By: Sharanya Ranga
‘Ease of doing business in India’ and nurturing the growth of startups through the ‘Start-up India, Stand-up India’ action plan has been the focus of various reformative measures brought about by the Government of India in the past few years. The thrust of the policy has been to make India an attractive investment destination for foreign investors and a global startup powerhouse to reckon with. A key feature of these policy announcements has been to boost fundraising options for home-grown startups by permitting startups to raise funds through issuance of convertible notes.
Globally, convertible notes are a popular mode of investment instrument in seed investments by individuals with investor contribution coming in as debt in exchange for equity upon closing of the next (Series A) fundraise. However, the exchange control regulations governing foreign direct investment (FDI) into India have traditionally permitted only fully and compulsorily convertible instruments (such as compulsorily convertible preference shares or compulsorily convertible debentures) for foreign investors. Optionally or partially convertible investments for foreign investors have been frowned upon as it takes the nature of debt that is subject to a different regulatory framework relating to external commercial borrowings.
In January 2017, the Reserve Bank of India (RBI) amended the exchange control regulations (the ‘Amendment’), allowing startups to raise funds through the issuance of convertible notes. This was post an amendment rolled out under the Indian company law excluding convertible notes from the purview of deposits to ease compliances for startups. The salient features of the Amendment relating to issuance of convertible notes for foreign investors are as follows:
Definition of a convertible note: a convertible note has been defined as an instrument issued by a startup evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup upon occurrence of certain specified events, within five years from the date of its issue as per the terms and conditions set out in the instrument.
Investment amount: a startup can issue a convertible note for a minimum amount of INR 2.5m (approximately $37,000) or more payable in a single tranche by foreign investors.
Transferability in compliance with pricing guidelines: convertible notes issued by startups may be freely transferred by the holder for a price that is in compliance with the pricing guidelines laid down by the RBI. That is, with no assured return and the price not exceeding the fair market value of the shares in question. Valuation of such shares has to be in accordance with internationally accepted pricing methodologies.
Prior government approval: prior government approval for the issuance of a convertible note will be required only for cases where the startup is engaged in any activity that falls under the approval route under the existing regulatory framework for FDI. Startups engaged in sectors falling in the automatic route for FDI do not require any prior approval with respect to such issuance.
Reporting and other compliances: all issuances and transfer of convertible notes must be reported to the RBI in accordance with the applicable reporting requirements. Further, corporate secretarial requirements such as shareholder approvals through a special resolution prior to issuance of such notes have to be complied with.
Definition of a startup: a startup has been defined to mean:
a private company incorporated under Indian company law within the last five years;
having an annual turnover not exceeding INR 250 million (US$3.8 million) in the past;
working towards innovation, development, deployment and commercialisation of new products, processes or services driven by technology or intellectual property; and
has been recognised/registered with the Department of Industrial Policy and Promotion.
Continuing on the pro-reform path, the government recently issued the new Consolidated FDI Policy (the ‘Policy’) with effect from 28 August 2017, which consolidates all the changes introduced in the Amendment in a single document for easy reference and clarity. A section on startups has been included for the first time in the Policy and also permits the issuance of convertible notes to persons resident outside India subject to the above conditions.
With India estimated to house the third-highest number of tech startups in the world (over 4,750) after the United States and England, this policy relaxation will help innovative startups raise seed capital in their initial (but critical) phase and explore funding opportunities with both domestic and foreign investors. While the pricing guidelines act as a dampener with the restrictions on assured return and valuation norms and the price for such instruments to be determined at fair market value, it is hoped that the RBI proactively exempts issuance of convertible notes by startups from the pricing guidelines for it to bring about the desired impact.
 Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) (Fifteenth Amendment) Regulations 2016NotificationNo.FEMA.377/2016-RB’ Reserve Bank of India (10 January 2016) www.rbi.org.in/scripts/NotificationUser.aspx?Id=10825&Mode=0.
 Consolidated Foreign Direct Investment Policy Circular of 2017’ Ministry of Commerce & Industries, Department of Industries, Policy & Promotion (28 August 2017) http://dipp.nic.in/sites/default/files/CFPC_2017_FINAL_RELEASED_28.8.17.pdf.
This article was first published at: https://www.ibanet.org/Article/NewDetail.aspx?ArticleUid=F7502700-0F34-496F-9689-A77130BDB8FA