What are Convertible Notes? How to Raise Funds through Convertible Notes?

Raising a Convertible Note as an Indian Company

Entrepreneurship is a roller coaster ride, and building a new-age company from the ground up is challenging and, at times, downright nerve-wracking. Along my journey from Mech Mocha to Mysa, I learnt that raising funds is crucial to the success of a startup.

While there are various ways to raise capital, one method gaining popularity amongst early-stage companies in India is raising convertible notes.

In this article, let’s understand convertible notes and the process of raising them as an Indian company.

What are Convertible Notes?

Convertible notes are short-term debt instruments that allow seed-stage companies to raise small amounts of money from family offices, micro venture capital (VC) funds, or angel investors. These can be converted into equity upon a predetermined trigger point or conversion event.

In simple terms, it is a loan from investors that allows founders to raise funds without immediately determining their company's valuation. Convertible notes serve as a hybrid financing instrument; it is originally structured as a debt instrument, with an option to convert into equity investment at a later date.

Through convertible notes, early-stage companies can secure the initial investment quicker than traditional equity financing with lower legal complexities while providing investors with economic exposure to an equity investment.

Convertible notes can be an excellent strategic move for founders as an interim financing solution, especially in the early stages. A banking, accounting, and taxation (BAT) platform like Mysa can significantly streamline the process, helping you organize financial records, handle compliance and reporting, and enhance transparency.

Key Terms Related to Convertible Notes

Now that we understand convertible notes, let’s dive into some terms you should be familiar with before raising funds using this method.

Principal Amount: The initial amount you receive from the investor is called the principal, or the face amount. It is converted into equity during a future funding round or repaid to the investor at an agreed date.

Maturity Date: The deadline for converting the note into equity is known as the maturity date. It usually ranges from 18 to 36 months.

Discount Rate: A perk for early investors, a discount percentage determines how much less the convertible note holders will pay for shares compared to new investors in the later funding rounds. Discount rate also varies for different periods of time, say next financing round happening in less than 6 months from the date of convertible note issuance, then discount rate could be 0.

Valuation Cap: It is the upper valuation limit at which the convertible note converts into equity. It ensures that early investors get a fair deal by limiting the price they pay per share during conversion.

Valuation Floor: It is the lower valuation limit to convert the convertible note into equity. It ensures Company/Founder is protected from significant downside when they have agreed for deep discount for convertible note conversion

Conversion Price: The price at which the convertible note converts into equity is called the conversion price. It determines the number of shares an investor will receive for the principal amount invested. It is calculated by dividing the future round valuation or valuation cap or valuation floor by the outstanding equity. A lower conversion price would result in more shares per note and vice versa.

Why do Convertible Notes Matter?

As a new-age company, there are times you have a great business idea, an app for testing, or a prototype ready to go. But, you are often stuck at the crossroads when it comes to funding. Traditional loans may not be the best fit, and you may not be at a stage to determine the company’s valuation due to low traction. Also family/friends or angel investors may not be savvy in determining the value at an such early stage and they would be more comfortable for an institutional VC to determine the valuation once product is ready or some traction is built.

A convertible note helps you raise capital quickly without dealing with the complexities of valuation discrepancies, equity dilution, or due diligence (DD) hurdles. The key advantages of convertible notes for an early-stage company are:

Delayed Valuation: One of the primary advantages of convertible notes is that they allow you to defer the valuation exercise for your startup until a more significant funding round. It gives you more time to prove the value of your business and negotiate a potentially higher valuation.

Founder-Friendly: As a founder, maintaining control and ownership is key. Convertible notes allow you to secure funding without an immediate equity exchange. It gives flexibility to get the capital you need without diluting your ownership too early.

Flexibility: With convertible notes, founders have more control in structuring the funding arrangement. The terms, such as conversion discounts, can be negotiated between the founders and investors, giving flexibility to both parties.

Simplified Process: Raising capital through convertible notes is simpler than equity financing. The regulatory requirements are Registrar of Companies (ROC) filing and resolutions of board and shareholder meetings. There is no need for detailed financial projections, valuation certificates, or extensive due diligence, which can be time-consuming and costly for early-stage companies. So, convertible notes are a convenient way to get your startup off the ground and running. However, there are a few cons of adopting convertible notes, such as:

Error in Calculating the Dilution Percentage: A typical error founders make is missing out on the details of convertible notes while calculating the percentage of their dilution in subsequent rounds. They may dilute more after including the promised equity in the convertible note.
Investor expectations: If there is a delay in hitting the conversion trigger within the specified time, it can lead to dissatisfaction or tension between you and the investors, potentially hampering relationships and future funding prospects.

Without proper bookkeeping, there can be complications in the subsequent funding rounds. A BAT platform can mitigate such limitations and risks associated with convertible notes by offering specific financial and compliance-related support.

The Process of Raising Convertible Notes

Step 1: Register with DPIIT

‍The first step for an Indian company to raise convertible notes is registering with the Department for Promotion of Industry and Internal Trade (DPIIT). This registration is mandatory for any startup seeking funding through convertible notes.

Step 2: Understand the Regulatory Guidelines

‍The startup must raise minimum funding of INR 25 lakhs in a single tranche. As per the Foreign Exchange Management Act (FEMA), 1999, a startup can issue convertible notes to foreign investors. The Indian startup should also comply with all other applicable laws and regulations.

Step 3: File Relevant Documents

‍It is essential to file relevant documents such as board meeting resolutions and shareholder agreements with ROC.

Step 4: Review and close Convertible Note Agreement

The Convertible note agreement is binding document that serves as the basis for negotiation between the investor and the company. It covers essential elements like conversion trigger event, maturity date, version discount, valuation floor or cap etc and conditions under which the investor is willing to invest in your startup.

This agreement is often prepared by investors based on their evaluation of the company's potential and their desired investment terms. You can hire a legal expert to review the document and understand the terms relevant to the investment.

Step 5: Negotiate with Investors

Once you have your legal documents in place, it is time to pitch your startup and negotiate with potential investors. They can be family, friends, angel investors, micro VCs, or family offices. As a founder, you should be well-prepared to answer questions about the company's business model, growth potential, and exit strategy.

Step 6: Receive Funding

Once all the formalities are completed, and the convertible notes are issued, you will receive the funding in your company's bank account.

Step 7: Meet Reporting Requirements

‍As per RBI guidelines, Indian companies must submit reports related to foreign investment within 30 days of receiving funds. Adhere to these guidelines to avoid any compliance issues.

Download our free convertible note agreement template crafted by the team of Constellation Blu !

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Roll-up Vehicle Versus Individuals

One critical decision that founders must make when issuing convertible notes is whether to raise funds from institutional or individual investors. A roll-up vehicle is a fund that pools together money from multiple institutional investors or venture capital firms to provide funding for startups. The main advantage of using a roll-up vehicle is raising money without negotiating with individual investors. Another benefit is that it allows for greater credibility and validation of the startup, as experienced institutional investors have shown confidence in its potential.

Aspect	Roll-up Vehicle	Individual Investors
Entity Formation	Formation of separate entity to aggregate funds	Direct engagement with individual investors
Structure	Simplified investment structure	Multiple individual agreements
Administrative tasks	Streamlined administrative tasks	More complex administrative management
Investor Management	Centralised communication and investor relations	Direct and potentially diverse investor relations
Alignment of Interests	Cohesive alignment of multiple investors' interests	Varied interests and negotiation complexities
Complexity	Simplified management but limited customisation	More personalised terms but increased complexity
Communication	Single entity for communication and updates	Individual communication and diverse perspectives

On the other hand, some founders may choose to raise funds through individual investors. It includes angel investors, high net-worth individuals, or even family and friends. One significant advantage is that it allows greater flexibility and control over the terms of the convertible note. Furthermore, individual investors may also bring more than just financial resources to the table. Their expertise and experience can be valuable for growing and scaling startups.

Choosing between a roll-up vehicle or individual investors for raising a convertible note depends on your startup's specific needs and goals. If speed and credibility are your top priorities, then a roll-up vehicle may be the best option. However, raising funds from individuals may be the way to go if you prefer flexibility and a personalised approach.

Takeaway

Convertible notes can be valuable for seed-stage startups looking to raise funds to cover operational expenses or product development costs, boost marketing efforts, or hire new talent. It is a quick and efficient fundraising process that gives founders time to focus on growing their business and creating value before diluting their ownership. If you are a founder looking for funding options, consider exploring the possibility of raising convertible notes to speed up your company's growth and success.

What are Convertible Notes? How to Raise Funds through Convertible Notes?

Download our free convertible note agreement template crafted by the team of Constellation Blu !

Roll-up Vehicle Versus Individuals

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Let's empower your first employees together!

Generate Custom JD

Focus on your growth & leave the boring stuff to us!

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What are Convertible Notes? How to Raise Funds through Convertible Notes?

Download our free convertible note agreement template crafted by the team of Constellation Blu !

Roll-up Vehicle Versus Individuals

Takeaway

Let's empower your first employees together!

Generate Custom JD

Focus on your growth & leave the boring stuff to us!

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Does your startup need AOP planning? Top FAQs answered

What is Startup Runway? Strategies to Reduce Cash Burn & Extend Your Startup Runway

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Focus on your growth & leave the boring stuff to us!