Convertible Notes: Comprehensive Guidelines And Compliance

Chaitanya Vaidya, Legal Advisor (Corporate and Real Estates practice areas)

Background:

In the context of The Companies (Acceptance of Deposits) Rules, 2014, specifically explanation II of Rule 2(xvii), a convertible note is defined as an instrument that initially represents the receipt of money as a debt. This debt is repayable at the option of the holder or can be converted into a specific number of equity shares of the start-up company upon the occurrence of specified events and in accordance with the terms and conditions outlined in the instrument.

Convertible notes are financial instruments that offer an option for conversion into equity at a future date. This means the holder of a convertible note can choose to exchange it for a predetermined number of equity shares of the company. These notes are particularly popular among early-stage companies as they provide a way to raise capital without the immediate need to determine the company's valuation, which can be a complex task during the initial phases of development.

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Pre-requisites for Issuing Convertible Notes:

For a company to issue convertible notes, it must be officially recognized as a “start-up” by the Department for Promotion of Industry and Internal Trade (DPIIT), as per explanation II of Rule 2(xvii) of The Companies (Acceptance of Deposits) Rules, 2014.

According to the DPIIT's amended notification dated January 16, 2019, an entity qualifies as a "start-up" if it meets the following criteria:

• The entity must be incorporated as a private limited company, a registered partnership firm, or a limited liability partnership in India.

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The entity should not have been in existence for more than 10 (Ten) years from the date