How Start-ups can Raise Capital by Issuing Debt

Wednesday July 04, 2012 , 3 min Read

Much has been written about how start-ups can raise capital by issuing equity, little however has said about how they can raise capital by issuing debt. In corporate law, debt and equity differ fundamentally in the sense that equity represents ownership in the company, whereas debt represents a liability in the form of a claim on the assets of the company, and provide a preferential claim to the holder in case of liquidation.

Debt in itself can either be in the form of loans or as hybrid instruments in the form of convertible securities such as convertible debentures and bonds. Loans are availed from banks and financial institutions who may not be willing to grant loans to start-ups as there is no asset available for pledge. Therefore, an available option for start-ups is issuing convertible debt to investors.

Investors investing in start-ups who purchase convertible debt are at a more advantageous position that they would have been had they purchased equity. The reason is that, equity represents an inherent risk, i.e. returns are not available till there is significant appreciation of the net worth of the company. This means that till such time that the company does not become a profitable venture the investor cannot sell the shares. This is problematic, as this event may not happen at all. This is where convertible debt is advantageous as the investor has the following options:

(a) Demand his principal amount plus interest: The agreement would guarantee payment of principal amount along with interest at a specified time.

(b) Demand conversion of his loan into securities: If the company becomes profitable within the time period specified for maturity of the instrument demand that his convertible security be converted into equity.

For a company, issuing convertible debt, can be advantageous as there is no automatic conversion of loans into securities, which protects the ownership interests of the promoters.

vakil_search — However there are significant compliance issues in case of optionally convertible preference shares/ debenture instruments when issued to foreign investors. When these are issued to Indian investors they represent share capital and when they are issued to foreign investors they represent debt. This anomaly is created due to the external commercial borrowing regime / foreign directed investment regime stipulated by the Reserve Bank of India (RBI) in case of investments by non residents in Indian companies, which classifies mandatorily convertible preference shares as equity and optionally convertible preference shares as debt. So therefore, in case of investments by foreign investors in convertible debt which are optionally convertible it is important to ensure that the foreign investor falls within the category of recognised lenders under the external commercial borrowing regime of the RBI.

So therefore,

If you are an entrepreneur looking for investments into your company do consider the option of issuing convertible debt. However, do keep in mind that in case of foreign investors the nature of instrument issued assumes particular importance as optionally convertible debt is classified as external commercial borrowing (ECB) and fully and mandatorily convertible debt is classified as foreign investment (FDI) and respective compliance of FDI / ECB regimes is required.

More resources on Legality over here