Template Description

The Convertible Note Agreement template provides a structured legal framework for startup companies seeking to issue convertible notes as part of their funding strategy, under the Companies Act, 2013. The template is a 17-page MS Word document. Intended audience includes companies, start-ups, Legal Professionals, Corporate Finance Teams. 

Understanding Convertible Note Agreement

Definition:

• A Convertible Note Agreement is a financial instrument that starts as debt and later converts into equity, typically during a startup’s next financing round. It allows companies to raise capital without immediately determining a valuation. This flexibility is particularly useful for early-stage companies. In India, the startup should ideally be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) to avail the benefit of Convertible Note Agreement.

Key Clauses:

• Conversion Terms: The principal and accrued interest convert into equity shares at the next qualifying equity financing event. The conversion price is based on either the pre-set valuation cap or a discount rate, whichever benefits the investor.

• Maturity Date: If no conversion occurs by the maturity date, the investor may opt for repayment or conversion into equity at a pre-determined price.

• Interest Accrual: Interest on the note accrues and is added to the principal for conversion purposes.

• Repayment Rights: If no qualifying financing occurs, the investor may demand repayment after a specific period.

• Liquidation Preference: In the event of liquidation before conversion, the investor is entitled to the higher of the investment amount or their pro-rata share as if they were equity holders.

• Confidentiality: The agreement includes provisions to keep all related information confidential, with exceptions for legal disclosures.

Supporting Documents:

•  Board Resolutions: Authorizing the issuance of convertible notes.
• Shareholder Resolutions: Approving the potential conversion of notes into equity.
• Regulatory Filings: Including MGT-14 and any necessary filings with the Reserve Bank of India.

Comparison with Other Funding Strategies:

• Equity Financing: Requires immediate valuation, which may undervalue the company at early stages. Convertible notes defer this valuation to a later round, potentially benefiting the company.

• SAFE (Simple Agreement for Future Equity): Similar to convertible notes but without accruing interest or a maturity date. SAFE agreements are simpler but may offer less protection to investors.

• Traditional Loans: Unlike convertible notes, traditional loans do not convert to equity, requiring regular repayments, which can strain the cash flow of startups.

Conclusion:

This convertible note agreement offers a balanced approach, providing flexibility for companies and attractive terms for investors, all within a legally sound framework under the Companies Act, 2013.