Hybrid Instruments for Investments in Startups

6th August, 2021 - 12:23 pm Categories: TAX 0 Comments

INTRODUCTION

The fast-paced growth of Start-ups in India has attracted support and aid from the government and also numerous industrial sectors. With the idea of promoting growth of the Indian economy, entrepreneurs have received several incentives and benefits to establish start-ups. The essence for their growth and success lies in the ‘financing and funding’, which is most often than not a challenge for these entrepreneurs.

At the nascent stage, the funding is usually provided by an internal source, such as friends and family, or the founder himself. This is called ‘Seed Capital’ which helps convert a business idea into something viable, thereby attracting additional financers. After this stage, the startups tend to tap in external sources of investment, usually through private individuals such as ‘Angel Investors’. This helps in a bringing a certain degree of advancement and stability to the business. However, the predominant source of start-up financing in India is through Venture Capitalists or Private Equity, done using different methods and instruments, some of which are discussed below.

FINANCING THROUGH CONVERTIBLE INSTRUMENTS

Financing is generally of two kinds, a) Debt Financing and b) Equity Financing. The former source is through loans and External Commercial Borrowings (ECB’s) which invites a high rate of interest along with a pre-requisite for collateral. Considering the nature and instability of these startups, debt financing is usually disregarded as a suitable option for such entrepreneurs.

On the other hand, Equity financing encompasses a high-risk factor as there is no guarantee of repayment in case the venture fails to perform. A private equity investor or venture capitalist invests in the shareholding of the company by way of subscribing to the equity share capital. This majorly helps in the expansion or diversification of the startup ventures.

Over the years, a recent development has emerged in equity financing to balance the interests of startup entrepreneurs as well as the investors. Financing is done by subscribing to Convertible Instruments such as Compulsory Convertible Preference Shares (CCPS) and Compulsory Convertible Debentures (CCD). These hybrid options are favorable as equity shareholding does not ensure fixed return on investment and does not offer any special rights or preferences. Additionally, by issuing convertible securities, the founders are able to retain their control over management and decision making in the venture.

Whilst there are other unconventional forms of investing such as ‘crowdfunding’ and ‘incubation’ which are now available, investors prefer hybrid securities due to their secure nature. The most eminent instruments are discussed below-

a. Compulsory Convertible Debentures (CCD)

 These are ‘deferred equity instruments’ as they mandatory get converted into equity shares with a lapse in their maturity period. They are hybrid securities as they get converted from a debt (debenture) to an equity share and thus possess qualities of both.

Section 71(1) of the Companies Act, 2013 authorizes a company to issue a CCD. Considering the nature of these hybrid securities the Hon’ble Supreme Court in the case of Narendra Kumar Maheshwari   v.   Union   of   India¹   held   that   “any   instrument   which    is   compulsorily convertible into shares is ultimately regarded as equity and not as a loan or debt”. On the other hand, according to the RBI Guidelines, they are treated as equity for all financial statements and records but not as Share Capital of the Company. Thus, it can be deduced that though they provide security to investors in the nature of debentures, and are ultimately rendered as shares, upon their conversion. According to Rule 2(1)(c) of the Deposit Rules, they can be issued provided they are converted to shares within 5 years of issue.

Since the initial stages of a start-up are not stable, there is usually a lack of assets and cash flow with the entrepreneurs. This makes it difficult to arrive at an accurate valuation of the company, which is an essential prerequisite for investors who pool in their resources. This is when the investors opt for such securities.

If the start-up venture fails to deliver, the investors are still secured as they are bound to receive interest with a future promise of receiving dividend on the equity shares. Additionally, the start- up eventually has to merely issue shares without the burden of exhausting their cash flow. Furthermore, they promote foreign investment as opposed to certain other hybrid securities. Thus, their subscription proves beneficial to both parties most of the time.

However, there are certain downsides to the subscription of CCD’s which is provoking investors to gradually shift to other hybrid securities. Whilst the initial purpose of this instrument was to curb the difficulty of valuation, the ventures are now required to obtain a ‘Valuation Certificate’ from the appropriate certifying officer at the time of investment. They also have to align with FEMA Guidelines, SEBI rules, FDI Regulations and Tax procedures. This severely increases the compliance requirements to be adhered to, which makes the investment procedure cumbersome.

b. Compulsory Convertible Preference Shares (CCPS)

 Compulsory Convertible Preference Shares are the preferred choice and most favoured amongst investors for two main reasons

-Dividend is first paid to preference shareholders, and the fixed amount of dividend gives them more.

– In case of liquidation, the preference shareholders have priority as per the waterfall mechanism (Section 53 of Insolvency and Bankruptcy Code,2016) which gives them a prior claim over the assets of the venture.

Additionally, in case the business renders successful, the preference shares get converted to equity shares thereby increasing the scope of capital growth and profit retention of the investors.

The main privilege with these shares is their conversion linked with the performance of the company. This helps the private equity investors to balance any disparity in the valuation expectation of the venture, as the general valuation method renders inefficient in case of start- ups due to the absence of a profit and loss account to show.

In this case, the investors chip in their resources when the company is at a lower valuation and eventually convert their shares to equity, which yields them higher dividend, without pooling in additional resources when the venture has higher valuation. Additionally, it benefits the start- ups to prevent the exhaustion of cash-flow, as contrary to CCD, this security is not a ‘debt’ or ‘loan’ which needs to be paid off with interest. This strikes a balance in the interests of the investors as well as the entrepreneurs.

However, like convertible debentures, this hybrid security is also infamous for its hefty load of compliance requirements and paperwork that is involved, mainly the pre-requisite for a valuation certificate.

The issue of these shares is regulated by Section 42, 62 and 55 of the Companies Act, 2013. Additionally, since the instrument is eventually converted into equity, foreign investment is permitted which makes it mandatory to adhere to FDI policy and FEMA Regulations. Similarly, the compliances under the Income Tax Act 1961 have to be followed. Issuance of these shares also provides certain rights to the shareholders, thus restricting the promoters of the venture in their decision- making process.

With the advent of CCPS, another form of modified investment was introduced in India, namely Term Sheets with Staggered Investments. In this the investments are made through preference shares and later divided into segments to meet certain pre-determined goals. These are usually referred to as ‘milestone’ based, as they are diverted to meet objectives and are highly driven by market conditions.

All things considered, CCPS is the most used instrument for start-up investments currently, due to the liquidity advantage and repayment of share capital in an event of failure.

OTHER SECURITIES

While CCPS and CCD are the most popular investment instruments used in India, some venture capitalists are now adopting different methods which have been proven successful in the international economy. They are-

-Convertible Notes

-SAFE- Simple Agreement for Future Equity

Convertible Notes

Convertible notes are issued in the form of a ‘debt instrument’ to fund money to a venture in the way of a loan. The investor can convert this instrument into an equity share of the company, which is usually done at the time of the subsequent funding that the venture receives. This is based on a threshold set by the investor, which if not met, makes the venture liable to pay back the principal amount to the investor along with the accumulated interest.

Whilst the underlying principle of a convertible note is the same as that of a CCD, this instrument has proven less expansive and user-friendly due to the absence of several compliance requirements, mainly the valuation report and certificate.

Thus, the ventures which are unable to produce a substantial valuation report are also eligible to accumulate funding. However, as per the RBI Regulation and The Companies (Acceptance of Deposit) Rules, 2014, only ‘recognised’ start-ups are eligible to issue convertible notes in India. The transferability of these securities in India is in accordance with the exchange rules, which makes it mandatory to convert within a period of 5 years from the issue.

This instrument is believed to be highly efficient in terms of security, which on the one hand caters to the interest of investors, however also brings about a great deal of uncertainty to the start-ups as there is no assurance whether the investors will/will not convert their securities, as in the case of CCD and CCPS.

SAFE- Simple Agreement for Future Equity

 SAFE is usually termed as an ‘equity derivative contract’ which converts the initial capital invested into future stock of the company, based on contractual terms and conditions.

The primary reason for the success of SAFE in countries like USA, Singapore, Germany etc. is because there is no interest, unlike a debt instrument or loan. There is also no maturity date or compulsory period of conversion, leaving room for greater flexibility and negotiations. Instead of having terms and schedules, they are based in certain contingent events, the happening or non-happening of which determines the interest of the investor to either:

-Reclaim the invested principal amount or

-Convert the capital into stocks/shares of the

Furthermore, since it is a contract and not a security, it is fully regulated by the parties (investor and entrepreneur). This allows them to customize the clauses as per their situation, financial capabilities and proposed business model, thus striking a balance in the interest of both.

However, they are not an immediate share in the company, but merely a promise. This provides no rights to the investor till the actual conversion of the capital takes place. Further, the investor has no rights in the business assets of the venture in case of liquidation as opposed to CCPS, and no fixed dividend or interest as in the case of CCD or a Convertible note. Since these contracts are not regulated by other laws, it is highly risky to invest using this mechanism.

Since it is merely a contract, it will be governed under Section 32 of the Indian Contract Act, namely contingent contracts. In accordance with this provision, the agreement can only be enforced if the contingent event takes place. Thus, considering the uncertainty of the event agreed upon, there is high-risk, potentially for the investor to even reclaim the nominal amount, in case of the non-happening of this event.

Lastly, since SAFE agreements don’t have any interest or maturity date, they cannot be classified as a ‘debt’. Likewise, due to the absence of dividend and other shareholder rights, it cannot be termed as ‘equity’ either. This makes the instrument non-reliable and less secure to a very large extent, which is the main reason of its failure in India.

SAFE/ CONVERTIBLE NOTE IN COMPARISON WITH CDC AND CCP

It is considered appropriate to choose these internationally adopted methods in India particularly when the valuation of the start-up cannot be ascertained, or the investor and founder of the start-up cannot agree upon a common ground for such valuation. Additionally, if the resources and time do not permit the parties to meet the documentation and compliance requirements, SAFE and CN are considered as more viable options.

However, if the investor seeks more protection and guarantee through his investment, and the parties wish to be regulated by the realm of more stringent laws, CDC AND CCPS are, without an iota of doubt the most appropriate mechanisms for start-up investments.

c. iSAFE

 India Simple Agreement for Future Equity is a standardised template-driven agreement that is gaining popularity due to its ease and efficiency. It is a hybrid of all the instruments mentioned above as it is neither a debt nor an equity but it regulated by the Company Law as a CCPS, which makes it sound and secure. It is convertible on the occurrence of specified events and is both investor and founder friendly.

In case of failure of the start-up, all assets left after discharging the liabilities are returned to the investors. Upholding the limited liability concept, it is the company and not the founders who are liable to pay-back. On the other hand, it is convertible on the happening of the event in case of success.

Lastly, it is free from the tedious documentation procedures that need to be adopted in case of CCD’s and CCPS. Thus, though relatively new, it is a growing concept which is being adopted by several ventures and investors in the country.

CONCLUSION

After the detailed evaluation of the most prominent hybrid instruments for start up investments, it is conclusive that there is no ‘one’ definite approach to adopt for all ventures and investors alike. While some possess the concern of tedious compliances, the other may bring about a challenge in the security or valuation of the concern. Thus, it is imperative to weigh the situation of each instrument and ensure that the most suitable investment method is adopted.

Author: Simran Chetwani, an intern at Khurana & Khurana, Advocates and IP Attorneys. In case of any queries please contact/write back to us at anubhav@khuranaandkhurana.com.