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Demystifying Debt Funding Instruments

While we are familiar with equity capital in the context of startups there are certain hybrid securities that combine the characteristics of both equity and debt-based financial instruments that are increasingly being used by startups. These debt funding instruments include debentures, bonds, Optionally Convertible Preference Shares (OCPS), Optionally Convertible Debentures (OCD). In short, they are instruments that guarantee a return to the investor, unlike equity capital where there is no guarantee on the risk. 

In 2016, the Supreme Court of India passed a law saying that all hybrid financial instruments, until they guarantee a return to the investor, will be considered as an equity-based instrument. Here we are going to discuss three such hybrid financial instruments that are commonly used: Convertible Notes (CN), Compulsory Convertible Debentures (CCD), and Compulsory Convertible Preference Shares (CCPS). 

  • CCPS: Preference shares are issued in this case; meaning the holder is entitled to a fixed dividend on a priority basis. This dividend will be converted into equity after a predetermined period of time. The pricing formula to calculate the equity is calculated at the time of the issue. It must not be less than the worked out fair value
  • CCD: In the case of CCD, debentures are issued and not preference shares. All other guidelines are the same as CCPS
  • CN: CNs can only be issued by startup firms (recognized by DPIIT). It is considered a debt instrument repayable at the choice of the holder. CNs get converted into equity shares within five years, or upon the occurrence of a specified event. The minimum investment an investor can make via a CN is INR 25 lakh in a single shot. 

In this webinar, Anshu Tiwari, Compliance Associate at LetsVenture talks about how these debt funding instruments are different from each other, how they can be used by startups and pointers to keep in mind when using these. 

Here’s the full webinar:

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