For “Note”-Worthy Beginnings: Evaluating Convertible Note Financing For Startups

By Tejaswini Kaushal (Batch of 2026-RMLNLU Lucknow)

[This Blogpost is a Runner-Up Entry of the 1st Edition of the National Blog Writing Competition 2023 organized by Centre For Innovation, Incubation & Legal Entrepreneurship (CIILE) in Association with PANDA LAW (TEAM CODE-06)]

Image Source: https://learn.angellist.com/articles/convertible-note

Introduction

Startups in India are booming at an unprecedented rate, with the Department for Promotion of Industry and Internal Trade (DPIIT) having recognized over 92,683 registered startups as of 28 February 2023.[1] In this era of dynamism and innovation, it becomes imperative for India to retain its position as the third largest ecosystem globally for startups and to reach even higher up the ranking.[2] However, for Indian startups, navigating the early stages of growth can be like walking a tightrope. Startups often find themselves in a precarious position— having substantial expenses with limited revenue streams.

To fulfill their financing needs, startups have traditionally turned to measures like bootstrapping,[3] venture capitalists,[4] crowdfunding,[5] etc. However, the Indian startup landscape has been searching for innovative and adaptable financing options that balance the interests of entrepreneurs and investors. Enter convertible notes (“C-Notes”), a financial instrument that bridges the gap between debt and equity financing.[6] Unlike traditional equity investments, C-Notes are a quicker and more flexible way for startups to secure capital. Notable players like Udaan,[7] Dunzo,[8] Byju’s,[9] and PharmEasy[10] have employed C-Notes to bolster their funding. These Real-world success stories showcase that C-Notes are indeed worthy contenders to traditional fundraising methods in startup financing.

The Law to Launch: Understanding the Legal Framework for Convertible Notes

Securing funding for an early-stage startup is no small feat, especially when the business is yet to take off.[11] Angel investors are typically hesitant to pour substantial capital into such ventures unless they can be assured of a return on their investment.[12] On the other hand, startups often struggle to convince investors of the commercial viability of their ideas, leading to disputes over valuations.[13] While Western countries have well-established seed financing practices,[14] India has only more recently caught up with the introduction of C-Notes.

The 2016 amendment to the Companies (Acceptance of Deposits) Rules, 2014 introduced C-Notes into the Indian framework.[15] These were defined as instruments that allow holders to subscribe to them at the current time and then, after ten years or specific events defined in the agreement, choose between converting them into equity shares or redeeming them.[16] Equity shares are issued upon conversion, and their quantity is determined based on either a predetermined valuation or the conversion date.[17] The process ensures eased regulatory burdens[18] and expendable requirements for share valuations for startups to raise funds.[19]

Another aspect that soon stole the spotlight was the strict regulation of investment forms other than equity shares, convertible preference shares, and convertible debentures (traditionally recognized as ‘capital’ under the Foreign Direct Investment Policy)[20] under the Foreign Exchange Management (Borrowing and Lending in Foreign Exchange Regulations), 2000.[21] This caused a greater regulatory burden on startups raising External Commercial Borrowings (ECB). To ease this, the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2016, was amended in 2017[22] to allow C-Notes issuance to foreign investors without the otherwise mandatory valuation requirements. [23] Evidently, C-Notes have significantly streamlined fundraising for Indian startups, offering both flexibility and opportunities for growth.

Unlocking Growth: Harvesting the Benefits of Convertible Notes

C-Notes offer a unique advantage as they sidestep the need for immediate business valuation and come with predetermined conversion options and timelines, assuring investors of returns. In the United States (US), C-Notes are used as bridge financing tools.[24] They delay the company’s valuation until it secures its next round of funding.[25] To maximize returns, C-Note holders sometimes have the right to set a valuation cap on equity shares for subsequent investors during conversion.[26] Companies can also pre-determine the conversion rate in the C-Note instrument, regardless of the share value at conversion time.[27] Other advantages include providing funding accessibility by allowing startups to secure early capital without the complexities of traditional funding rounds.[28] Moreover, they are cost-efficient, saving both time and expenses associated with issuing new shares, with the added benefit of not requiring valuation reports.[29] Additionally, C-Notes enable startups to reduce dilution by postponing equity issuance to a later stage, ultimately benefiting founders, early employees, and existing investors.[30]

One of the most important features is that investors enjoy discounts on future valuations or lower conversion prices than later investors. To illustrate this, consider two investors in a startup [, Mr. X and Mr. Y. Mr. X invests INR 2 million in C-Notes at a 30% discounted valuation, and at the time of conversion, the company’s valuation is INR 20 million. On the other hand, Mr. Y invests INR 2 million in equity shares during a financing round. Here is how the convertible note investor, Mr. X, benefits from the discount:

Mr. X (C-Notes Investor):

• Investment Amount = INR 2 million
• Valuation at Conversion = INR 20 million
• Discounted Rate = 30%

Now, let’s calculate the equity Mr. X will receive at the time of conversion:

Equity = Investment Amount / (Valuation – Discount)

Equity = INR 2 million / (INR 20 million – 30% * INR 20 million)

Equity = INR 2 million / (INR 20 million – INR 6 million)

Equity = INR 2 million / INR 14 million

Equity = 14.29%

So, Mr. X will receive 14.29% of equity shares at the time of conversion.

Mr. Y (Equity Investor):

• Investment Amount = INR 2 million
• Valuation = INR 20 million

Now, to calculate Mr. Y’s equity ownership:

Equity = (Investment Amount / Valuation) * 100%

Equity = (INR 2 million / INR 20 million) * 100%

Equity = (0.1) * 100%

Equity = 10%

So, Mr. Y will receive 10% of the equity shares at the time of the financing round.

In this scenario, Mr. X gets a higher percentage of equity (14.29%) compared to Mr. Y (10%) because he took the risk by investing in C-Notes at a discounted valuation when the company’s worth was not as high. This reflects positively on investors about how investing in C-Notes at a discounted valuation can yield a higher percentage of equity for early investors, compensating them for taking on more risk when the company’s value was uncertain, further maximizing the funds they bring into the startup and incentivizing even more investors to invest early in a business.

Caveats for C-Notes: Conscientiously Charting a Startup’s Course

While C-Notes offer notable benefits, some caveats follow. Convertible notes, despite delaying company valuation, often come with a valuation cap and automatic conversion prices that influence future equity discussions.[31] Moreover, if the note matures without conversion, it can lead to repayment challenges for the startup and prompt careful consideration of the commitment to surrender equity shares in the future despite its debt-like nature.[32] Additionally, attracting new investors in subsequent financing rounds may prove challenging, as loan note investors might gain similar rights but pay less for equity shares upon conversion.[33] This situation could lead to a loss of control for founders, as loan providers may accumulate a majority shareholding interest.[34] Insolvency risks may also arise, potentially impacting the issuing company’s solvency and even the founders personally if personal guarantees are involved.[35] Furthermore, clauses like valuation caps and conversion discounts can complicate pricing discussions in future equity rounds, warranting careful consideration and planning.[36]

The Path Forward: Recommending Improvements for a Robust System

C-Notes have become a valuable financing tool for India’s burgeoning startup ecosystem. Entrepreneurs can harness the power of C-Notes by understanding the terms that align with the current legal framework, attracting crucial investments, and nurturing startup growth. However, there are areas of significant improvement to improve this dynamic form of startup financing further. Firstly, this advantage is currently limited to recognized startups, leaving non-recognized startups unable to utilize C-Notes as a capital instrument under RBI regulations or as a non-deposit under the Rules. Adopting a wider application net for C-Note issuance will allow non-recognized startups to benefit and contribute to the Indian entrepreneurial landscape equally. It is also recommended that the threshold for a minimum investment of INR 25 lakhs[37] be removed to allow even greater flexibility in the quantum of funds to be raised in a single tranche.

Another critical consideration involves the terms of conversion for C-Notes. If these are converted into equity shares during a subsequent investment, the conversion will be based on the valuation at that time. Factors like whether there will be a discount compared to shares issued to new investors and other terms must be carefully evaluated to ensure compliance with applicable laws, including pricing guidelines for non-resident investors holding convertible notes. Furthermore, in the US, there are similar financing instruments such as ‘Simple Agreement For Future Equity’ (“SAFE”)[38] and ‘Keep It Simple Security’ (“KISS”),[39] which, unlike convertible notes, lack a maturity date and do not accrue interest. They are simpler and more founder-friendly, with the option to include a valuation cap and discount price on conversion. The Indian government could explore initiatives like these to further simplify C-Notes for startups in India, fostering an even more conducive environment for entrepreneurial

[1] Ministry of Commerce & Industry, More than 92,000 entities recognized as startups since launch of Startup India, PIB (Apr. 5, 2023), https://pib.gov.in/PressReleaseIframePage.aspx?PRID=1913977 (last visited Oct. 8, 2023).

[2] Investment Promotion and Facilitation Agency, The Indian Unicorn Landscape, Invest India, https://www.investindia.gov.in/indian-unicorn-landscape (last visited Oct. 9, 2023).

[3] Amar Bhide, Bootstrap Finance: The Art of Start-ups, Harvard Business Review (Dec. 1992), https://hbr.org/1992/11/bootstrap-finance-the-art-of-start-ups (last visited Oct. 3, 2023).

[4] Bob Zider, How Venture Capital Works, Harvard Business Review (Dec. 1998), https://hbr.org/1998/11/how-venture-capital-works (last visited Oct. 4, 2023).

[5] OECD, Crowdfunding explained, Internal Market, Industry, Entrepreneurship and SMEs, https://single-market-economy.ec.europa.eu/access-finance/guide-crowdfunding/what-crowdfunding/crowdfunding-explained_en (last visited Oct. 6, 2023).

[6] Companies (Acceptance of Deposit Rules), 2014, r 2 (1) (xvii), Notification No. G.S.R 256(E), Ministry of Corporate Affairs, 2014 (India).

[7] Udaan raises $120 million through convertible notes, IPO delayed, The Economic Times (Oct. 27, 2022), https://m.economictimes.com/tech/funding/udaan-raises-120-million-through-convertible-notes-cfo-tells-employees/articleshow/95121486.cms (last visited Oct. 8, 2023).

[8] Exclusive: Dunzo secures funding via convertible notes, lays off 30% of staff, The Economic Times (Apr. 26, 2023), https://m.economictimes.com/tech/startups/dunzo-secures-funding-via-convertible-notes-lays-off-30-of-staff/articleshow/99277213.cms (last visited Oct. 8, 2023).

[9] Byju’s to raise $250 mn via convertible notes in Aakash pre-IPO funding, Business Standard (Mar. 9, 2023), https://www.business-standard.com/article/companies/byju-s-to-raise-250-mn-via-convertible-notes-in-aakash-pre-ipo-funding-123030900298_1.html (last visited Oct. 7, 2023).

[10] PharmEasy To Raise Rs 750 Crore Through Convertible Notes, IIFL Securities (Oct. 6, 2022), https://www.indiainfoline.com/article/news-business/pharmeasy-to-raise-rs-750-crore-through-convertible-notes-122100600001_1.html (last visited Oct. 7, 2023).

[11] Rohini Krishnamurthy, Economic Survey 2022-23: Indian startup ecosystem faces several challenges, causing companies to ‘flip’, Down To Earth (Jan. 31, 2023), https://www.downtoearth.org.in/news/governance/economic-survey-2022-23-indian-startup-ecosystem-faces-several-challenges-causing-companies-to-flip–87400 (last visited Oct. 8, 2023).

[12] Darian M. Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 Vanderbilt Law Review 1405 (2008), https://scholarship.law.vanderbilt.edu/cgi/viewcontent.cgi?article=1520&context=vlr (last visited Oct. 5, 2023).

[13] Id. at 2.

[14] Convertible Notes Overview, Penn University, https://www.law.upenn.edu/clinic/entrepreneurship/startupkit/convertible-note.pdf (last visited Oct. 7, 2023).

[15] Notification, Ministry of Corporate Affairs (Jun. 29, 2016), https://www.mca.gov.in/Ministry/pdf/Rules_30062016.pdf (last visited Oct. 7, 2023).

[16] Supra, note 6.

[17] Supra, note 6.

[18] Supra, note 6.

[19] Akshay Vasantgadkar, Issuance Of Convertible Notes In India – Inward/ Foreign Investment – India, Mondaq (July 28, 2023), https://www.mondaq.com/india/inward-foreign-investment/1347874/issuance-of-convertible-notes-in-india- (last visited Oct. 10, 2023).

[20] Paul Albert, Issuance Of Convertible Notes In India – Inward/ Foreign Investment – India, Mondaq (Feb. 12, 2019), https://www.mondaq.com/india/inward-foreign-investment/780642/issuance-of-convertible-notes-in-india (last visited Oct. 8, 2023).

[21] Foreign Exchange Management (Borrowing and Lending in Foreign Exchange Regulations), 2000, Notification No. FEMA 3/2000-RB, Ministry of Corporate Affairs, 2000 (India).

[22] FEM (Transfer Or Issue Of Security By A Person Resident Outside India) Regulations, 2017, Notification No.FEMA.20(R)/2017-RB/GSR 1374(E), Ministry of Corporate Affairs, 2017 (India),  

https://incometaxindia.gov.in/Documents/Provisions%20for%20NR/FEM-Transfer-or-Issue-of-Security-by-a-Person-Resident-Outside-India-Regulations-2017.htm (last visited Oct. 8, 2023).

[23] Master Circular on Foreign Investment in India, 2011, Master Circular No. 15/2011-12, Reserve Bank of India, 2011(India), https://www.rbi.org.in/commonperson/English/Scripts/Notification.aspx?Id=856 (last visited Oct. 9, 2023).

[24] Supra, note 13.

[25] Supra, note 13.

[26] Rohit Subramanian, Convertible Notes – A case of square pegs in a round hole!!, Lexology (Feb. 11, 2020), https://www.lexology.com/library/detail.aspx?g=2efa0981-7aa0-48d6-a471-3b998d20b22c (last visited Oct. 8, 2023).

[27] Id, at 4.

[28] Issue of Convertible Notes by Indian Start-up Company | SCC Blog, SCC Blog (Mar. 13, 2021), https://www.scconline.com/blog/post/2021/03/13/convertible-notes/ (last visited Oct. 8, 2023).

[29] Id, at 4.

[30] Convertible Note – Additional and flexible funding option for startups, Taxmann (Sept. 19, 2023), https://www.taxmann.com/research/company-and-sebi/top-story/105010000000023305/convertible-note-additional-and-flexible-funding-option-for-startups-experts-opinion (last visited Oct. 8, 2023).

[31] Interpreting Convertible Notes, KPMG (2023), https://assets.kpmg.com/content/dam/kpmg/bh/pdf/2023/05/convertible-notes.pdf (last visited Oct. 2, 2023).

[32] Id, at 6.

[33] Jeffry A. Timmons and Dale A. Sander, Everything You (Don’t) Want to Know About Raising Capital, Harvard Business Review (1989), https://hbr.org/1989/11/everything-you-dont-want-to-know-about-raising-capital (last visited Oct. 8, 2023).

[34] Id, at 33.

[35] New Approaches to SME and Entrepreneurship Financing: Broadening the Range of Instruments, OECD (2015), https://www.oecd.org/cfe/smes/New-Approaches-SME-full-report.pdf (last visited Oct. 7, 2023).

[36] Supra, note 33.

[37] Companies (Acceptance of Deposits) Rules, 2014, r 2(ixa), Notification No. G.S.R 256(E), Ministry of Corporate Affairs, 2014 (India).

[38] Simple Agreement for Future Equity (SAFE), Practical Law- Reuters, https://uk.practicallaw.thomsonreuters.com/w-001-0673?transitionType=Default&contextData=(sc.Default) (last visited Oct. 8, 2023).

KISS Note: All You Need to Know, Contract Lawyers, https://www.contractscounsel.com/t/g/us/kiss-note/1 (last visited Oct. 8, 2023).