Under the Companies (Acceptance of Deposits) Rules, 2014, a convertible note is defined as an instrument demonstrating receipt of money initially as a debt that is repayable at the option of the holder or convertible into that number of equity shares of the start-up company upon the occurrence of specified events and under the other terms and conditions agreed and indicated in the instrument ("Convertible Note"). By notification of 29 June 2016, any amount of INR 25,00,000 (Rupees 25,00,000) or more obtained by a start-up undertaking by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche from an individual was effectively excluded from the scope of 'deposit'. The Rules, however, define start-up as a private company incorporated under the provisions of the Companies Act, 1956 or the Companies Act, 2013 (the 'Act') and recognized as a start-up under the start-up notification issued by the Department of Industry Promotion and Internal Trade ("DPIIT"). Before this amendment, if a start-up (whether recognised by DPIIT or not) wanted to raise funds through any compulsory or optional convertible capital instruments, the start-up had to undertake the valuation of its shares (at least for the floor value). Early-stage valuations are always difficult, regardless of the valuation method adopted. The eligibility for convertible note is such that it may be issued to Convertible Notes issued by a recognized start-up company may be purchased by a person residing outside of India (other than an individual who is a citizen of Pakistan or Bangladesh or an entity registered/incorporated in Pakistan or Bangladesh). Investors from countries sharing land borders with India may also invest only through the approval of the vacant route Press Note 3 issued by the Ministry of Commerce and Trade. A Non-Resident Indian (NRI), an Overseas Citizen of India (OCI), a trust company and a non-Indian partner company owned and controlled by NRIs or OCIs can also purchase Convertible debt. The investment will, however, be considered to be domestic investment at the same level as the investment made by the residents. For cases where the start-up is engaged in any activity that falls under the approval route under the existing regulatory framework for FDI, prior government approval for issuance of a convertible note will be required. Start-ups operating in sectors falling under the automatic FDI route do not require prior approval for such issuance.

An amount equal to more than INR 25 Lakhs (INR 25,00,000) in a single tranche should be the amount against which Convertible Notes may be issued.
The balance is either repaid or exchanged over a span of 5 years and is converted into equity shares only in the case of conversion.

At the time of issuance of the Convertible Notes, the conversion conditions will have to be determined in advance. However, at the time of conversion, the conversion price may be determined and the price may not be lower than the fair market value prevailing at the time of conversion.

Convertible notes are freely transferable and can be purchased/transferred by way of sale, provided that the sale complies with the RBI's pricing guidelines. As convertible notes are initially debt, at the time of such issuance there are no tax implications. If the conversion price is above the fair market value, then, pursuant to section 56(2)(viib) of the Income Tax Act, 1961, the difference between the conversion price and the fair market value may be taxable in the company's hands. However, this is exempted if, at the time of conversion, the company is registered as a start-up and has received tax exemption approval from the Income Tax Department.

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