Over the past few years, issuing convertible notes has become the preferred way for companies to raise funding, especially when they need funds quickly and want to postpone valuation to a future round of financing. In fact, several seed funding rounds for early-stage startups raise are closed by issuing convertible notes.
So, what are convertible notes, and what rights do they give investors? What features make them popular? This blog aims to tells you all this.
What are convertible notes?
Convertible notes are short-term financing instruments that are issued when the company is in its growth phase or wants to raise an interim round of financing skipping company valuation. Usually, notes convert to equity based on a trigger factor either on a discounted basis or on the basis of a cap on valuation. The trigger could be a future round of financing, operation metrics or a pure passage of time. The investor may also submit a conversion notice to the company to convert the note in line with the terms agreed upon at the time of investment.
Can all startups issue convertible notes?
No, only companies recognised as ‘start-ups’ by the Department for Promotion of Industry and Internal Trade (DPIIT) and receiving investments more than INR 25,00,000 either from a single investor or in a single tranche, can issue convertible notes.
Can convertible notes be issued to non-resident investors?
Until 2017, Indian companies could issue convertible notes only to resident investors. From 2017, recognised startups have been allowed to issue convertible notes to foreign investors under the FEMA Act.
According to this Act, a non-resident individual (NRI) can acquire convertible notes, so long as the proceeds from the sale of their investment are not taken out of India. If the startup company is engaged in a sector that requires prior approval from the Government to receive such a foreign investment, then the company must obtain approval before issuing the note. Few sectors covered under this route include broadcasting content services, print media, mining and minerals etc. Further, a non-resident can convert the convertible note only to equity of the company.
What are the main terms that need to be decided when issuing a convertible note?
- Conversion rate: A convertible note converts to equity in the immediate subsequent round of financing. For example, if a company raises funds in the seed round and issues a convertible note, that note will convert to equity in the subsequent Series A round of financing.
Convertible notes can be converted by:
1. Discount: Here, the note holder converts the note by applying the discount percentage on the issue price of the share in the new round. Typically, the discount rate ranges from 10% to 20%. If the percentage of discount is based on a sliding scale rather than being a fixed number, it is not uncommon to agree on a cap on the discount. A cap on the discount percentage serves as a protection for founders, to limit their dilution.
Seed round investment amount
Price per share in Series A round
Applying the discounted rate of 20% to the price per share of Series A round, the discounted price per share for the seed investor will be INR 8 per share. This means the seed investor can convert his investment into 1,25,000 Series A shares (10,00,000/8) as against a Series A investor who would receive 1,00,000 Series A shares (10,00,000/10) for the same amount of investment.
- Conversion ratio: This is the ratio at which one convertible note converts to one or more equity shares. As companies grow, conversion ratios are adjusted for many reasons. Standard among these are anti-dilution and adjustments for stock restructuring, including stock splits, stock consolidations, bonus issue or issue of share dividends, etc. If a conversion/adjustment results in a fractional amount of shares, then the nearest whole number must be considered and equity has to be issued accordingly.
2. Cap on the valuation: A cap on company value sets out the maximum price at which the note converts to equity. Here, when deciding the value for conversion, the lower of the cap value or the value of the round is considered.
|Pre money value of the company in the Series A round||20,00,00,000|
|Price per share in Series A round||10|
Price per share under cap = (Cap on value / pre-money value * price per share in the Series A round)
= (10,00,00,000/20,00,00,000) * 10
Accordingly, under this scenario, a seed investor will convert his investment into 2,00,000 Series A shares (1,00,00,000/5), compared to the Series A investor who will receive 1,00,000 Series A shares (1,00,00,000/10) for the same amount of investment.
3. Convertible notes with a discount and a cap on the company value.
In such scenarios, the lower of the discounted price per share or the adjusted price per share is considered during conversion.
The price per share derived under scenario 1 and 2 are:
|Discounted share price||8|
|Adjusted share price||5|
Here, since the price per share under cap value is lower, INR 5 is adopted for conversion.
With all terms remaining the same as per scenario 1 and 2, if the pre-money value of the company was slightly modified and fixed at INR 11,00,00,000, the adjusted price per share under the capped value would have amounted to INR 9.09.
In such a case, the discounted rate of INR 8 per share would have been considered and accordingly the note would have converted.
- Interest: Convertible note holders are also eligible to receive interest. Interest can be cumulative or non-cumulative. Payment of interest takes a chunk of cash away from the company. So, it’s better to fix the rate of interest at the lowest rate permissible under law. A rate of interest is usually non-cumulative fixed at 0.001% and is typically negotiated as part of the term sheet. Interest is usually payable at the time of maturity or convertible to equity at the time of note conversion.
- Note Period: The term of a convertible instrument lasts until the security is repaid or is converted to equity. If the company raises a round of financing before the term expires, then the convertible note will convert to equity during that round of funding. If the note is issued to a foreign investor, the term cannot be longer than five years.
- Repayment: The investor may have an option to seek repayment of the convertible instrument on maturity or at the end of the term, although this is not so common. The note may be redeemed inclusive of the interest amount. Where the note expires before a future round of financing is closed, the company can request the investor for an extension of the maturity date to prevent a liquidity crunch.
Like any other security, issuance of notes in return for funding must also be supported by documentation that include terms accepted by both investors and the company. Failure to comply to the terms may lead to arbitration.