Convertible Note- The Simpler Form of Fundraising
Anyone who has gone through the process of fundraising in India, will tell you how cumbersome and tedious the process can be! Right from haggling over valuation for a startup that is still in the process of building a product or testing the waters to having to procure a valuation certificate and a string of board and shareholders’ resolution – the entire process can sometimes leave you in need for a break even before you have started out!
“Why can’t we simply do a Convertible Note?” was a common question we got asked often. For most of you familiar with the Silicon Valley style convertible note – this was not an option in India till very recently. A “Convertible Note” structure in India till recently, still required you to go through the process of allotment of instruments like “Compulsorily Convertible Preference Shares” (CCPS) or “Compulsorily Convertible Debentures” (CCD) which involve several compliance related paperwork but most importantly still required you to assign a valuation to the startup, either a current valuation or for a potential future conversion value.
In yet another step to ease doing business in India, the Ministry of Commerce and Industry, Government of India, has permitted recognized “Startups” to raise funding through the convertible note route. What does this mean? If you are a company that has received a Certificate recognizing you as a “Startup” from the Government of India, you can accept funds in the form of a debt from investors, which can convert into equity at a future date. Of course everything comes with conditions. In order for a recognized 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 atleast INR 25 lakhs in a single tranche
The amount will have to be converted within 5 years
The terms of conversion will have to be determined upfront
Take this quick 2 minute test to find out if you can raise or invest in Convertible Notes!
For those who haven’t fundraised and are wondering what the brouhaha is about, well the below graphic should answer your questions:
The VC view. Here is what Karthik Chandrasekar, our Co-Founder and also Founder & CEO of Sangam Ventures has to say about Convertible Notes:
I’m one of those that keeps whining to Anisha about how painful it is to do seed investments without the ability to do true Convertible Notes. When we (@ Sangam Ventures) had a chance to do a SAFE investment in Inficold, Inc. in the US, we jumped on it. So, when the awesome folks at Startup India gave recognized startups the ability to issue Convertible Notes, we had to jump on it and make good use of it!
Most startups need to raise funds soon after incorporation to fund hiring and operations, and the Convertible Note can be a vehicle for investors to fund companies at this very early stage. Most of the value is in the idea and vision of the founders and the founding team. 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. 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.
A Convertible Note is typically set up like a debt instrument with an interest rate and maturity date along with a discount on the next significant round of investment which values the startup. If the Convertible Note hasn’t converted by the maturity date it converts to equity in the startup, again requiring to set a valuation for this potential conversion today. But, thankfully the convertible note unlike a CCD does not require filing a valuation certificate on the issue date.
We took the Convertible Note opportunity given by the folks at Startup India a bit further by moving to what Y-Combinator developed for its investments, the SAFE. As defined by Y-Combinator, “A SAFE is a Simple Agreement for Future Equity. An investor makes a cash investment in a company, but gets company stock at a later date, in connection with a specific event. A safe is not a debt instrument, but is intended to be an alternative to convertible notes that is beneficial for both companies and investors.” The key difference is that the SAFE does not have a maturity date, for our case, we ignore the maturity date provision of 5 years in the regulatory requirements because in 5 years we are all dead in the startup universe – i.e. we expect to use SAFEs / Convertible Notes when investing in very early stage startups that we expect will raise money within 12-18 months or die! I will speak a bit later on our preference and different options one can have under the SAFE.
So, when does a Convertible Note / SAFE make sense? [at least for us]
When the value of the startup cannot be determined easily
When the value of the startup cannot be agreed upon between the founders and the investor within meaningful bounds
When the focus for both the investor and founders is to be very efficient with their time and the investment is for very short time horizons – seed round to get to a fund raise or bridge round to get to the Series-A
When does it not make sense to do a Convertible Note / SAFE?
The investor is looking for a lot of protective provisions or a complicated set of terms for the conversion
There is no urgency in closing the round and with some effort a value for the startup can be determined by the investor
There has been a recent investment where another investor has valued the startup or there are already multiple investors in the startup
What the startup is looking for is a loan or other non-dilutive forms of financing
On the SAFE option
The preferred options in a SAFE instrument for the Y-Combinator (this might be a good time to give the SAFE Primer a read) is one with a Valuation Cap i.e. the investment amount will convert to equity at the lower of the next round valuation and the Valuation Cap. In India, we have found this to be problematic where the next round investors are always looking into what the previous round investor set as a potential future valuation – also our pet peeve with the CCDS. So, we dropped the Valuation Cap – exposes us to not getting the upside if our startups get some absurdly high valuation, we will rethink it when a few of our startups do that 🙂 For now, we are going with a discount on the next round of investment which builds up and gets capped at the end of a 12-18-month period by which we expect our investees to fund raise. For investors who want to be super safe with value coming back to you can always take the option of doing both. The last one that is used in the SAFE which we like is the MFN or Most Favored Nation provision – where if the startup issues a SAFE or Convertible Note before getting to a valued financing round, the SAFE investor has the option of converting to the new instrument at which point the SAFE and the MFN provision ceases to exist.
Many thanks to the LexStart team for templating the Convertible Note (in the form of a SAFE) which we used for our investment in Delectrik Systems Pvt. Ltd. The same can be downloaded here along with a primer for you to review and use for yourselves. Would recommend reaching out to the LexStart team if you have any questions or using their services for the first time you do a Convertible Note investment, they can also help your startups with the process of getting the Startup India recognition.
Here is hoping this really opens up the seed stage investment eco-system for FDI investors and we see the Convertible Note becoming the instrument of choice for seed investing in India.