What are the types of internal audits?

Internal audits can include operational audits, compliance audits, financial audits, forensic audits, IT audits, and environmental audits.

What are the key standards in internal audits?

The key standards include independence, objectivity, proficiency, quality assurance, and communication.

What is the risk-based approach in internal audits?

The risk-based approach prioritizes auditing high-risk areas within an organization to focus resources where they are needed most.

What are the 5 C's of internal audit?

The 5 C's are Control, Compliance, Cost, Consistency, and Communication, which are critical for a successful audit process.

How does an internal audit help in risk management?

Internal audits help identify and mitigate risks by ensuring that internal controls are effective and that the company complies with laws and regulations.

Convertible Notes Open Doors to Foreign Investments for Startups

Published on June 1, 2020

The Reserve Bank of India (RBI) amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Management Regulations in 2017, allowing “recognized startups” to issue “convertible notes” for fund-raising. The policy aims at making India an attractive foreign investor destination, improving the funding options for home-grown startups. This amendment is further supported by Companies (Acceptance of Deposits) Amendment Rules, 2016, whereby MCA exempted “convertible notes” from the definition of “deposits” to allow an individual to lend money to an Indian startup for a period not exceeding five years, provided the amount of investment should not be less than Rupees Twenty Five Lakh in a single tranche. The objective was to allow only serious and big individual investors to invest in a company and not the general public.

What are Convertible Notes?

Convertible Notes (CN) in the simplest words are debt instruments issued by startups to raise funds. Convertible Notes, as the name suggests, are convertible, the holder can either convert them into equity or redeem them, ideally before the next fund-raising round. Under the amended Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017, Convertible Notes issued by qualified startups to a non-resident investor is a debt instrument, which by the option of the note holder, can either be repaid or converted into equity within five years from the date of issuance. Thus, the investor may enjoy the benefit of fixed return for initial years till CN is debt for the company and later may get it converted into equity to enjoy other benefits like voting rights, profit-based return.

Definition of Convertible Notes under FEMA and companies Act is as follows:

Foreign Exchange Manager (Non-dept Instruments) Rules, 2019

convertible note’ means an instrument issued by a startup company ackanowledgeing receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon the occurrence of specified events as per other terms and conditions agreed and indicated in the instrument;

Explanation under Companies (Acceptance of Deposit) Rules, 2014 (as amended from time to time)

convertible note’ means an instrument evidencing receipt of money initially as a debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of the startup company upon occurrence of specified events and as per the other terms and conditions agreed to and indicated in the instrument.

Situation Prior to January 2017:

Before 2017, RBI permitted foreign investments only through Foreign Direct Investments (FDI) with equity-based instruments like Equity Shares, Compulsorily Convertible Preference Shares (CCPS), or Compulsorily Convertible Debentures (CCD). Any other form of investments including instruments with optional convertibility into equity were treated as debt and had to comply with the External Commercial Borrowings (ECB).

Why only startups?

Department for Promotion of Industry and Internal Trade (DPIIT) started recognizing newly incorporated entities as “startups” which are working towards innovations, development or improvement of products or a scalable business model with a high potential of employment and wealth generation having low turnover. Such entities always require investors who could invest in their ideas however, the investors were reluctant to invest in these startups, as there was no surety on the performance of these entities in the longer run. Every investor wanted to watch and observe the performance of startups before investing in equity instruments as a perpetual investment. Hence, in order to ease the raising of finance from foreign entities/individuals, Government announced amendments in FEMA regulations and Companies Act to attract investors for startups in India.

Why Convertible Note?

The objective of the investor investing in CN is to get the investment converted into equity at the time of the second round of funding at a certain discount to get the benefit of early entry in the Company. Although the definition of CN under FEMA says that CN may be converted “as per other terms and conditions agreed and indicated in the instrument”, however, there are no clear guidelines issued under FEMA as to whether CN can be converted into equity at a discount (agreed at the time of issuance of CN) on valuation arrived at the time of second round of funding. Unless this benefit is there, the purpose of CN seems to be defeated for foreign investors. Similar relaxation is required under the Income Tax Act also, with respect to the investment made by a resident investor in the form of Convertible Notes in an Indian startup, when his investment gets converted into equity at a discounted rate.

Benefit of issuing of Convertible Note (CN):

Unlike FDI instruments namely equity shares, CCPS, CCDs, or ECB, no valuation is required at the time issuance of CN. However, valuation is required at the time of transfer of CN from Non-resident investor to Resident Investor or at the time of conversion of CN into equity shares. This is the most lucrative advantage for startups as the valuation of the business of startups during the initial years has always remained a challenge. It is pertinent to note here that prior approval of the Government would be required, where the startup is engaged in any activity that falls under the approval route under the existing regulatory framework for FDI.

Requirements for issue of convertible Note (CN):

Convertible Note can be issued only by “startups” recognised by Department of Industrial Policy and Promotion, Ministry of Commerce and Industry (DIPP)
Convertible Note is an instrument evidencing receipt of money initially as debt, which is repayable at the option of the holder.
Minimum amount investment in Convertible Note shall Rs.25 Lakhs or more in a single tranche.
Convertible Note can either be repaid or can be convertible into such number of equity shares of such startup company
Repayment or conversion to happen within a period of five years from the date of issue of the convertible note
The terms and conditions of the Convertible Note to be agreed and indicated in the instrument.
Requires Fillings of Form CN to be filed with the Reserve Bank of India (RBI), in case of a foreign investor.

India houses the second largest startup ecosystem in the world and this policy relaxation is helping the innovative startups explore the pool of opportunities both domestic and foreign investors for raising the seed capital in the initial phase. This mechanism has also given the opportunity to individual investors to lend money to companies as debt, which was otherwise prohibited for private companies. However, the pricing guideline still acts as a hurdle and we hope that the RBI will exempt the limitation on the price to improve the impact.