ABSTRACT
We are in the golden age of seed financing where start-ups are becoming a new asset class for the rich and connected so competition is growing with even small & medium scale incubators and ‘friends & family’ playing the seed financing game and investing early in start-ups resulting in the boom in the Startup Sector as we are evidencing today and are increasing the scope and market of the angel investors.
As a result, the pendulum has swung dramatically in the founders’ favour, and the issuance of Convertible Notes for seed financing has never been more prolific as a substantial amount of investment in a start-up during the early stages is undertaken through the same.
The present article deals with the various facets of investment in Start-Ups through Convertible Notes.
Keywords: Convertible Notes, Venture Capital, Private Equity, Start-Ups, Investment, India
INTRODUCTION
There is a sudden shift in the Indian Ecosystem in the field of investments leading to extensive use of Convertible Notes in the sub INR 10 million range of investments in early stage scalable businesses that potentially attract venture capital.
Earlier this year in January, the Reserve Bank of India [“the RBI”] vide its notification introduced the Convertible Notes for Start-Ups in order to evolve its regulations to attract investments, from both foreign and domestic sources, in the start-up sector through the Foreign Exchange Management (Transfer of Issue of Security by a Person Resident Outside India) (Fifteenth Amendment) Regulations, 2016.1 The same was facilitated pursuant to the Companies (Acceptance of Deposits) Rules, 2016 (amendment) exempting Convertible Notes from the ambit of deposits and allowing the start-ups to issue these instruments to prospective investors.2
Earlier, any convertible debt raised by a company was treated as External Commercial Borrowing [“ECB”] requiring compliance with the strict guidelines for ECB. Also, raising such ECBs was also restricted to specific companies under the ECB Guidelines and only for specifically restricted end uses. However at present, in accordance of the abovementioned notifications, Convertible Notes can only be issued by ‘Start-Ups’3 to a person resident outside India for a minimum amount of INR 25 lakh in a single tranche and such inwards remittance would be treated as Foreign Direct Investment [“FDI”] making the start-up environment more business and investor friendly. However, investments done by NRIs through such instruments would be non-repatriable in nature and such investment would now come under the garb of FDIs requiring prior Government approval for such issuance of Convertible Notes where a start-up company is engaged in a sector in which foreign investment requires prior government approvals.
WHAT ARE CONVERTIBLE NOTES?
A Convertible Note is a hybrid, part debt and part equity, where it functions as debt, until a certain defined point in the future, when it may convert to equity according to some predefined terms. Convertible debt is typically secured from the same angel investors and venture capitalists that funds equity deals and is usually used for smaller rounds of financing at the early stages of start-ups who wish to delay establishing a valuation until a later round of funding or milestone.4 A Convertible Note is a contractual agreement structured as loans with the intention of converting them into equity after a certain trigger event or when it is called upon, whereas the outstanding balance of the loan is automatically converted to equity at a specific milestone, often at the valuation of a later funding round. A Convertible Note is a popular way for investors to invest in a business that is in its formative stages due to its less risky nature. It is basically structured as a loan, the only difference being that it converts into equity after the business becomes more established i.e. when it acquires more funding or reaches a particular milestone.
HOW DO THEY WORK?
This mode of investment provides flexibility to both the investor and the start-up as the money is received right away however the number of shares the investors are entitled to is determined during its next round of financing, or Series A as per the terms & conditions of the Convertible Note. By that point the company creates some operating history and hence more experienced angel investors or venture capitalists can review the business in order to determine a fair price / valuation. Once the Series A investors determine a price, the loan converts into equity at a discount to reward the investors for the additional risk they took by investing early. The amount of equity that a note converts into depends on the price of the Series A funding and some other key components of the note, which are as follows:
i. Discount Rate
This represents the valuation discount the investors receive in comparison to investors in the subsequent financing round compensating the initial investors for the additional risk they took by investing in the early stage of the business.
ii. Valuation Cap
The valuation cap is similar to valuation of a company during priced rounds, hence giving the investors an additional reward for bearing risk earlier on. In other words, it is a cap on calculation for valuation of the company, and during conversion the valuation cap is taken into consideration for deciding the value of shares at which debt will be converted. It effectively caps the price at which the initial investors’ notes are to be converted into equity and, for practical purposes, provides Convertible Note holders with an equity-like upside if the company does well in further rounds of investments. It should also be noted that Convertible Notes while converting into equity do so by calculating either the discount rate or the valuation cap, not both. Further, such valuation must be done through any internationally recognized pricing methodology at an arm’s-length basis by a qualified chartered accountant adhering to / complying with the other requirements of the applicable FDI policy.
iii. Interest rate
Since the investors are lending money to a company, convertible notes will more often than not accrue interest as well. However, as opposed to being paid back in cash, this interest may even accrue to the principal invested, increasing the number of shares issued upon conversion.
iv. Maturity date
This denotes the date on which the note is due i.e. at which time the company needs to repay it. However, if the company is not able to raise Series A financing before the note’s maturity or becomes profitable enough to not need further financing; outstanding balance of the convertible note can also be converted into a set number of shares. It is to be noted that the above mentioned notification of the RBI stipulates that such instruments shall be issued with a maturity of not more than 5 years.
WHY SHOULD CAPITAL BE RAISED THROUGH CONVERTIBLE NOTES?
Convertible Notes are ideal for raising capital for start-ups that have the potential to enter into successive rounds of funding as a part of their business mode and which are operating in sectors where it is difficult / complex to assess the investment cycle and needs hence giving an option to the investor to freeze their equity participation at a pre-determined level without the hassle of conducting a proper due diligence at the earlier stages of the start-up.
Convertible Notes offer a simple, cheap, and fast method for start-up funding as compared to traditional priced equity rounds. It also defers the more complex discussion of start-up valuation to the next round of financing, as Convertible Notes do not set the exact terms of the investment.
The valuation issue is postponed until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the start-up (i.e., price the round). A valuation of the start-up is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.5
Furthermore, issuance of Convertible Notes avoids giving the investors any control. When investors receive shares of preferred stock, they are typically granted certain significant control rights, including a board seat and veto rights with respect to certain corporate actions pursuant to the ‘protective provisions’. Convertible Note holders are rarely granted control rights and have no minority stockholder rights before they achieve maturity and are converted into equity.
Convertible Notes also allow extraordinary flexibility in connection with ‘herding’ prospective investors and raising the second round of funding and makes variable pricing possible.
The reason start-ups have been using more convertible notes in angel rounds is that they make deals close faster and reduces unnecessary management deadlocks. By making it easier for start-ups to give different prices to different investors, convertible notes help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.
CONSEQUENCES OF A POORLY NEGOTIATED CONVERTIBLE NOTE
Investors through Convertible Notes get additional rewards for investing early on in a start-up and for bearing the risk for the same. As rewards, convertible notes generally have provisions for valuation cap (similar to pre-money valuation of a start up) or a discount rate at which the debt would be converted into equity. Unintentionally, the promoters while rewarding the investors with these benefits, ends up giving indirect benefits to the investors such as:
i. Multiple Liquidation Preference
Convertible Notes often include multiple liquidation preference when not properly negotiated. Investors holding Convertible Notes with a valuation cap stand to get a significantly higher liquidity preference than the principal they invested in. During the Series A financing if the Convertible Notes are converted directly into equity (which are allotted to the new investors), investors holding the Convertible Notes get their aggregate liquidity preference increased (multiplied) as per their valuation cap. They thus get more number of stocks which has a higher aggregate value than what the value of their initial actual investment that is calculated according to the valuation cap or the discount rate. Even though a Convertible Note holder receives the stocks at a lower price, the liquidity preference of these stocks remains the same as other stocks allotted during future financing. Hence during their exit or an IPO, instead of the Convertible Note holders getting the standard 1x liquidity preference which is typical, they get a multiplied liquidity preference for which they never had to invest for which in turn has to be paid for by the company or the founders.
i. Anti-Dilution Protection
As it is discussed previously that one of the advantages of issuing a Convertible Note over having a Series A financing during the early stages of a start up is avoiding giving any controlling rights to the investors. While a convertible note does not have an explicit anti dilution protection, the valuation cap provided with the Convertible Note effectively functions like one. When any Convertible Note is issued to an investor, on its maturity the investor gets some controlling right through equity, which is proportionate to the principal invested and the interest accrued on the same. Since a valuation cap functions similar to a pre-money valuation of the company before the Series A financing, investor holding a convertible note would not only get some controlling right on earlier investment through a Convertible Note but also be able to get more equity (calculated according to the pre-agreed valuation cap) enabling him to have the same controlling rights without getting to invest further. Thus, a Convertible Note with a valuation cap enables the investor to hold the same percentage of controlling right in a company which it would have held before a Series A financing even if the company is valued higher in a Series A funding round.
CONCLUSION
Convertible notes have been touted as a “best of both worlds” deal; both from a start-up's perspective as well as from the investor’s perspective. They not only protect investors but also the businesses as well. One thing is for certain though; Convertible Notes offer a fast, simple, and inexpensive method for start-up funding in comparison to traditional priced equity rounds and India too is adapting and evolving its legal framework to welcome / introduce such alternative forms of investment providing flexible investment opportunities to both, the investors and the young entrepreneurs of India.
1 Notification No.FEMA.377/2016-RBdated 10th January, 2017 of the Reserve Bank of India
2 Companies (Acceptance of Depots)Rules, 2016 amended vide Notification No.G.S.R.639(E) dated 29thJune, 2016 of the Ministry of Corporate Affairs
3 Recognised as such in accordance with the Notification No. G.S.R. 180(E) dated17th February, 2016 issued by the Department of Industrial andPromotions, Ministry of Commerce and Industry
4 ‘Comparing Equity, Debt andConvertibles for Startup Financing’ accessed at http://www.forbes.com/sites/georgedeeb/2014/03/19/comparing-equity-vs-debt-vs-convertibles-for-startup-financings/#1129f6496aa3
5 ‘Everything You Ever Wanted To KnowAbout Convertible Note Seed Financings (But Were Afraid To Ask)’ accessed at
https://techcrunch.com/2012/04/07/convertible-note-seed-financings/
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