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Convertible Notes – A case of square pegs in a round hole!!

11 February 2020

by Rohit Subramanian

Given the dynamic and volatile nature of India’s start-up ecosystem, start-up(s) are always in the look-out for innovative and cost-effective fund-raising opportunities. To promote start-up(s), the government also upgrades regulatory norms and practices, in alignment with prevalent economic conditions and market dynamics. One of these initiatives is the introduction of “convertible notes” (“C-Notes”) which was first introduced by the Ministry of Corporate Affair vide amendment to Companies (Acceptance of Deposits) Rules, 2014 (“Deposit Rules”), to exempt money received by a company through issuance of C-Notes from the definition of deposit. C-Notes have been defined as an instrument of debt, which can be converted to equity or redeemed at the option of the holder subject to the terms and conditions stated in the instrument and upon the happening of a specified event. In order to qualify for the said exemption, the issuance of C-Notes have to satisfy principal criteria(s) which are as stated below:

  • (i) The issuing entity has to be a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognized as such under notification dated 17.02.2016 (“DIPP Notification”)1 issued by Department of Industrial Policy and Promotion, Ministry of Commerce and Industry (“DIPP”); and
  • (ii) The amount against which C-Notes can be issued should be an amount equal to more than INR twenty-five lakhs (INR 25,00,000); and
  • (iii) The aforesaid amount should be received by the start-up in a single tranche.

Correspondingly, the Reserve Bank of India (“RBI”) has defined “C-Notes”1 as an instrument issued by a startup company, acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.

In terms of the erstwhile Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FEMA TISPRO Regulations”) and the recently notified Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (FEM NDI Rules), a person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered/ incorporated in Pakistan or Bangladesh), is permitted to purchase convertible notes issued by an Indian startup company, subject to the following conditions:

  • a.) The investment through C-Notes shall not exceed INR 25,00,000 (Twenty-Five Lakh rupees only);
  • b.) The start-up company shall be engaged in activities allowed under the Automatic Route and in the event, investment in the Company requires Government approval, C-Notes can be issued only after obtaining such approval.
  • c.) Mandatory compliance with entry route, sectoral caps, pricing guidelines and other attendant conditions for foreign investment.
  • d.) A non-resident can also transfer or acquire C-Notes by way of sale to a person resident in India or outside India subject to entry routes and pricing guidelines prescribed by RBI.

Basis the definition(s) and details stated hereinabove, it can be inferred that C-Notes are fashioned as debt instrument(s) until the holder exercises the option to convert the instrument into shares. If this inference is correct, C-note seems very similar to an optionally convertible debenture (“OCD”). Section 2(30) of the Companies Act provides an inclusive definition of a debenture to include debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the company or not. On perusal of the aforesaid definition, one can argue that the definition of “debentures” as stated above is wide enough to include any instrument evidencing debt. As a result, C-Notes may be classified as a “debenture” for the purposes of the Companies Act.

A private limited company desirous of issuing OCD is required to follow the procedure prescribed under the Companies Act, 2013 (Companies Act), which inter alia includes the approval of shareholders by way of a special resolution and a debenture redemption reserve account to be created out of the profits of the company, for the purpose of paying dividends. Similarly, if C-Notes are treated as “debentures”, then their issuance should mandatorily comply with Section 71 of the Companies Act read with Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014.

Moreover, definition of “securities” prescribed under The Securities Contracts (Regulation) Act, 1956 (“SCRA”) is broad enough to cover C-Notes as marketable securities equivalent to shares, scrips, stocks etc. Therefore, if C-Notes is to be classified as a “security”, Section 42 of the Companies Act read with relevant rules, prescribes a rigorous issuance process which will have to be necessarily followed and shall include passing of a special resolution and valuation by registered valuer etc. Further, if money were to be invested in an Indian start-up entity from outside India, investment through C-Note(s) will be facilitated through the FDI route, subject to the provisions of the FEM NDI Rules. Whereas, investment through issuance of OCD(s), are presently treated as External Commercial Borrowing(s) (“ECB”) and regulated by the provisions of the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018.

It is relevant to note that an angel investor cannot be expected to invest huge capital in a business that is yet to be started, unless there is an assured return on his investment. Since, investing in a start-up is a high-risk investment, start-ups struggle to convince the investor on the commercial viability of their business venture which leads to disagreement on the valuation itself. While, there are no precedents in the Indian ecosystem, most western countries have a mature seed financing practice, wherein C-Notes are already a popular tool of investment. C-Note are preferred because in most jurisdictions, primarily because the issuance procedure does not involve valuation of the business and the option & timeline for “conversion” is pre-determined, which guarantees an assured return on investment. However, it must be noted that C-Notes does not entail incentives such as directorship and/or veto rights.

In the United States C-Notes are structured as a bridge financing tool, wherein valuation of the Company and subsequent conversion of the instrument is delayed until the company can secure its next round of funding. To maximize returns, a C-Note holder is sometimes granted the right to set a valuation cap on the equity shares acquired by the third-party investor(s) in the subsequent round of financing, when conversion is triggered. The investee company may also pre-determine and set a conversion rate in the C-Note instrument, irrespective of the value of the shares arrived at the time of conversion.

The regulatory landscape for start-ups in India is bound to be ever-evolving. Presently, investors are more inclined to adopt a traditional approach and opt for conventional equity/preference shares, which assures certainty in shareholding and board rights. However, if the regulatory issues discussed herein are addressed and the issuance procedure is further streamlined, C-Notes may yet prove to be a game changer in the start-up financing space

[The author is a Principal Associate in Corporate Advisory team, Lakshmikumaran & Sridharan, Bangalore]



  1. Notification No. G.S.R. 180(E) dated February 17, 2016 has been superseded. Currently, Notification No G.S.R. 127(E) dated February 19, 2019 is in force.
  2. Rule 2(e) of Foreign Exchange Management (Non-debt Instruments) Rules, 2019.