Foreign Direct Investment in Indian Start-Ups: Opening up the Flood Gates

The Reserve Bank of India (India’s apex bank) (“RBI”) has recently amended and notified its Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) (Fifteenth Amendment) Regulations, 2016 (the “Regulations”) whereby it is now easier for the foreign investee to invest in Indian start-ups by issuing Convertible Notes.

The Amendment now permits Indian start-ups to raise early-stage funding by issuing Convertible Notes (the “Note”). The Note is an instrument which is issued as an instrument of debt which later gets converted into equity if and when certain specified conditions are met. If the contingent event does not take place, the instrument continues to be held as a debt which the issuing start-up will have to repay. Uptil now, the start-ups were not permitted to issue Convertible Notes and could raise funds only by way of equity participation.

The RBI has outlined certain key features of these Notes which are briefly explained as under:-

·       Definition of Note: The Note has been defined as an instrument which is issued by an Indian start-up to a foreign investor investing in the start-up on receipt of the money initially as a debt and which later gets converted into equity shares when certain specified conditions as mentioned in the Note are met. This conversion has to take place within 5 years from the date of issue of the Note. Alternatively, the holder of the Note has the option to continue it as a debt which becomes repayable by the start-up as per the terms and conditions stated therein.

·       Definition of a start-up: The start-ups for the purposes of these Regulations has been defined as a private company incorporated under the Companies Act, 2013 and 1956 and has been recognised as a start-up by the Department of Industrial Policy and Promotions, Ministry of Commerce. Effectively, this means that the start-up company must not be older than 5 years from the date of its incorporation and turnover of which has not exceeded INR 25 million in any financial year.

·       Minimum Amount: The minimum amount which the foreign investor needs to invest under the amended Regulations is INR 25,00,000 in a single tranche. Non-resident Indians may acquire the Notes but on non-repatriation basis in accordance with the Regulations.

·       Remittances: The amounts shall be received by the start-ups through normal banking channels or by debit to the NRE/FCNR (B) accounts. Additionally, the Regulations permit opening of the Escrow accounts for this specific purpose. Such Escrow accounts shall be closed immediately after the requirements have been met or not later than six months from the date of opening of the account.

·       Issuance of Equity: The equity shares shall be issued as per the provisions of the Regulations.

·        Transferability: The Notes are transferable. A person resident outside India may acquire or transfer, by way of sale, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. Prior approval from the Government shall be obtained for such transfers in case the start-up company is engaged in a sector which requires Government approval.

·       Compliances: The reporting of the issuance of the Notes by the start-ups have to be made to the RBI as prescribed in the Regulations.

Gray Areas

·       The start-ups engaged in the sectors where foreign investment is permitted on government approval, have to take prior approval of the government for issuance of convertible Notes. This may make the whole process more time-consuming and tedious.

·       The non-repatriation restriction for NRIs may make the instrument less attractive to them for investing and this may prove to be a substantial loss to the start-ups.

·       The Regulations are silent on the pricing/interest rate at the time of issuance of the Notes.

·       The Regulations are also ambiguous on the five-year period within which the Notes must be converted, if opted for conversion by the holder. Do they become compulsorily convertible at the end of the 5-year term?

Conclusion

All said and done, these amendments do open a new avenue for raising early-stage funding by the Indian start-up companies and also for foreign investment to come into India. Foreign investors too can rest at peace with their funds because if the start-up does well, they have an option to be a shareholder and reap benefits on their investments.

India is witnessing a surge in entrepreneurship and start-ups with the young technocrats eager and raring to take risks with their technological innovations. These Regulations surely seem to be a step in the right direction.