Convertible Note- The Simpler Form of Fundraising

Anyone who has gone through the process of fundraising in India, will tell you how cumbersome and tedious the process can be! Right from haggling over valuation for a startup that is still in the process of building a product or testing the waters to having to procure a valuation certificate and a string of board and shareholders’ resolution – the entire process can sometimes leave you in need for a break even before you have started out!

“Why can’t we simply do a Convertible Note?” was a common question we got asked often. For most of you familiar with the Silicon Valley style convertible note – this was not an option in India till very recently. A “Convertible Note” structure in India till recently, still required you to go through the process of allotment of instruments like “Compulsorily Convertible Preference Shares” (CCPS) or “Compulsorily Convertible Debentures” (CCD) which involve several compliance related paperwork but most importantly still required you to assign a valuation to the startup, either a current valuation or for a potential future conversion value.

In yet another step to ease doing business in India, the Ministry of Commerce and Industry, Government of India, has permitted recognized  “Startups” to raise funding through the convertible note route.  What does this mean? If you are a company that has received a Certificate recognizing you as a “Startup” from the Government of India, you can accept funds in the form of a debt from investors,  which can convert into equity at a future date. Of course everything comes with conditions. In order for a recognized Startup to receive funding through Convertible Note, the following additional conditions will have to be complied with:

  • The amount of investment will have to be atleast INR 25 lakhs in a single tranche
  • The amount will have to be converted within 5 years
  • The terms of conversion will have to be determined upfront

Take this quick 2 minute test to find out if you can raise or invest in Convertible Notes!

For those who haven’t fundraised and are wondering what the brouhaha is about, well the below graphic should answer your questions:

The VC view. Here is what Karthik Chandrasekar, our Co-Founder and also Founder & CEO of Sangam Ventures has to say about Convertible Notes:

I’m one of those that keeps whining to Anisha about how painful it is to do seed investments without the ability to do true Convertible Notes. When we (@ Sangam Ventures) had a chance to do a SAFE investment in Inficold, Inc. in the US, we jumped on it. So, when the awesome folks at Startup India gave recognized startups the ability to issue Convertible Notes, we had to jump on it and make good use of it!

Most startups need to raise funds soon after incorporation to fund hiring and operations, and the Convertible Note can be a vehicle for investors to fund companies at this very early stage.  Most of the value is in the idea and vision of the founders and the founding team. Unlike the sale of equity in traditional priced rounds of financing, a company can issue a Convertible Note quickly and efficiently, without multiple documents and the necessity of amendment to the charter documents.  As a flexible, one-document security, without numerous terms to negotiate, the Convertible Note should save companies and investors money and time.

In the simplest terms the Convertible Note is an IOU as in “I owe you money!” and can be linked to the expected return rather than a valuation and percentage of ownership getting away from the valuation quagmire for a seed stage investment.

A Convertible Note is typically set up like a debt instrument with an interest rate and maturity date along with a discount on the next significant round of investment which values the startup. If the Convertible Note hasn’t converted by the maturity date it converts to equity in the startup, again requiring to set a valuation for this potential conversion today. But, thankfully the convertible note unlike a CCD does not require filing a valuation certificate on the issue date.

We took the Convertible Note opportunity given by the folks at Startup India a bit further by moving to what Y-Combinator developed for its investments, the SAFE. As defined by Y-Combinator, “A SAFE is a Simple Agreement for Future Equity. An investor makes a cash investment in a company, but gets company stock at a later date, in connection with a specific event.  A safe is not a debt instrument, but is intended to be an alternative to convertible notes that is beneficial for both companies and investors.” The key difference is that the SAFE does not have a maturity date, for our case, we ignore the maturity date provision of 5 years in the regulatory requirements because in 5 years we are all dead in the startup universe – i.e. we expect to use SAFEs / Convertible Notes when investing in very early stage startups that we expect will raise money within 12-18 months or die! I will speak a bit later on our preference and different options one can have under the SAFE.

So, when does a Convertible Note / SAFE make sense? [at least for us]

  1. When the value of the startup cannot be determined easily
  2. When the value of the startup cannot be agreed upon between the founders and the investor within meaningful bounds
  3. When the focus for both the investor and founders is to be very efficient with their time and the investment is for very short time horizons – seed round to get to a fund raise or bridge round to get to the Series-A

 

When does it not make sense to do a Convertible Note / SAFE?

  1. The investor is looking for a lot of protective provisions or a complicated set of terms for the conversion
  2. There is no urgency in closing the round and with some effort a value for the startup can be determined by the investor
  3. There has been a recent investment where another investor has valued the startup or there are already multiple investors in the startup
  4. What the startup is looking for is a loan or other non-dilutive forms of financing

On the SAFE option

The preferred options in a SAFE instrument for the Y-Combinator (this might be a good time to give the SAFE Primer a read) is one with a Valuation Cap i.e. the investment amount will convert to equity at the lower of the next round valuation and the Valuation Cap. In India, we have found this to be problematic where the next round investors are always looking into what the previous round investor set as a potential future valuation – also our pet peeve with the CCDS. So, we dropped the Valuation Cap – exposes us to not getting the upside if our startups get some absurdly high valuation, we will rethink it when a few of our startups do that 🙂 For now, we are going with a discount on the next round of investment which builds up and gets capped at the end of a 12-18-month period by which we expect our investees to fund raise. For investors who want to be super safe with value coming back to you can always take the option of doing both. The last one that is used in the SAFE which we like is the MFN or Most Favored Nation provision – where if the startup issues a SAFE or Convertible Note before getting to a valued financing round, the SAFE investor has the option of converting to the new instrument at which point the SAFE and the MFN provision ceases to exist.

Many thanks to the LexStart team for templating the Convertible Note (in the form of a SAFE) which we used for our investment in Delectrik Systems Pvt. Ltd. The same can be downloaded here along with a primer for you to review and use for yourselves. Would recommend reaching out to the LexStart team if you have any questions or using their services for the first time you do a Convertible Note investment, they can also help your startups with the process of getting the Startup India recognition.

Here is hoping this really opens up the seed stage investment eco-system for FDI investors and we see the Convertible Note becoming the instrument of choice for seed investing in India.

Happy Investing!

Company Structuring – How many subsidiaries can you have?

The Ministry of Corporate Affairs, with effect from September 20, 2017 restricted companies from having more than two layers of subsidiaries. This restriction will apply across the board to all the companies, whether private or public, listed or unlisted.

Exempted Companies

The following companies are exempted from this restriction:

  1. Banking companies as defined in clause (c) of section 5 of Banking Regulation Act, 1949;
  2. Systematically important NBFCs registered with the Reserve Bank of India;
  3. Insurance companies; and
  4. Government companies under the Companies Act, 2013.

 

Compliance Requirements

All companies (apart from the exempted companies) that currently have more than 2 layers of subsidiaries will have to disclose details of the subsidiaries by February 19, 2018.

 

Penalty for Contravention

The penalty for contravening the above restriction is fine which may extend upto INR 10,000/- with an additional INR 1,000/- every day after the first during which such contravention continues. The penalty can be levied on the Company and every officer of the company who is in default.

Did you know that registering for Startup India is a breeze? Myth Vs. Reality!

Given our experience in helping startups obtain Startup India recognition, we are surprised at how many people still think it is a cumbersome exercise. The process is so easy and painless, that getting a Startup India recognition now is less than a day’s job!

Startup Recognition now takes only a day!

In this blog, LexStart aims to clarify the popular myths around the process for a Startup India recognition. Please click here to read more.

Do you qualify to be a STARTUP?


Are you a recognized Startup?

If you haven’t heard about the Startup India Initiative, then you’ve definitely been living under a rock! The initiative was launched last year with much fanfare to encourage entrepreneurship and promote sustainable growth within the Indian startup ecosystem. In fact, it was only in 2016 that “startup” was defined as a separate term[1] by the Department of Industrial Promotion and Policy (“DIPP”). But despite many incentives for startups such as tax benefits, credit availability etc. it wasn’t very well received by the startup community. After taking feedback and suggestions from various stakeholders within the startup ecosystem, the government reassessed its Action Plan and in May 2017 and the DIPP[2] notified a broadened definition of the term “startup” (discussed below), relaxed the norms for eligibility and made the process for recognition of startups much simpler. As a result of this much needed amendment as of now 3160[3] startups have been recognized and 67 out of those have already received funding support from the government!

[1] DIPP Notification No. G.S.R. 180(E) dated February 17, 2016

[2] DIPP Notification No. G.S.R 501(E) dated May 23, 2017

[3] http://startupindia.gov.in/ (last visited August 30, 2017)

The eligibility criteria for “Startup” recognition is now broader!

Having assisted multiple startups with their application for recognition, over a period of time we felt there was dearth of information regarding the relevant documents and the process of application. In this blog post we would like discuss the relevant details and information that an applicant must furnish as well as keep in mind the key parameters for the eligibility criteria for recognition of a startup. We hope to bring clarity and help many applicants realize their dream of being recognized as a startup.

But before we delve any further, it is imperative to understand the revised definition of a startup which will help in understanding the process of application and the key parameters that applicants must keep in mind. The broadened definition of startup is:

  1. It has to be an entity, i.e., a private limited company or an LLP or a registered partnership firm
  2. It should be less than 7 years’ old. In case of a biotechnology company, this limit is 10 years.
  3. The entity must not be formed by splitting up, or reconstruction of an existing business.
  4. It should not have annual turnover exceeding INR 25 crore in any preceding financial year.
  5. It should be working towards innovation, development or improvement of products or processes or services, with a scalable business model and can generate employment opportunities or wealth creation.

If an applicant fulfills the above mentioned criteria, then it may be eligible to apply for recognition as a startup.

Certificate from Incubator not mandatory anymore!

Let us now proceed to understand the application process, necessary documents and other relevant information that an applicant must furnish with its application:

  1. The application can be made online either through the DIPP web portal[1] or via their mobile app.
  2. Following documents are required to be submitted:
  • KYC (Know Your Customer) details, i.e., certificate of incorporation, registered office address, details about the directors or partners, authorized representatives of the company, number of employees etc.
  • Details of all or any intellectual property rights that the applicant may have registered or applied for. This includes the entire gamut of IPRs such as trademarks, patents, copyrights, design and plant varieties.
  • Identify the industry, sector and category.
  • To facilitate ease of doing business in India, the government has introduced self certification of the application. That means that it has eliminated regulatory and bureaucratic hurdles of obtaining recommendation and support letters from incubators and industry associations.

Once all the basic details regarding the entity are filled in, we come to the section that we believe can make or break the chances of receiving the recognition. Every applicant must keep in mind the revised definition a startup that is, an entity that is working towards innovation, improvement (existing product/service/process) and scalability. Applicants are required to submit a brief note highlighting how their startup is supporting these 3 key parameters in about 250 words. This section also requires the applicant to indicate the current stage of development of its product that is, whether it is in ideation, validation, early traction, or scaling stage. Apart from this, applicants may submit links to their website, any videos and press coverage of their entity. The application also requires applicants to submit a pitch deck, however, in our experience, essentially, the applicant has to submit an overview of their business and their business plan. Any document whether it is a brief profile of the startup, or an executive summary or a pitch deck that elucidates this would suffice

This sums up the application process for recognition of a startup. Unless there are issues, a certificate of recognition is granted within 3-4 days (sometimes even 1) of making an application.

Startup recognition can be obtained in less than 7 days!

It goes without saying that the Government has taken steps to simplify the application and kudos to the government for that. For instance, it comes as a huge relief that the self certification has been introduced and that the age limit for startups have been extended. But like all things new there are teething issues and of course, there are areas of concern that need to be looked at; for instance, we believe that at present the list of industries is not exhaustive. The Indian startup ecosystem is young and extremely dynamic. However, the list of industries is very limited and in our experience, a number of industries are missing from the list. This poses a huge problem for applicants. Kudos to the government for relaxing the age limit for startups, but we feel that there are many startups that have a longer gestation period and age limit of 7 years may be unfair to quite a few. Further, we also feel that a lot of startups may not be able to meet the criteria of employability and wealth creation in their early stages. Having said that, we also believe that the government has taken steps in the right direction. Over the next few years we hope to see favorable amendments that will benefit the entire startup ecosystem and give the Indian entrepreneurial spirit the impetus that it truly deserves!