Overseas investors looking to invest in Indian companies through the foreign direct investment (FDI) regime have traditionally had to do so either through equity shares or through instruments that are compulsorily convertible into equity shares, namely, compulsorily convertible preference shares (CCPS) or compulsorily convertible debentures. All other instruments, including those that are optionally convertible into equity, are treated as debt and have to comply with the more onerous regulations applicable to external commercial borrowings (ECBs). In January 2017, however, an amendment to the regulatory framework permitted eligible startup companies to issue convertible notes to non-resident investors under the FDI regime.
Convertible notes are debt instruments that are convertible into equity at the option of the holder or upon specific trigger events, most typically the company’s next equity fund-raising round. In jurisdictions such as the US and Singapore, convertible notes are an attractive option for venture capital funds investing in early-stage companies when determining the valuation can be a tricky process. Such notes also have the advantage of being redeemable at maturity if the startup fails to perform as expected.
Under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, a convertible note issued by a qualifying startup to a non-resident investor is initially a debt instrument that may, at the option of the note holder, either be repaid or converted into equity within five years from issuance. The time limit suggests that convertible notes in India, as elsewhere, are intended to be short-term instruments for seed funding or for a bridge round, enabling note holders to either be repaid or receive equity shares at the company’s subsequent equity fund-raising round.
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Aparna Ravi is a partner at the Bengaluru office of Samvad Partners.
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