Raising Fund from Foreign investor for your Startup

Sanjay/ May 20, 2019/ Startup

Govt. of India issued Consolidated FDI Policy in 2017. The thrust of the policy is to make India an attractive investment destination for foreign investors. 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 which was earlier not allowed. Convertible Notes are extremely popular investment instrument in advanced startup ecosystems such as Silicon Valley, Tel Aviv, Singapore etc.

What is Convertible Notes? 

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. 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. Such notes also have the advantage of being redeemable at maturity if the startup fails to perform as expected.

What is the situation in India prior to January, 2017? 

In India, issuing Convertible Notes (CN) to foreign investors was earlier forbidden since the Reserve Bank of India (RBI) allowed Foreign Direct Investment (FDI) permitted only in equity instruments and instruments that are compulsory convertible into equity shares like Compulsorily Convertible Preference Shares (CCPS) or Compulsorily Convertible Debentures (CCD). All other instruments, including those that are optionally convertible into equity, are treated as debt and have to comply with the External Commercial Borrowings (ECB). Before the new F.D.I policy, it was difficult for startups to raise funds from foreign investors, who are habituated to investing in startups through a convertible note issuance. In addition to that, such notes were not allowed to be issued because they would be considered as ‘Deposits’ under the Companies Act, 2013 and the  Companies (Acceptance of Deposits) Rules, 2014.

R.B.I January, 2017 Notification  

In one of many steps being taken for Ease of Doing Business (EODB) and promote F.D.I in start-ups, the R.B.I has permitted “recognized startups” to raise funding through the convertible note route. The RBI has amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, w.e.f January 10, 2017, to allow “recognized startups” to issue convertible notes to foreign investors.

Valuation Requirements

Unlike other FDI instruments, like Equity Shares or CCPS, pricing guidelines need not to be complied with at the time of issuance of a convertible note. However, the conversion of the convertible note into equity as well as the transfer from a non-resident to a resident investor must be in accordance with the pricing guidelines. The price of shares issued upon conversion must be at or above fair market value, determined by a certified chartered accountant or merchant banker.

Conditions to issue Convertible Notes by Recognized Start-up

  • The minimum investment in a single tranche will have to be at least INR 25 lakhs. This means only serious and bigger investors must be benefitted from a note.
  • The amount will have to be converted within 5 years;
  • The terms of conversion will have to be determined upfront at the time of issue of Convertible Notes.
  • The consideration for convertible notes can be sent through banking channels or through an escrow account. Escrow account to be closed immediately after the requirements are completed or within six months, whichever is earlier.
  • The issue of equity shares in lieu of convertible notes must be in compliance with RBI’s pricing guidelines, that is, valuation must be done through any internationally recognised pricing methodology at an arm’s-length basis by a qualified chartered accountant or merchant banker.
  • Convertible notes are freely transferable and can be acquired/transferred by way of sale, provided the sale is in accordance with the pricing guidelines prescribed by the RBI.
  • Prior Government approval for the issuance of a convertible note will be required 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.

India estimated to house the third-highest number of tech startups in the world 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 still act as a hamper with the restrictions on price of 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.

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