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“Convertible Notes” are those instruments which are issued by a startup company acknowledging the receipt of funds (Minimum of Rs.25 Lakh to be invested in one trench by one investor) initially as debt, repayable at the holder's option, or convertible into the specified number of equity shares of that company, within a time frame not exceeding five years from the date of the convertible note, upon the occurrence of specified events as per other terms and conditions agreed upon and indicated in the instrument.

Any ‘Startup’ company issuing convertible notes must be first registered under ‘Startup India Scheme’. For this purpose, the terms “Startup” has been defined by the Department of Industrial Policy and Promotion (hereinafter referred to as “DIPP”), Ministry of Commerce and Industry vide amended Notification dated 16-1-2019 as:

l  Up to a period of ten years from the date of incorporation/registration, if it is incorporated as a private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm (registered under Section 59 of the Partnership Act, 1932 or a limited liability partnership (under the Limited Liability Partnership Act, 2008 in India.

l  Turnover of the entity for any of the financial years since incorporation/registration has not exceeded one hundred crore rupees.

l  Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a “start-up”.

The convertible notes are issued by the registered startups to raise capital from investors without having to provide a valuation report. It is the simplest and most practical approach to raise money. These investors to whom convertible notes are issued can be a person residing outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered or incorporated in Pakistan or Bangladesh) or they can also be an NRI or an OCI who may acquire convertible notes on non-repatriation basis and subject to other terms and conditions as mentioned in the NDI Rules (hereinafter referred to as “the eligible subscriber”).

The laws that shall be applicable while issuing “convertible notes”are: Foreign Exchange Management Act, 1999, Foreign Exchange Management (Non-debt Instruments) Rules, 2019 and Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019. 

Mode Of Payment In Convertible Notes Purchase:

Payment for the purchase of the convertible notes in case where they are issued to person who are residents outside of India must be credited with the consideration amount by inward remittance through banking channels or by debit to the NRE/FCNR(B)/Escrow account held by the aforementioned individual in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

Payment for the purchase of the convertible notes in case where they are issued to person who are NRI or OCI on non-repatriation basis shall receive the agreed-upon consideration by inward remittance through banking channels or from funds in their NRE, FCNR(B), or NRO accounts, as per the 2016 Foreign Exchange Management (Deposit) Regulations.

Remittance of Repayment/Sale Proceeds of Convertible Notes:

For convertible notes issued to individuals residing outside of India, the proceeds may be remitted outside of the country or credited to the investor's NRE/FCNR(B) account, in compliance with the Foreign Exchange Management (Deposit) Regulations, 2016.

In the case of convertible notes issued to Non-Resident Indians (NRIs) or Overseas Citizens of India (OCI) on a non-repatriation basis, the proceeds must be credited to the investor's NRO account, regardless of the account from which the consideration was paid. Additionally, it should be noted that the amount invested in convertible notes issued by an Indian company shall not be eligible for repatriation abroad.

Reporting Requirements:

In the event of issuing convertible notes to a person residing outside India, the Indian startup must file Form CN within 30 days of the issue.

If a convertible note is transferred, the person residing in India who is involved in the transfer, whether as a transferor or transferee, must report the transfer of the convertible notes issued by an Indian start-up to or from a person residing outside of India, as the case may be, in Form CN within 30 days of such transfer.

Additionally, an Indian startup that has received Foreign Direct Investment (FDI) is required to submit an annual return on foreign liabilities and assets (FLA) to the Reserve Bank of India on or before the 15th day of July each year. This is done by filing Form FLA.

Compliance Under Companies Act, 2013:

As convertible note is a form of debt instrument, the issuing company is required to obtain the approval of its members through a special resolution at the General Meeting. The company is then obligated to notify the Registrar of Companies by filing eForm MGT-14 within 30 days of the said General Meeting.

Conclusion:

Convertible notes are a popular and flexible option for startups seeking funding from angel investors. It has become an increasingly attractive choice for early-stage funding since its inception in 2017. Convertible notes allow a Private Limited company to take an unsecured loan from an individual who is not a director. However, it is important to note that they also involve a degree of risk, as the investor has the option to convert the notes into equity or request repayment.

References:

1.       https://taxguru.in/rbi/fdi-startup-companies-issue-convertible-notes.html

2.       https://taxguru.in/rbi/convertible-notes-india-raising-fund-foreign-investors.html

3.       https://www.scconline.com/blog/post/2021/03/13/convertible-notes/

4.https://www.businesssetup.in/convertiblenotes/#:~:text=Convertible%20note%20means%20an%20instrument,exceeding%20five%20years%20from%20the

5https://economictimes.indiatimes.com/news/economy/policy/startups-get-up-to-10-yrs-for-converting-debt-investment-into-equity/articleshow/90332410.cms?from=mdr