Updated: Sep 23, 2020
Silicon Valley: S01E04 - Peter Gregory throws around legal jargon like convertible note and incorporation. Confused? Well, so was Richard.
A convertible note is a short-term debt instrument, typically employed by startups to raise funding. Akin to any other convertible instrument, the holder of the convertible note is entitled to a future equity stake in the company in exchange for current debt. The principal advantage for startups in raising funds by the issuance of convertible notes is that both the startup and the investors do not have to determine the value of the company at the time of issuance, when there might not be much to base a valuation on.
There are instances where a startup needs to raise money at the idea stage itself or soon after incorporation, to fund hiring and operations, and one cannot be expected to ascertain a fair valuation at this stage of the process. This is where convertible notes come into the picture. The convertible note can be a vehicle for investors to fund companies at this very early stage.
Unlike the sale of equity in traditional priced rounds of financing, a company can issue a convertible note quickly and efficiently, without multiple documents and the necessity of amendment to the charter documents. As a flexible, one-document security, without numerous terms to negotiate, the convertible note should save companies and investors money and time.
Until 2016, the convertible note was not a legally recognised debt instrument in India. An amendment to the Companies (Acceptance of Deposits) Rules, 2014 vide notification dated June 29, 2016 defined and recognised convertible notes as an instrument for fundraising by startups.
Now, “recognised startups” can raise funding through the convertible note route. A “recognised startup” is a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 and recognised as a startup under the notification on startups issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”).
Are you a “recognised startup”? Find out:
In order for a recognised startup to receive funding through Convertible Note, the following additional conditions will have to be complied with:
• 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 10 years.
• The terms of conversion will have to be determined upfront.
In the simplest terms, the convertible note is an IOU, as in “I owe you money!”, and can be linked to the expected return rather than a valuation and percentage of ownership getting away from the valuation quagmire for a seed stage investment.
For understanding convertible notes further, check out our various blog posts and videos:
For a comprehensive understanding of convertibles notes, check out LexStart’s Primer on Convertible Notes on Amazon Kindle. This Convertible Note e-Primer gives an overview of features of convertible note as an instrument that can be issued by a Company along with its advantages and the process of issue.