Convertible Notes (CN): Reporting Issuance or Transfer to Foreign Investors by Indian Companies
Md Saddam Hussain
Md Saddam Hussain is a highly skilled and experienced Company Secretary specializing in corporate laws, regulatory compliance, and legal advisory. With expertise in the Companies Act, FEMA, LLP regulations, SEBI compliance, NCLT proceedings, and liaisoning with government authorities, he provides strategic guidance to businesses, ensuring seamless adherence to statutory obligations. Known for his meticulous approach and in-depth knowledge of corporate governance, he assists companies in mitigating risks, handling regulatory filings, and navigating complex legal frameworks. With a commitment to excellence and integrity, Md Saddam Hussain plays a crucial role in supporting businesses with compliance, litigation, and corporate structuring.
Introduction
Convertible Notes (CNs) have become an increasingly popular fundraising instrument, especially among startups in India. Their hybrid nature — combining features of both debt and equity — offers flexibility to both the issuing company and the investor. When these notes are issued or transferred to foreign investors, Indian companies must comply with specific regulatory requirements under the Foreign Exchange Management Act (FEMA), 1999, as administered by the Reserve Bank of India (RBI).
This article explores the concept of Convertible Notes, their key features, eligibility, and the prescribed reporting framework that Indian companies must adhere to when dealing with foreign investments through this instrument.
What is a Convertible Note?
A Convertible Note is a debt instrument issued by a company that promises to repay the amount with interest or convert it into equity shares at a future date, typically upon a specified event like the next major funding round or maturity.
Under Indian law, specifically as per RBI guidelines, a CN is defined as an instrument evidencing receipt of money initially as a loan, which is repayable at the option of the holder or convertible into equity shares of the issuing company within a period not exceeding five years from the date of issue.
Eligibility for Issuing Convertible Notes
Convertible Notes can only be issued by startups recognized under the Startup India Scheme, subject to the following conditions:
The company must be registered as a Private Limited Company.
It must be DPIIT-recognized as a startup.
The minimum investment per investor (whether resident or non-resident) must not be less than INR 25 lakhs in a single tranche.
Convertible Notes must be converted into equity shares within five years from the date of issue.
Permissibility of Investment by Foreign Investors
Foreign investors — excluding citizens or entities of countries sharing land borders with India, unless prior approval is obtained — are permitted to subscribe to Convertible Notes issued by Indian startups. Such investments are subject to the following conditions:
Sectoral Caps and FDI Policy Compliance: The company must operate in a sector where 100% foreign direct investment (FDI) is allowed under the automatic route. If not, prior government approval may be required.
Pricing Guidelines: Since CNs are debt instruments convertible into equity at a future date, pricing norms applicable to equity instruments are not mandatory at the time of issuance. However, upon conversion, the issue price must be determined by FEMA valuation norms.
Non-Repatriation Basis: NRIs and OCIs can invest in CNs only on a non-repatriation basis.
Transfer of Convertible Notes to Foreign Investors
Convertible Notes can be transferred from a resident to a non-resident (and vice versa), provided such transfers:
Comply with FDI sectoral caps and entry routes.
Are priced as per the valuation guidelines if converted at the time of transfer.
Are reported to RBI within the stipulated timelines.
FEMA Reporting Requirements for CNs
To ensure compliance, the issuance and transfer of Convertible Notes to foreign investors require specific reporting obligations under FEMA regulations, especially through the Single Master Form (SMF) on RBI’s FIRMS portal.
1. Reporting of Issuance to Foreign Investor
a. The issuing Indian startup must file Form CN within 30 days from the date of issue of Convertible Notes.
b. The filing is done through the FIRMS portal (Foreign Investment Reporting and Management System).
c. The following details must be submitted:
Name and address of the foreign investor
Details of the Convertible Notes (amount, terms, maturity)
Board resolution authorizing the issue
KYC of the foreign investor, as obtained from their AD Bank
Company incorporation certificate and recognition as a startup
Any applicable government approval (if under approval route)
2. Reporting of Transfer of Convertible Notes
a. If a Convertible Note is transferred between a resident and a non-resident, the company must file Form CN within 30 days of such transfer.
b. Pricing guidelines must be followed if the conversion into equity is part of the transaction.
c. Transfer documents, the share purchase agreement, and the KYC of the transferee are also required.
Key Compliance Points
Timely Filing: Delay in reporting can attract penalties under FEMA (compounded by RBI).
Authorized Dealer Bank Role: The application and KYC must be routed through the AD Bank (bank authorized to deal in foreign exchange).
Conversion into Equity: When CNs are converted into equity, Form FC-GPR must be filed within 30 days of the date of issuance of equity shares.
End-Use Restrictions: Funds raised through CNs must not be used for activities prohibited under FDI policy, such as real estate or gambling.
Advantages of Using Convertible Notes
Ease of Fundraising: CNs allow startups to raise funds without the immediate need to value the company.
Deferred Dilution: Equity dilution is postponed until a future valuation event.
Investor Protection: Investors get debt-like security with the option to convert in case the company performs well.
Regulatory Clarity: RBI’s clear guidelines on reporting and permissible structures have increased CN adoption.
Challenges and Practical Considerations
Regulatory Oversight: Any non-compliance may lead to regulatory scrutiny.
Conversion Timelines: The five-year window for conversion requires careful planning.
Cross-Border Transfers: Additional compliance under FEMA and taxation laws if CNs are transferred to or from non-residents.
Valuation Hurdles: At the time of conversion, valuation must comply with applicable laws, which could lead to disputes or negotiations.
Conclusion
Convertible Notes provide a powerful funding tool for Indian startups looking to attract foreign capital without immediate equity dilution. However, the issuance or transfer of these instruments to foreign investors brings with it a host of FEMA-related reporting obligations that must be strictly followed.
By ensuring compliance with the reporting timeline, valuation norms, and sectoral restrictions, Indian startups can harness CNs effectively while avoiding legal complications. As the Indian startup ecosystem continues to thrive, Convertible Notes will likely play a crucial role in bridging early-stage financing gaps, especially from global investors.
For any clarifications or queries, please feel free to reach out to us at admin@fintracadvisors.com
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