Convertible Notes: A More Flexible Approach To Early-Stage Fundraising?

India’s startup ecosystem is a dynamic powerhouse and the world’s third largest. The country has rapidly become a startup hub, fostering innovation and entrepreneurship across diverse sectors. As this landscape continues to evolve and expand, the need for fundraising continues to grow. 

Securing funding is a constant challenge for early-stage startups. These young companies often struggle to determine a fair valuation, which can pose a hurdle while seeking investors. At such a juncture, convertible notes emerge as a game-changing solution, offering a more flexible approach to fundraising.

What Are Convertible Notes?

In the simplest terms, convertible notes are short-term convertible debt instruments specifically designed for startup funding. They provide a unique mechanism that enables investors to convert their debt into equity at a future date. 

By issuing convertible notes, companies can access capital without immediately pinpointing their exact worth.

Unlike traditional equity funding, the process of issuing convertible notes is more efficient. It typically involves a single document, significantly minimising the time and costs associated with fundraising for both startups and investors. This simplicity makes convertible notes an attractive option for companies seeking quick access to capital while focusing on growth and development. 

Moreover, convertible notes allow startups to delay valuation discussions until a later stage when the company may have a higher value. This can potentially result in better terms for the startup when the notes convert to equity.

The Benefits 

Convertible notes offer several advantages for startups seeking to raise funds. Here are a few of the advantages that come with leveraging these instruments:

• Flexibility And Quick Capital: The primary benefit is the ability to secure capital without immediately determining the company’s valuation and negotiating the investors’ rights. This flexibility allows startups to focus on growth and development rather than negotiating complex equity terms. 
• Better Rights Upon Conversion: Convertible notes allow the company to defer discussions with regards to their rights. This means that convertible note holders and the startup often agree that they will get rights along with certain future/ existing investors upon conversion of the notes into equity. However, this requirement does not arise if the convertible note is completely paid off by the company.
• A Bridge Between Funding Rounds: With convertible notes, startups can bridge the gap between various rounds of equity funding. For instance, startups can raise convertible notes to bridge the gap between the seed funding and the Series A round. This enables startups to extend their runway without a fund crunch to continue their business seamlessly. 
• Straightforward Approach: For startups, the process of issuing convertible notes is typically faster and more straightforward than the traditional funding route. The simplified documentation reduces legal fees and accelerates the fundraising timeline. This efficiency is particularly valuable for early-stage companies that need to move quickly in competitive markets.

Legal Recognition In India 

Before 2016, convertible notes did not have legal recognition in India. However, a significant shift occurred with the Companies (Acceptance of Deposits) Amendment Rules, 2016, which officially recognised convertible notes as a legitimate fundraising instrument for startups in the country.

Under the current regulation, Department for Promotion of Industry and Internal Trade (DPIIT)-registered startups can now leverage convertible notes, subject to specific conditions. The minimum investment amount per note is set at INR 25 lakhs, and the conversion must occur within a ten-year timeframe. Additionally, the terms of conversion must be clearly defined upfront.

Eligibility Criteria 

Startups must fulfil certain prerequisites to raise funds through convertible notes. For instance, the company must have been incorporated within the last ten years, and its annual turnover must not exceed INR 100 Cr. Additionally, the startup must also be involved in “innovative practices” or possess a scalable business model.   

These criteria ensure that the benefits of convertible notes are directed towards genuine startups with growth potential.

The Investor Advantage 

Convertible notes also offer benefits to a startup’s backers. Investors can avoid the complexities often associated with early-stage investments by linking the notes to expected returns rather than immediate valuation and ownership percentages. 

This approach provides a more flexible and potentially lucrative opportunity for investors backing startups in their initial phases.

Conclusion

Convertible notes offer a streamlined approach to fundraising, allowing startups to access capital quickly and efficiently. As India’s startup landscape continues to evolve, the use of convertible notes is likely to increase. With proper understanding and implementation, convertible notes can play a crucial role in fueling the growth of India’s dynamic startup ecosystem.