Government extends timeline for startups to convert debt investment into equity by 10 years

The government has extended the timeline up to ten years for startups to convert debt investments made in the company into equity shares, a decision which is likely to give a relief to budding entrepreneurs to deal with the impact of Covid-19 pandemic, according to a press note of the DPIIT.

Earlier the option of changing convertible notes into equity shares was allowed for up to five years from the day when initial convertible note was issued. Now that timeline has been extended to ten years.

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An investor can invest in a startup through convertible notes, which is a kind of debt/loan instrument. But in this investment, the investor is given the option that if the startup performs well or achieves some performance milestones in future, the investor can ask the startup to issue equity shares of the company against the money that they had initially invested as loan/debt.

"Convertible note means an instrument issued by a startup company acknowledging receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup company, within a period not exceeding ten years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument," the note has said.

According to experts, convertible notes have increasingly emerged as attractive financing instruments for early stage funding of startups since its inception in 2017.

Unlike convertible debentures /debts, convertible notes offer the flexibility of optional conversion into equity without having to determine the conversion ratio upfront (and fewer regulatory covenants), Sumit Singhania, Partner, Deloitte India, said.

"Extending such optionality to 10 years will help ease the burden on startups to prove the concept to early stage investors (especially in highly innovative cases requiring longer gestation for building scale) without triggering mandatory pre-mature exits. This policy move ought to enable a new generation of start ups too in raising seed capital /loan with better promise of retaining investments," Singhania said.

Rudra Kumar Pandey, Partner, General Corporate, said that it seems that the government wishes to extend the flexibility to the start-up companies for appropriate valuation and conversion of the convertible note by additional five years until the startups are able to secure its next round of funding and to save them from the impact of COVID and liquidity issues.

"Startups operating across the sectors will be benefited out of this change, and particularly the startups in financial, educational and retail sectors," Pandey said