Fund Raising Instruments | Part 2 | Convertible Notes

“Indian Government is exploring unveiling of a wide array of Hybrid Instruments that would focus on how Founders can raise capital and yet retain control even with minority stake.. “

Many of us woke up to this ET news news couple of weeks back. This is a great step up from the current scenario of equity raising in India where only Compulsorily Convertible Preference Shares / Debentures were allowed. [However, as per a Notification in Jan 2017, Convertible notes were restrictively allowed for startups (firms <5 years old and <INR 25 cr turnover. Read Yourstory article on it and RBI FAQs]

In this post, we will discuss an Hybrid Instrument — Convertible Note.

What is a Convertible note, why is it useful & general terms

A convertible note is considered as debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.

When is Convertible note typically useful?

Convertible notes are typically useful in a scenario either where the investor and/or the firm do not wish to be forced into valuation exercise (could be due to any of the below scenarios):

· Stage of start-up is very early and difficult to put a value to the idea

· Bridge Fund raising round in-between two rounds of funding

· Current round is happening in quick succession to previous one and any change in valuation is difficult be justified by both parties

Common terms in a Convertible Note

Since Convertible notes are by nature debt which converts to equity, they have commercial terms of debt — interest rate and maturity. Apart from that, they have other terms to enable equity conversion.

Common terms of convertible notes are -

· Discount Rate: This is the discount in valuation of subsequent financing round, the Convertible note investor gets. This is the incentive for investing earlier in the firm.

· Valuation Cap: This is the cap of the valuation at which your notes will convert into equity. This is not a mandatory term however mostly used by investors.

For example, a Convertible Note is issued with the below terms:

o Investment Amount to be converted to preference shares at 30% discount to the pre-money valuation offered by a potential next round investor

o The valuation for conversion of the Investment Amount shall be capped at USD 5M pre money

Now, let’s see what would be the ‘Conversion Valuation’ under two scenarios of Pre-money valuation

· Interest Rate: Since convertible notes are by nature debt, they will often accrue interest as well. However, most often, this interest accrues to the principal invested and increases the no. of shares converted as opposed to being paid back in cash.

· Maturity date: This denotes the date on which the note is due, at which time the company needs to repay it. The general expectation is, the firm raise subsequent round of funding by then and the notes gets converted to equity. In the eventuality when it doesn’t happen, below are the options laid out,

o the maturity date is extended by mutual agreement between the investor and the firm — no mandatory equity conversion assigned in the beginning

o automatic equity conversion and value at which equity would convert is assigned

o amount is repaid with accrued interest if any

In India, the maximum term of maturity for a convertible note is 5 years.

An Example of Conversion scenario

Let’s continue the example discussed above on Conversion Valuation. Let’s assume an investment of $200k

A Convertible Note is issued with the below terms:

o Investment Amount to be converted to preference shares at 30% discount to the pre-money valuation offered by a potential next round investor

o The valuation for conversion of the Investment Amount shall be capped at USD 5M pre-money

o For simplicity’s sake, we will ignore accrued interest and maturity date in this example

We can see above, additional % stake Convertible note investor is getting vs. a Series A investor. This is the incentive for early risk taking.

Current Scenario in India

Raising money through convertible notes is quite common in Silicon Valley, Singapore or Israel. In India, Convertible Notes, especially if they have an ‘Option’ to convert to equity was forbidden for foreign investors. Hence, the “Convertible Note” structures allowed in India till recently were “Compulsorily Convertible Preference Shares” (CCPS) or “Compulsorily Convertible Debentures” (CCD).

These instruments defeats the primary advantage of a Convertible note, (ie. Deferring valuation) as, under these instruments, a valuation has to be mandatorily laid out for current or future conversion value and also a valuation certificate is to be filed. Apart from that, the compliance procedures to issue CCPS/CCD is higher than that of Convertible Notes.

[However, as per a Notification in Jan 2017, Convertible notes were restrictively allowed for startups (firms <5 years old and <INR 25 cr turnover. Read Yourstory article on it and RBI FAQs]

There is more to come

In our last post we discussed on Venture debt. In this series of posts, we will discuss on different instruments and how do founders across the globe retain control despite raising institutional capital.