Raising Funds Using Convertible Notes
Raise funds for your business using convertible notes - a type of debt that can be converted into equity at a later date. Understand the pros and cons, terms and conditions, and best practices for using this funding method.
By teammarquee . January 25, 2023
Are you a business startup looking to raise funds, but you have just started, and it is difficult to judge the valuation of your company?
With convertible notes, you can quickly raise funds and postpone your company’s valuation to a future fundraising round. If you haven’t heard about convertible debt, it is the easiest and most flexible way to raise startup capital, even if your company doesn’t have an actual valuation.
Let us now tell you what convertible notes are and what rights they offer investors.
Delving deeper into convertible notes
Talking about the convertible note definition, they are the short-term debt instruments issued by companies to raise an interim round of funding without calculating the company’s valuation. It is essential to understand that convertible notes have a provision to convert into equity stocks once at the occurrence of a triggering event, which is generally the next fundraising round.
Early-age startups prefer convertible notes because they receive investments at much lower rates than corporate bonds and bank loans. As per the Companies act 2013, a convertible debt must be raised for a minimum of Rs. 25,00,000 from each investor. Additionally, it also contains the provision of being repayable at the discretion. However, it must be converted into equity shares within five years from the issue date. Detailed terms and conditions are followed after happening of certain events.
Should a startup raise money through convertible notes?
Convertible notes are a plausible way to raise money for a business startup or a private limited company. It is beneficial, especially in the early stages of startup funding, when it is difficult to find the exact valuation of the company. The presence of debt components in the investments also keeps fair market valuations, allowing for benefits in taxation.
However, it’s a lot riskier than other forms of investments because if the startup funding doesn’t take place in the future, the investor can retrieve all the investments.
Should startup capital be raised through convertible notes? What are its pros and cons? Let us look at the same in the following paragraphs.
Convertible notes; Bliss or distress?
It is essential to measure the pros and cons of any funding option before adding them to your investment cap. It gives you a broader horizon about the future and allows you to measure uncertainty well in advance. Let us consider the pros and cons of convertible debt for startups.
- Easy, simple and flexible
The structure of the convertible notes in startups is relatively simple and cheaper than other market investment options. A company doesn’t need to issue common stocks when convertible notes are issued.
- No Voting rights
Unlike venture capital or private equity investments, these startup investors do not get any right to vote in company meetings. Hence, they do not have any direct control.
- Type of pre-valuation investment
As mentioned above, a startup can only evaluate the valuation for raising the convertible notes. The initial investment provides an easy boost to the company and takes care of its initial expenses. It offers the necessary time for the company to build its brand and hold a stable position in the market.
- Leads to a lot of debt
The convertible notes can only benefit an early-stage startup if a series of funding rounds happen. If the company is yet to grow significantly, and the startup investors want their principal plus interest back, the company can fall into the debt trap leading to bankruptcy.
- A minimum cap of 25 lakhs is a hurdle.
The minimum cap of issuing Rs 25 lakh as convertible debt is a big hurdle if early-stage companies are looking for a smaller amount of debt.
- More Equity dilution than expected
As per the terms and conditions, your convertible note can have a feature of a valuation cap. In such a condition, if the company raises the series funding at a valuation below the valuation, the convertible note investor would be eligible to hold more equity than previously decided by the parties.
Are you eligible to be an investor in convertible notes?
Specific criteria need to be fulfilled to be an investor in convertible notes in startups. Let us peruse the same in the following paragraph.
Any person who fulfils the following criteria is eligible to be an investor in convertible notes.
- Indian companies under the purview of the Companies act, 2013.
- Any Indian investor(minimum amount for investing is Rs. 25 Lakhs)
- Foreign companies
- Non-Resident Indians
How to get started for issuing convertible notes in India.
If you have a partnership company, can you issue the convertible notes? Let us understand the requirements below. To issue the convertible notes, you must be a private limited company or a company recognised as a ‘startup’ by the Department for Promotion of Industry and Internal Trade (DPIIT) and willing to receive an investment of INR 25,00,000 or more, either from a single investor or in a single tranche. Let us now explain the procedure for issuing convertible notes by a company.
- Determining the total amount of money that the company wishes to raise
- Determining the conditions of raising startup capital using the convertible note agreement. A convertible note agreement defines the terms and conditions of the convertible note, allowing the startup to raise money from an investor/another company. It is pertinent that the agreement mentions the manner of conversion of debt into shares.
- Passing off the resolution of the board to sanction the convertible note agreement
- Once the resolution is passed, the extraordinary general body meeting takes place in order to issue the convertible notes.
- An amount of 25 lakhs or more is raised as a bank deposit.
- The convertible notes are issued to the investor.
A convertible note is one of the easiest, fastest and most hassle-free options for a startup to raise money, especially during it’s early-stage. Understanding the impact of the decision on the equity dilution is one of the crucial steps and must be decided in advance before issuing the convertible notes to an investor.
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