Amendments to the FDI Policy of 2020 in relation to warrants & convertible notes.

Aneesh Gupte

The Government has, vide Press Note 1 of 2022, introduced some welcome amendments to the FDI Policy of 2020 in relation to FDI in warrants and convertible notes.

Change in the definition of‘warrants’:

The definition of warrants has been amended to include warrants issued by an Indian company in accordance with the SEBI regulations, Companies Act, 2013,
or any other applicable law. The erstwhile definition stated that warrants include warrants issued by an Indian company in accordance with the SEBI Regulations
and the Companies Act, 2013.

The switch from ‘and’ to ‘or’ appears to have been made to clarify the ambiguity created by the erstwhile definition as to whether or not the FDI Policy permitted FDI in warrants offered by unlisted Indian companies. Reference to the SEBI regulations in conjunction with the Companies Act was widely being interpreted to mean that FDI was permitted only in warrants of listed companies and hence unlisted companies were not permitted to issue warrants to non-residents.

While there seemed to be no apparent rationale for not allowing unlisted companies to issue warrants to non-residents as long as the warrant instrument had the twin conditions attached (i.e. investing 25% of the consideration up front at the time of issuance and the balance within 18 months from the date of issuance), the aforesaid interpretation found favour more so from the fact that the Foreign Exchange Management (Non-debt Instrument) Rules, 2019 (“Non-Debt Rules”), in the samecontext, only made reference to the SEBI regulations.

With this subtle change in the definition, the Government has delinked the SEBI regulations from the Companies Act. Hence warrants issued even by unlisted companies should now be permissible/FDI compliant instruments. A corresponding change in the definition of warrants in the Non-Debt Rules may soon be made. It remains to be seen if the Companies Act is also amended in due course to introduce specific provisions pertaining to warrants which are aligned with the foreign exchange laws.

Warrants not only have the benefit of locking the valuation for an 18-month runway by requiring only 25% of the investment amount to be invested upfront, but they also serve as downside protection instruments as the balance amount is required to be invested only if the conversion option attached to the warrant is exercised, which option may not be exercised if the valuation were to dramatically fall.While warrants are quite commonly used as investment instruments by both resident and non-resident investors in PIPE deals, especially in volatile markets, this amendment has opened the door for non-resident investors to consider using such instruments for investments in unlisted Indian companies as well.

Change in the definition of ‘convertible notes’:

The maximum tenure for exercising the conversion option attached to convertible notes permitted to be issued by recognized start-ups to non-resident investors has been increased from 5 years to 10 years.

Convertible notes are short-term debt cum quasi-equity instruments issued at low interest rates and used in bridge financing rounds. They convert into equity typically in conjunction with a future financin ground. The main feature of such notes is the fact that they do notforce a valuation exercise to be undertaken at the time of issuance of the note. Unlike in relation to equity shares, convertible preference shares, convertible debentures, or convertible warrants, the RBI pricing guidelines do not kick-in when the convertible note is issued and become applicable only at the time of conversion to equity.

The aforesaid feature of a convertible note is beneficial particularly to start-ups for raising funds in their formative years when there may not be enough metrics to base a valuation on. An incorrect valuation early-on may risk a downround in future and trigger anti-dilution clauses in investment documents.

The Government has recognized that many start-ups may not gain adequate business traction in just 5 years from incorporation thereby resulting in a lot of uncertainty in valuation. Increasing the maximum tenure for conversion to 10 years will give investors a lot more flexibility in determining the opportune time to exercise the conversion option as more empirical data points would be available to arrive at a credible valuation.

This amendment should make convertible notes an attractive investment instrument for foreign investment in Indian start-ups, alargely untapped instrument so far in India, unlike other jurisdictions.