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AGA

Funding

instruments for

startups

Convertible instruments

These instruments, as the name suggests, are hybrid in nature, with dual characteristics. Initially, they act as debt instruments (earning a fixed interest rate or fixed dividend rate) and at a later stage, they get converted into equity – either compulsorily or at the option of the investor – subject to fulfillment of mutually decided conditions.

Since startups, at least in the initial stages operate in cash-preserving mode, the interest/dividend is usually cumulative and converted into equity rather than regular payout in cash. Investment by non-residents in convertible instruments are governed by FDI regulations under FEMA, irrespective of the legal status of the receiving entity. Examples – CNs, CCDs, CCPS.

Non-convertible
instruments

These instruments are not convertible into equity at all and are purely in the nature of debt. Since these instruments do not provide an option to convert into equity, they are the least preferred source of investment for the investors as no equity stake is promised.

Investment by non-residents in non-convertible instruments are governed by ECB regulations under FEMA. Examples – NCDs/NCPS, OCDs/OCPS, PCDs/PCPS, pure loans.

Convertible notes

Definition

  • As per the Companies Act, 2013:
    An instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the start-up company within a period not exceeding 10 years from the date of issue and upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.
  • As per FEMA:
    Same as in Companies Act, 2013 except that the maximum period in FEMA is still 5 years. We believe that this should have also been amended to 10 years but, for some reason, it seems to have been missed out.

Prerequisites for issuing CNs

  • Can only be issued by DPIIT-recognized startups;
  • Can only be issued by a private limited company;
  • Minimum investment amount per investor – INR 25 Lakh in a single tranche.

Features

Funding Instruments for startup
  • CN can only be issued by a startup recognized by the DPIIT.
  • Can be issued to ROI as well as NROI unless an individual, who is a citizen of Pakistan or Bangladesh, or other than individual, which is registered/incorporated in Pakistan or Bangladesh*.
  • Investment by non-resident investors shall be subject to sectorial restrictions and other restrictions prescribed under FDI Guidelines under FEMA.
  • Subsequent conversion in equity is subject to prescribed pricing and other guidelines under FDI Guidelines under FEMA.

* Vide notification dated 22 April 2020, the Central Government extended the approval route for making FDI in equity instruments to all countries sharing land border with India. However, in our opinion, since CN does not fall under the definition of equity instruments (which includes CCDs and CCPS); restriction on CN issuance with government approval only applies to Pakistan and Bangladesh citizens/entities.

Advantages

  • No share valuation is required while issuing CNs. This makes it convenient for startups to raise funds without worrying about the valuation.
  • Investors do not have any control or voting power until CNs are converted into equity.
  • From investors’ perspective, CNs are preferable over CCDs as, under CNs, the investor has an ‘option’ but ‘not an obligation’ to convert debt into equity.

Disadvantages

  • Since CNs are akin to call options, the investors may opt not to convert them into equity and the CNs will remain as debt and thus require redemption. This could potentially put financial stress on the startup companies. Hence, it is important that the CN agreement is drafted carefully.
  • The threshold of minimum investment of INR 25 Lakh in a single tranche also becomes a hurdle for start ups raising funds.
  • CNs can only be issued by DPIIT-recognized startups and that too by startups which opt for incorporating a company as the form of the legal entity.

Taxation aspects

Funding Instruments for taxation
  • Subsequent conversion into equity is exempt from capital gains tax. However, the conversion price shall have to be at FMV. In case the conversion price is anything other than the FMV, it shall be taxable as under:
  • Conversion price greater than FMV – Difference between the conversion price and the FMV is taxable in the hands of the startup company. However, this is exempted in case the company is a DPIIT-recognized startup and has obtained tax exemption approval from the income tax authorities at the time of conversion.
  • Conversion price less than FMV – Difference between the conversion price and the FMV is taxable in the in the hands of investor.
  • Interest paid on CNs, if any, shall be a tax-deductible expense for the startup entity.
  • Interest received by the investor shall be taxable in the hands of the investor based on the applicable rates under the ITA or tax treaty (in case of NR investors), whichever is more beneficial to the investor. Startup entity will be obliged to comply with the withholding tax provisions.

Compulsorily convertible
debentures/preference shares

Definition

  • CCDs/CCPS are considered as good as equity and fall under the definition of capital instruments under the Indian foreign exchange regulations.

Non-convertible/optionally/partially convertible debentures and preference shares are governed by the ECB guidelines which have been discussed later in this document.

Minimum investment

  • Unlike CNs, no minimum investment limit is prescribed for CCDs.

Features

Funding Instruments for taxation
  • CCDs can be issued to ROI as well as NROI unless an individual, who is a citizen of any country sharing land border with India, or, in case of other than individual, any entity, which is registered/incorporated in any country sharing land border with India.
  • Valuation report to be obtained from a registered valuer irrespective the issuance is made to ROI or NROI.
Non-In case of foreign investors, following conditions are applicable:
  • Issuance cannot be at less than the price determined by internationally accepted valuation methodology. Acceptable methods include the DCF method.
  • Valuation to be certified by a CA, practicing Cost Accountant, SEBI-registered MB.
  • Price/conversion formula required to be determined upfront at the time of issuance of CCDs.
  • Issue price at the time of conversion into equity cannot be less than FMV worked out at the time of issuance of CCDs. In other words, the FMV worked out during the issuance of CCDs will act as a floor price.

Advantages

  • From investors’ perspective, it is certain to get equity stake at the time of conversion into equity.
  • It provides for transparency, as the terms and conditions of CCDs are decided upfront. Such terms and conditions include price/conversion formula.
  • From startups’ point of view, unlike the CNs, there is no uncertainty as to redemption on demand since the conversion into equity is compulsory,. Furthermore, since the conversion into equity is certain, CCDs have comparatively low coupon rate.
  • Unlike CNs, there is no minimum investment threshold nor there is any pre-condition of being recognized as a startup by DPIIT.

Disadvantages

  • Valuation at the initial stage of startups is always a challenge. Hence, fixing the price/conversion formula is a tedious task.

Taxation aspects

Funding Instruments for taxation
  • Subsequent conversion into equity is exempt from capital gains tax. However, the conversion price shall have to be at FMV. In case the conversion price is anything other than the FMV, it shall be taxable as under:
  • Conversion price greater than FMV – Difference between the conversion price and the FMV is taxable in the hands of the startup company. However, this is exempted in case the company is a DPIIT-recognized start-up and has obtained tax exemption approval from the income tax authorities at the time of conversion.
  • Conversion price less than FMV – Difference between the conversion price and the FMV is taxable in the in the hands of investor.
  • Interest paid on CCDs, if any, shall be a tax-deductible expense for the startup entity.
  • Interest received by the investor shall be taxable in the hands of the investor based on the applicable rates under the ITA or tax treaty (in case of NR investors), whichever is more beneficial to the investor. Startup entity will be obliged to comply with the withholding tax provisions.