RBI allows convertible notes for Startups from foreign sources

As part of policy hacks, we covered the issue of Convertible notes being recognized by Ministry of Company affairs (MCA) in our earlier blog here.

For benefit of users to start, the convertible note has been explained below.

What is a convertible note?

Convertible notes are debt instruments that converts in to equity, at a later date. The lender initially gives a loan with an understanding that he can convert these in to equity. In most cases, this later date is the date of next valuation of the company. If there is no next round of valuation, the company should return the debt back to lender in a fixed time interval.

Convertible notes are quite popular in startup ecosystems like Silicon Valley in USA.

Earlier Ministry of corporate affairs has announced acceptance of the convertible note as a concept for startups through a circular no. G.S.R. 639(E) New Delhi, dated 29th June, 2016.

The announcement by RBI is a development further to the above given MCA circular.

How does new RBI provision help startups?

Foreign investors were allowed, foreign direct investment (FDI) by way of equity and other instruments that were at par with equity e.g. compulsorily convertible preference shares/debentures. Convertibles notes were not allowed till now.

Reserve Bank of India (RBI) notification of 10 January 2017 has amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, to allow ‘Startups’ to issue convertible notes to foreign investors.

This opens new avenues for ‘Startups’ to raise funding.

iSPIRT volunteer Sanjay Khan Nagra, covers the RBI announcement on Convertible Notes here in the video below.

The complete circular is given here  on RBI website.

Other provisions in the new RBI notification explained

Convertible note has been defined in the notification

‘Convertible note’ means an instrument issued by a startup company evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.

Who can invest and how much?

A person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered / incorporated in Pakistan or Bangladesh), may purchase convertible notes issued by an Indian startup company for an amount of twenty-five lakh rupees or more in a single tranche.

NRIs may acquire convertible notes on non-repatriation basis in accordance with Schedule 4 of the Principal Regulations.

What is a Startup?

For the purpose of this Regulation, a ‘startup company’ means a private company incorporated under the Companies Act, 2013 or Companies Act, 1956 and recognised as such in accordance with notification number G.S.R. 180(E) dated February 17, 2016 issued by the Department of Industrial Policy and Promotion (DIPP) , Ministry of Commerce and Industry.

Govt. approval required for some sectors?

A startup company engaged in a sector where foreign investment requires Government approval may issue convertible notes to a non-resident only with approval of the Government.

Inwards remittance of amount?

A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to the NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time.

Provided that an escrow account for the above purpose shall be closed immediately after the requirements are completed or within a period of six months, whichever is earlier. However, in no case continuance of such escrow account shall be permitted beyond a period of six months.

Convertible notes are transferable

A person resident outside India may acquire or transfer, by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the Government shall be obtained for such transfers in case the startup company is engaged in a sector which requires Government approval.

Compliance and reporting

The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.

ESOP provisions get a booster from MCA for Startups

ESOP another Stay-in-India checklist item gets MCA nod

Ministry of corporate affairs (MCA) has recently relaxed sweat equity issuance norms for startups. These new relaxations are for limited to Startups recognized by Department of Industrial Policy and Promotion (DIPP).  The announcement will immensely help startups. For startups not recognized under DIPP, there is not change.

The new announcement is  – Companies (Share Capital and Debentures) Third Amendment Rules, 2016 (Amendment Rules). It amends the Rule 8 governing sweat equity shares issuance and Rule 12 of Rules 2014 that pertains to issue of shares under ESOP. The other rules to draw out an ESOP plans remains same.

This blog explains the new announcement and some basic concepts for those who may not be aware of terms like ESOPS and Sweat Equity and how they benefit the startups.

Mr. Sanjay Khan Nagra, iSPIRT volunteer explains the new announcements in below the embedded video.

There is lot of material on internet on examples and ESOPS plans and how they benefit the entrepreneur and the employee both. The objective of this blog is to set a background and describe new announcement.

An ESOP plan effects the basic capital structure of the company. It also has long term legal or tax implications. A good ESOP plan can maximizing the benefits from the existing and new provisions. Hence, we suggest startups interested in drawing up an Employee Stock Option Plan (ESOP) should seek a professional advice.

What is an ESOP?

An Employee Stock Option Plan (ESOP) is a benefit plan for employees which makes them owners of stocks in the company. ESOPs have several features which make them unique compared to other employee benefit plans. Most companies, both at home and abroad, are utilising this scheme as an essential tool to reward and retain their employees. Currently, this form of restructuring is most prevalent in IT companies where manpower is the main asset. (Definition Source: The Economic Times).

How ESOPS benefit Startups

ESOPs are a proven tool for startups to succeed and grow. There are many ways that ESOPS can be beneficial for startups.

Some of the ways this helps are as given below:

  • Promoters or founders who can’t contribute capital but bring knowledge and dedication to startup can be have access to equity.
  • Startups can attract experience and talent with sweat equity
  • Startups can use ESOPs as a reward to motivate employees
  • It gives sense of ownership to employees and hence act as an employee retainer ship tool

Change made for Startups

MCA has announced two changes. One, that will increas the base of sweat equity that a startup can issue. Two, that will expand the horizon of sweat equity to promoters and director. Both the changes have are described below.

Increase in limit of Sweat equity shares issued by start-ups

The Rule 8(4) of Rules, 2014 restricted companies from issuing sweat equity shares in excess of 25% of the paid up capital at any time. The rule also limits the issuance of sweat equity shares per year to 15% of the paid up capital or issue value of Rs.5 crores whichever is higher.

The amendment in new announcement expressly permits Start-ups to issue sweat equity shares not exceeding 50% of its paid up capital up to 5 years from the date of its incorporation or registration.

The limits of 15% of paid up per year or capital or Rs.5 crores whichever is higher will still need compliance.

Stock options to promoters and shareholder/directors of startups

The new announcement allows Startups to issue the sweat equity under ESOP to their promoters and to directors who hold more than 10% for the first 5 years from the date of their incorporation. The restriction on issuing stock options to promoters and such directors continues for all other companies

In order to provide this benefit MCA has used notification to exempt the startups from application of Clause (i) and (ii) under Explanation C of Section 62 (1)(b) of Act, 2013 that defines the term ‘Employee’. The Explanation in Section 62(1)(b) reads as below.

Explanation:

For the purposes of clause (b) of sub-section (1) of section 62 and this rule ”Employee” means-

(a)   a permanent employee of the company who has been working in India or outside India; or

(b)   a director of the company, whether a whole time director or not but excluding an independent director; or

(c)    an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company but does not include-

             (i).   an employee who is a promoter or a person belonging to the promoter group; or

           (ii).   a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.

[The clauses (i) and (ii) given in blue does not apply on DIPP registered startups for 5 years]