Introduction
A1. A company typically undertakes an unpriced financing round (referred to in this article as a ‘convertible round’) when the investor and the company choose not to determine the company’s valuation at that time. This often occurs when the company is at a very early stage, lacking sufficient data points to establish a valuation, or in the case of a bridge financing round, where the investors and the Company prefer to defer the valuation until the company raises a larger round. Bridge rounds are typically entirely or substantially contributed by existing investors.
A2. The manner in which the securities in a convertible round (“convertible shares”) are ‘priced’ is elaborated in paragraphs B1 and B2 below.
A3. The instruments available in the Indian market for convertible rounds are
1. Compulsorily Convertible Debentures.
2. Compulsorily Convertible Preference Shares; and
3. Convertible Notes.
Why are debentures and preference shares required to be compulsorily convertible in an equity financing round?
A4. It is permissible for an Indian company to issue non-convertible debentures, optionally convertible debentures, and fully/compulsorily convertible debentures. Similarly, it is permissible for an Indian company to issue non-convertible preference shares, optionally convertible preference shares, and fully/compulsorily convertible preference shares. Notwithstanding this, in convertible rounds, only fully/compulsorily convertible debentures and preference shares are issued.
A5. Non-convertible and optionally convertible debentures and preference shares offer a debt-like protection to the capital (the company has an obligation to return the capital in the case of non-convertible debentures and preference shares), and the investors have the right to demand the capital from the company in the case of optionally convertible debentures and preference shares), in each case, with a pre-determined ROI. In other words, the risks associated with equity investments are absent fully or partially in non-convertible and optionally convertible debentures and preference shares. The usual commercial understanding is that a convertible round is an equity round.
A6. Further, India’s foreign direct investment (FDI) framework permits foreign investors making FDI investments to invest only in equity instruments (the term “equity instruments” encompasses equity shares, fully convertible debentures, fully convertible preference shares, and share warrants issued by an Indian company.
Compulsory Convertible Debentures (CCDs) and Compulsory Convertible Preference Shares (CCPS):
B1. Pricing of CCDs and CCPS: Where CCDs or CCPS are issued to foreign investors, pricing guidelines under the Indian FDI framework and the valuation norms under the Companies Act, 2013 (“Act”) must be complied with while pricing CCDs or CCPS. Where CCDs or CCPS are issued to Indian resident investors, the valuation norms under the Act have to be complied with. The pricing guidelines under the FDI framework mandate that equity instruments of Indian companies may be issued or transferred to foreign investors at the ‘fair market value’ of such instruments determined as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a merchant banker registered with the Securities and Exchange Board of India or a practicing cost accountant, in the case of an unlisted Indian Company. The valuation norms under the Act mandate that the price of the shares or other securities to be issued on a preferential basis, either for cash or for consideration other than cash, shall be determined on the basis of valuation report of a registered valuer. The discounted cashflow method is the commonly used valuation methodology under the pricing guidelines and the Act. Under both the FDI framework and the Act, the rule is that the conversion price should not be lower than the fair value determined at the time of issuance. The FDI framework mandates that the conversion formula and the lowest price at which convertible instruments could be converted must be determined at the time of issuance of the convertible securities. The Act read with Rule 13 of The Companies (Share Capital and Debentures) Rule, 2014 provides two options to determine the conversion formula and the price: (a) either upfront at the time of issuance of the convertible securities, or (b) at the time, which shall not be earlier than thirty days to the date when the holder of convertible security becomes entitled to apply for shares, on the basis of the valuation report of the registered valuer given not earlier than sixty days of the date when the holder of convertible security becomes entitled to apply for shares. Provided that the company shall take a decision on (a) or (b) at the time of the offer of convertible security itself and make such disclosure in the explanatory statement.
B2. Convertibles shares are structured to be priced upon the occurrence of a subsequent priced round, with or without a discount from the priced round’s valuation. The terms of unpriced convertibles usually also provide for determination of price upon lapse of a specified period if the subsequent priced round has not occurred within such period at a pre-determined valuation (which in companies that have previously raised a priced funding round is often the company’s valuation in the latest equity funding round prior to the convertible/unpriced round) or at a valuation calculated based on the company’s then prevailing financial metrics (for instance “x” times annualized revenue run rate, or “y” times trailing 12 month EBITDA/revenue).
B3. Conversion of CCDs: The terms of CCDs issued in convertible rounds often provide for conversion of the CCDs first into Compulsorily Convertible Preference Shares (“CCPS”), which eventually convert into equity shares. Conversion of CCDs into CCPS (as opposed to equity shares) entitles the convertible round investors to liquidation preference rights. While the Act does not explicitly provide that such ‘two-step’ conversion is permissible, the Act also does not restrict/prohibit such two-step conversion. Questions regarding the permissibility of such two-step conversion are occasionally raised. However, the prevailing market view, based on the views of relevant stakeholders and Authorized Dealer (AD) Banks at the time of publishing this article, is that there is no bar on such two-step conversion.
B4. Conversion of CCPS: CCPS are typically convertible at the earlier to occur of (a) IPO of the company; (b) nineteen or twenty years from the issuance of the CCPS; or (c) when the CCPS holder(s) requests the company for conversion. Under Indian law, a company is required to convert all outstanding convertible securities prior to the public listing. Similarly, under the Act, twenty years is the maximum period that preference shares are permitted to be outstanding (i.e., preference shares must be converted or redeemed within twenty years of issuance).
B5. A practical note related to anti-dilution protection: The terms of CCDs and CCPS usually provide for valuation protection for their holders (commonly known as ‘anti-dilution protection/adjustment’) by way of limited or full protection against a future issuance of equity shares or convertible instruments at a valuation lower than the valuation at which the relevant CCDs or CCPS were issued. For unpriced CCDs and CCPS, the extent of anti-dilution protection/adjustment would be capable of being calculated only once CCDs/CCPS are priced.
Convertible Note:
C1. Convertible Notes can be termed as the Indian version of SAFE notes. Convertible Notes are debt securities convertible into equity shares. Indian companies were permitted to issue Convertible Notes under a notification dated June 29, 2016, issued by the Ministry of Corporate Affairs. This notification amended the Companies (Acceptance of Deposits) Rules, 2014 and exempted loans raised by companies registered as startup companies from being treated as public deposits (it is impermissible for companies other than banking company and non-banking financial company as defined in the Reserve Bank of India Act, 1934, to accept public deposits, except in the manner as provided under the Act). An Indian registered start-up may issue Convertible Notes to a person resident outside India provided it complies with the requirements prescribed under the Foreign Exchange Management (Non-Debt Instruments) Rules of 2019. Furthermore, the issuance of equity shares against such Convertible Notes must comply with the entry route, sectoral caps, pricing guidelines, and other attendant conditions for foreign investment.
C2. Convertible Notes are also structured with similar pricing dynamics as unpriced CCDs and CCPS. A Convertible Note is defined as an “instrument evidencing receipt of money as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.”
C3. To issue Convertible Notes, a company must satisfy the following pre-conditions:
1. Obtain recognition/registration as a “Startup” by the Department for Promotion of Industry and Internal Trade (DPIIT).
2. The investment per investor must be a minimum of INR 25 lakh in a single tranche; and
3. Convertible Notes must be repayable or convertible into equity shares within a period not exceeding 10 years from the date of issue. However, as per the (Non-Debt Instruments) Rules of 2019, the time period for repayment or conversion of Convertible Notes is 5 years from the date of issue.
C4. The procedural requirements for issuing Convertible Notes are lighter than those for issuing other equity instruments such as compulsorily convertible preference shares, compulsorily convertible debentures and equity shares. Perhaps the most important procedural/statutory relaxation for issuing Convertible Notes is that there is no statutory requirement to undertake a formal valuation exercise. Valuation can be deferred to the future at the time of conversion of the Convertible Note. Additionally, while investing in Convertible Notes, investors typically accept limited rights in the company, similar to what is found under SAFE notes.
C5. Conversion of Convertible Notes: The conversion of Convertible Notes typically occurs when the company undertakes a subsequent “priced” funding round. This approach aims to enable the company to develop its business sufficiently to establish valuation metrics. In certain instances, conversion may also occur during a liquidity event, such as an acquisition that takes place before the Convertible Notes convert into equity.
C6. Convertible Notes are, therefore, issued with the understanding that they will convert into the company’s equity shares based on the valuation determined at the time of the next funding round. Conversion usually occurs at a discount to the subsequent round’s valuation and may be subject to a valuation cap and/or floor, rewarding the early investors for taking a risk at an early stage. While the exact valuation remains undetermined, both investors and founders typically operate under certain assumptions regarding the valuation range that the company has or is expected to achieve.
C7. Another notable feature of Convertible Notes is that they may be converted only into equity shares (rather than CCPS). While Convertible Notes, being in the nature of debt instruments, enjoy priority for distribution at a liquidation, once converted into equity shares, the investors who originally invested in Convertible Notes would not enjoy statutory liquidation preference. Given this, sophisticated financial investors like venture capital funds are seen to prefer CCDs or CCPS over Convertible Notes while making early-stage unpriced investments.
This article was first published in Lexology.