Posted By
Eldon Chan

Often viewed as a quick interim source of funding until the next round of equity financing, convertible notes have become ubiquitous in Southeast Asia and India for many early-stage and even late-stage companies looking to raise capital. While convertible notes in the US venture practice feature a familiar mixture of terms such as conversion caps and conversion discounts (see our primer on convertible debt and FAQ on convertible debt for an introduction to convertible notes), the relative lack of market norms and generally investor-favorable market dynamics in both Southeast Asia and India have given rise to bespoke terms in many convertible notes in these markets, which can sometimes be problematic for founders. While convertible notes in Southeast Asia and India do feature many of the common US terms such as conversion caps and conversion discounts, this article focuses on the additional terms that are sometimes seen in Southeast Asia and India.

Operational and Financial Covenants

Convertible notes in Southeast Asia and India sometimes feature extensive operational and financial covenants, many of which would, in the US practice, be more likely to appear in a traditional loan context as opposed to the start-up convertible loan context. These operational covenants generally restrict the company from undertaking certain corporate actions (for example, issuing new securities, amending any policies in relation to the distribution of dividends and changing the capital structure of the company). Financial covenants can include restrictions on a company’s ability to incur additional debt or requiring that certain financial ratios are maintained throughout the term of the loan.

Founders should be aware of certain potential issues with these kinds of covenants. First, from an operational and risk perspective, it may be difficult for the company to track and ensure compliance with these covenants, especially if the company also has to simultaneously track a parallel list of matters requiring shareholder consent under a shareholder agreement. Second, by agreeing to operational and financial covenants, founders may be inadvertently granting the convertible noteholders backdoor veto rights which may inhibit the company’s decision-making process.  Third, financial covenants in particular may be difficult for development stage companies to comply with, and may create a high risk of default.

Conversely, from an investor’s perspective, much like a traditional bank loan, the benefits of imposing operational and financial covenants helps keep the risk profile of the investment within the investor’s acceptable parameters. Given that convertible notes are generally entered into with the intention of ultimately converting into equity, the covenants provide the investor with some indirect influence on the capital structure of the company, such that if and when the convertible notes are converted, the company has not become a completely different investment proposition.

Representations and Warranties

In addition to the operational and financial covenants described above, convertible noteholders sometimes request for the company to provide a fresh set of representations and warranties about the company’s affairs, which may be closer to the more fulsome set of representations and warranties an investor may require in an equity financing in the US practice, as opposed to the lighter set that a convertible debt investor would often require. The company and founders thus run the risk of “foot faults” and making incorrect representations and warranties, which may unexpectedly lead to a breach or default under the convertible loan documents. This risk is compounded by the general perception that convertible notes are a cheap and hassle-free way of securing funding, hence the founders may believe they do not need to review the loan documents carefully. Failing to properly scrutinize and negotiate the documentation can expose the company and founders to unnecessary risks down the road.

Jurisdiction-Specific Features

In addition to the terms described above, founders should bear in mind jurisdiction-specific requirements that also may impact a capital raise via convertible note. For example, in India, there are foreign exchange restrictions which limit the ability to issue notes to foreign investors, such that Indian-incorporated companies primarily use convertible notes to raise from “onshore” angel investors. It is important to consult with lawyers licensed in the relevant jurisdiction for advice on these matters.

Conclusion

Given the varying terms of convertible notes in Southeast Asia and India, founders in these markets should pay careful attention to the terms of the convertible notes, with the same level of scrutiny that might otherwise only be given to an equity fundraising, and should carefully consider the consequences of any bespoke or unusual terms that convertible note investors require.