The Indian Startup Ecosystem has lately witnessed a new trend of Debt Funding during early-stage operations. Unlike an equity round, there is no requirement of valuation of shares for debt funding. However, there have been many misconceptions doing rounds on debt funding so here I am trying to demystify the challenges and process around debt funding for Indian Startups.
What is debt?
If we go by the definition of Investopedia, a Debt is an amount of money borrowed by one party from another. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
Sounds like a Loan, Why is it called Funding?
This is a very fair question, which is being asked often Why do we call it a “funding”? Well unlike a typical “loan”, an entrepreneur is not required to pay “interest” here. Instead, the investor gets a right to buy equity at a future investment round (typically series A, with a formal valuation of the company) at a discounted price(against the interest value of the debt funding). Due to the option of “conversion” at a future date, these instruments are often referred to as “Convertible Notes”.
All right, I have an Idea, a Product, initial Users but I am not incorporated as a company, can I go for a Debt Funding?
NO, a convertible note is an instrument issued by a “Private Limited Company” only. An individual or a partnership firm can not get into an agreement for “debt funding” as proprietorship firms or partnership firms cannot issue “shares” at a later date. So incorporating a private limited company is a pre-requisite for a debt funding round.
I have Incorporated a “Private Limited Company” but my consultant has no idea about “Convertible Notes”, What to do next?
Well, that’s because we have borrowed “Convertible Notes” as a term from Silicon Vally. Legally there is no instrument here in India which is referred to as “Convertible Notes”. The parallel of “Convertible Notes” here is India is coined as “Compulsory Convertible Debenture”
What is a Debenture?
A Debenture is defined under section 2(30) of the Company Act, 2013 as “debenture includes debenture stock, bonds or any other instrument of a company, whether constituting a charge on the assets of the company or not.
In simple words, a debenture is an instrument of acknowledgment of the debt by the company where it undertakes the amount covered by it and till then it undertakes further to pay interest thereon to the debenture holder.
However, in the case of an early-stage startup, the interest element is replaced by the future discount on equity round.
Why so much of fuss? Why not issue equity in the first place?
This is an obvious thought as to why not issue “equity shares” in the first place and avoid all the compliances around “Compulsory Convertible Debenture” or “CCDs”. The straight forward answer to that is because it is difficult to value a company during its initial stage of operation. This is the time when most of the investors are backing a startup for the mere reason of a strong and motivated team. In actuality, there is no real value behind the equity. Also, certain clauses of income tax law might result in tax liability in the hands of the startup company. This is commonly referred to as “Angel Tax” these days.
If we breakdown this law in simple words, it says any valuation over and above the “fair” price of the share would be treated as income in the hands of the company and a straight forward tax of 30% needs to be paid by companies issuing such shares. It means, 30% of the funding is clearly wiped as tax liability.
Then how do so many startup companies are raising funds through equity rounds?
Well, that’s because the government has lately notified section 80 IAC under income tax law, which exempts notified startups from the above-mentioned provisions of tax liability. If as a startup you want to go forward for an equity round, you must have a DIPP recognition and Section 80 IAC approval.
A Debt Round seems much simpler in that case, what are the procedures involved?
For a “Debt Funding” round, you must be a “Private Limited Company” incorporated under the Companies Act 2013. Some of the other formalities involved are:
- Passing a special resolution in general meeting for the issuance of “Compulsory Convertible Debenture” must be passed and duly filed in Form MGT-14 to ROC.
- A Debenture Trust Deed must be executed in Form SH-12 between the company and investors mentioning all the clauses and terms of the investment round.
- E-Filing for charge created within 30 days of the creation of charge.
- The trust deed should be executed in the favor of the Debenture Trustees within 3 months of allotment of debentures.
- In the case of CCDs, there is no requirement of creation of Debenture Redemption Reserve by the company which is otherwise mandatory for “Non-Convertible Debentures”.
- Issue of Debenture Certificates is not mandatory in case of CCDs, however, the investor may ask for it. Such Debenture Certificates can be issued after payment of stamp duty at applicable rates.
While I have tried to cover as much ground as possible, however, execution of the deed, issuance of Debenture Certificates, etc has many other operational challenges and compliance requirement. Will try to cover those points separately in another post.
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