“Convertible Note” means 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 upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument [Section 2 of the Companies Act, 2013].

The term convertible note is specifically excluded from the ambit of deposits as stated in Section 2 of the Companies Act, 2013. Section 2 states that:

• an amount of INR 25 lakh or more;
• received by a startup company;

Startup company means: a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognised as such in accordance with notification number G.S.R. 180(E) dated 17th February, 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry;

• in form of a convertible note;
• in a single tranche;
• from a person;
• The terms of conversion will have to be determined upfront.

Definition of startup as per notification number G.S.R. 180(E)- an entity which is –

1. up to five years old, from the date of its incorporation;
2. its turnover for any of the financial years has not exceeded Rupees 25 crore; and
3. is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.

Any such entity formed by splitting up or reconstruction of a business already in existence shall not be considered a startup”.

Further, Section 2 of the Companies Act, 2013 states that the convertible note shall be either:

• converted into equity shares; or
• repaid within a period of 5 years from the date of issue of the convertible note.

The Ministry of Corporate Affairs has exempted convertible notes from the ambit of deposits, and thereby allowing companies to issue convertible notes in tranches exceeding INR 25 lakhs to prospective investors, without having to comply with the requirements mandated by the Deposit Rules.

Further, the RBI has amended[1] the Foreign Exchange Management (Transfer or Issue of Security by a

Person Resident outside India) Regulations, 2000 (FEMA 20/2000), implementing a key change in the foreign exchange policy by allowing startup companies to issue convertible notes to foreign investors.

Issue of Convertible Notes to Foreign Investors by Startups

1. A startup company can issue convertible note to a person resident outside India;
2. The issue size shall be INR 25 lakh or more per tranche;
3. Convertible note shall not be issued to a person who is a resident of Pakistan or Bangladesh or to an entity which is incorporated/registered in Pakistan or Bangladesh;
4. Consideration on issue of convertible notes must be received through normal banking channels;
5. Consideration may be received in an escrow account, provided the escrow account is closed as soon as the funds are utilized or within six months, whichever is earlier;
6. Government approval shall be taken, if the startup company falls under such sector which requires government approval prior to acceptance of foreign investment;

Note: A startup company which has raised foreign investment under the government approval route shall comply with Regulation 1 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20/2000) for issue of shares.

7. NRIs may acquire convertible notes on non-repatriation basis in accordance with Schedule 4 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20/2000).

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10825&Mode=0