Convertible Notes in India: What Founders Must Know

So you’ve got a startup in India and you’re looking to raise some capital to get your big idea off the ground. You’ve heard about convertible notes as an option and are wondering if they might work for you. Convertible notes are a popular funding mechanism in Silicon Valley and beyond, but how do they work in the context of Indian regulations? Before you dive in, here are the key things you as a founder need to understand about convertible notes in India.

What Are Convertible Notes?

So, what exactly are convertible notes? In simple terms, convertible notes are a form of short-term debt that can be converted into equity shares of a company.

As an early-stage startup, raising funds can be challenging. Convertible notes provide a means to get seed funding to build your minimum viable product and gain initial traction. The investors essentially lend you money with the option to convert the amount into equity shares when you raise your next round of funding.

Some key points about convertible notes:

1. Flexible and founder-friendly. The terms are more flexible than traditional equity rounds. There is no fixed valuation and founders maintain control.
2. Fast and easy. The process is simpler and faster than a full-fledged equity round. This allows you to raise funds quickly and focus on growth.
3. Deferred valuation. The conversion of notes into equity shares is done at the valuation of the next funding round. This avoids lengthy discussions on valuation at an early stage.
4. Discounted conversion. Investors often get the shares at a discount when the notes are converted to equity. This provides them some incentive and extra upside.

While convertible notes seem appealing, there are a few downsides to consider like potential dilution of equity, higher interest rates, and complications in the next funding rounds. However, when used strategically, convertible notes can be a win-win for both startups and investors.

Does this help explain what convertible notes are all about? Let me know if you have any other questions!

How Convertible Notes Work in India

If you’re fundraising for your startup in India, convertible notes are an attractive option. Here’s how they work:

Convertible notes are essentially short-term loans that convert into equity. Investors loan you money now with the understanding that their loan will convert into shares of preferred stock in your company later on. Usually at a discount to the price of the next funding round.

• The key benefit for founders is that you get funding without having to determine a valuation for your company right now. The conversion price is determined in the future based on the valuation set by new outside investors.
• For investors, convertible notes are less risky than equity since they’ll either get their money back with interest if you don’t raise a next round or will get equity at a lower price if you do.

In India, convertible notes typically have:

1. An interest rate of 12-20% per year.
2. A maturity period of 12-24 months. If a next funding round isn’t completed by then, the notes are repaid with the accrued interest.
3. A discount of 10-30% to the next round’s price. So if the next round values your company at $10M, notes may convert at $7M.
4. A valuation cap which limits the highest price at which the notes will convert. This protects investors from an excessively high next round valuation.
5. Repayment of 1-2 times the amount invested if the company is acquired before the next funding round.

Convertible notes provide flexibility for early-stage funding when valuations are difficult to determine objectively. Make sure you work with experienced legal counsel to properly structure your notes in compliance with Indian regulations. When used right, convertible notes could be the key to getting your startup off the ground!

Key Terms of a Convertible Note

When raising capital through convertible notes in India, there are a few key terms you’ll want to understand. These define how your startup will utilize the funds and your investors’ rights.

Valuation Cap

The valuation cap sets the maximum valuation at which the convertible note will convert to equity in your company. This protects your investors by ensuring they get equity at a fair price. The cap is often a multiple of your last funding round valuation. If your valuation increases significantly before conversion, the cap provides a ceiling so investors can still convert at the agreed maximum price.

Discount

The discount refers to the reduced price at which convertible note holders can convert to equity compared to future investors. For example, a 20% discount means investors can convert to equity at a 20% lower price than the valuation of your next funding round. This rewards early investors for their higher risk. The discount incentivizes them to invest at an earlier, more speculative stage.

Maturity Date

The maturity date is the deadline for investors to decide whether to convert their notes to equity or be repaid the principal with interest. If a funding round hasn’t occurred by the maturity date, you’ll need to repay the notes or renegotiate an extension with investors. Most notes have maturities of 1 to 2 years. But you can choose a shorter or longer period depending on your funding plans.

Interest Rate

The interest rate determines how much interest will accrue on the convertible notes. The interest is paid to investors along with the principal if the notes are repaid. A typical rate for convertible notes is 6-8% per year. The interest compensates investors for the risk of their money being tied up for the duration of the note.

Conversion Mechanics

The conversion mechanics specify the process for converting the notes to equity when a funding round occurs. This includes details like the conversion formula, the amount of equity investors will receive, and any discounts or valuation caps that apply. Clearly defining the conversion terms upfront avoids confusion and disputes later on.

Advantages of Using Convertible Notes for Startups

Convertible notes provide several advantages for startups in India. ###Flexibility

Convertible notes give you flexibility since you can decide to convert the notes into equity shares or repay the amount with interest. If your startup is doing well, you can convert the notes into shares at a discounted valuation. If things aren’t going as planned, you can repay the amount and avoid dilution of equity.

Avoiding Complex Legals

Dealing with equity and shareholders agreements can be complicated and time-consuming for startups. Convertible notes allow you to quickly raise funds without going through the legal hassles of finalizing shareholder documents. You can focus on growing your business rather than dealing with legal paperwork.

Attracting Investors

Convertible notes are attractive to investors because they can get equity shares at a discounted price if they convert the notes. Investors also have the safety of getting their principal amount back with interest if they don’t convert. This makes convertible notes appealing and helps startups raise funds from investors.

Interest Payments

Unlike equity, convertible notes allow you to pay interest to investors. This can motivate them to invest in your startup. The interest also compensates them for the risk of lending money to your new venture.

Avoiding Low Valuations

If you raise equity too early, you may end up with a lower valuation for your startup. Convertible notes allow you to raise funding now and convert when you have a higher valuation in the next funding round. This helps maximize the amount of money you raise from investors.

In summary, convertible notes provide flexibility, help avoid legal complexities, attract investors, allow interest payments, and prevent low valuations. For high-growth startups in India, convertible notes can be an ideal option to raise funds and scale rapidly. With the right terms, convertible notes balance the interests of both startups and investors.

Disadvantages and Risks of Convertible Notes

While convertible notes offer many benefits to startups and investors in India, there are some potential downsides and risks to be aware of.

Dilution of equity

When the notes convert into equity, the founders’ ownership stakes will be diluted. The more notes are issued, the more dilution will occur. Founders should calculate various dilution scenarios to understand the impact before taking on convertible notes.

Lack of maturity date

Convertible notes typically don’t have a maturity date, so investors can convert at any time. This uncertainty can make financial planning difficult for startups. Founders should consider setting a maturity date to provide more clarity.

Possibility of a “down round”

If a startup raises a follow-on round at a lower valuation, convertible note holders will get equity at a lower price. This is known as a “down round” and can be problematic. Startups should aim to raise at an increasing valuation to avoid this.

Interest accumulation

Convertible notes often accrue interest over time. If it takes a startup a while to raise their next round, the interest can substantially increase the amount of equity that will be given to note holders upon conversion. Founders should account for various timeframes to raise a next round to understand how much extra equity may be given away.

While convertible notes are popular for early-stage startups in India, founders must go in with realistic expectations about the potential downsides. Understanding the various risks and running through different scenarios will help set the right terms to minimize dilution and other disadvantages. With the right terms and timeframes, convertible notes can still be an advantageous option. But as with any investment, there are always risks, so founders should make fully informed decisions.

Conclusion

So there you have it, the basics of convertible notes and how they work in India. While they may seem complicated, convertible notes can be a founder-friendly way to raise capital without giving up too much equity or control too early. Just make sure you understand the details, find good investors, set the right terms, and keep your company’s best interests in mind. If used properly, convertible notes can help get your startup the funding it needs to reach the next level. The funding landscape in India is evolving fast, so take advantage of all the options out there. You’ve got this! Now go out there, raise some capital, build an awesome company, and make it big. We’re all rooting for you.