure. Section 2(30) of the Companies Act defines debentures as an instrument of the company showing the debt irrespective of whether it constitutes a charge on the assets or not.

There are various types of debentures. Section 71 (1) of the Companies Act, 2013 provides for the issue of unsecured debt via debentures with an option of them to convert such debentures into shares, party or wholly upon redemption. Such debentures can be issued by approval from the board passed at an extra-ordinary general meeting through a special resolution. CCDs must be converted into equity within ten years from their issuance.

Under FEMA, foreign investment can only be made into CCD, which is entirely convertible. The interest paid on the CCD will be subject to the transfer regulation of India as per the Income Tax Act, 1961 and shall not be more than the acceptable benchmark.  Further, the issuance of shares by a private limited company shall not be at a price less than the FMV calculated per Rule 11UA of the Income Tax Act, 1961.

Let’s examine the differences and the requisite compliances for both in the following table:

	Convertible Note	CCD
Company Type	Can only be issued by a Private Limited Company.	Can be issued by a Private Limited Company.
Monetary Cap	The minimum amount should be INR 25,00,000/-  or more by a single Investor in one tranche.	No such requirement.
DPIIT Recognition	The start-up shall be recognised by DIPP, i.e., a company less than ten years old with less than 100 crore turnover.	Any Company which is a private limited.
Procedure for issuing securities	Special Board resolution passed for the issue of Convertible Notes. Conduct an Extraordinary General Meeting authorising the issue of same. File MGT 14 Prepare convertible notes agreementAfter funds are received, File Form CN with RBI (Funds are to be received through Authorized Dealer Bank within 30 days)Issue the CN Documents required for issue:FIRC and KYC of the non-resident investorName and address of the investorDetails of an authorised dealer bankMOA and AOA copyIncorporation certificateStart-up recognition certificateCertificate from a practising Company Secretary	Special Board resolution passed for the issue of Convertible Notes. Approval of draft offer letter in Form no PAS 4; PAS 5Valuation report by a registered valuer for setting conversion rate Open a separate bank account for receiving CCD moniesConduct an Extraordinary General Meeting authorising the issue of same. File MGT 14 form Filing PAS 4 and PAS 5 with ROC along with GNL-2 Approval from the Board o increase the borrowing limit and approval for filing for PAS-3, FIRC and FC-GPR with RBI.Filings with ROCValuation reportList of AllotteesBoard Resolution for allotmentCopy of a special resolution passed
Valuation Report	Not required	It is a requirement unless the CCDs are issued to domestic investors.
Foreign Investors	Convertible Notes and iSAFE are preferred since there is lesser compliance involved.	CCDs are only issued to Domestic investors.
Convert option	Conversion of the convertible note to equity is at the buyer’s option.	These are compulsorily convertible to equity shares.

Conclusion:

Convertible Notes and CCDs are thus very attractive instruments especially for early stage startups for whom a valuation cannot be arrived at. Startups can choose either based on their specific requirements and priorities.

For more such information, watch this space.