Compulsory Convertible Debenture- The Preferred Investment Instrument
CCD or Compulsory Convertible Debenture is a familiar term for most promoters and investors in the start-up ecosystem as it basically means an instrument issued by a portfolio company in the form of debt against an investment and is convertible into equity shares of such company at a specified time (no later than 10 years from the date of issuance in India). Once the CCD(s) are converted into equity shares, the holder of CCD(s) automatically becomes a shareholder in the company and acquires all the rights of a shareholder as prescribed under the Companies Act, 2013.
According to the Reserve Bank of India guidelines, CCDs are treated as equity for all the reporting purposes and financial statements, however, unless converted into equity, CCDs are not considered as part of the share capital of a company. Although issuance of CCDs does involve dealing with regular compliance work, however, the advantages offered by this instrument are manifold. Some have been listed below:
a) Secured Debt: The fact that CCDs get converted into equity shares at a specified time encourages investors to put in their money. Typically, most investors prefer to co relate the conversion of CCDs into equity shares to the portfolio company’s performance. This essentially means that the debt get converted only after the company achieves the undertaken growth. If the milestones are not achieved, then the investor reserves its right to either increase the stake or exercise a put option subject to the terms agreed between the parties.
b) Pricing and Discount: The CCD issuance mechanism eliminates the hassle of fixing portfolio valuation straight away. At the time of issuance, CCDs are mostly issued at a discount to the valuation of the next round of investment, since an investor is investing in the nascent stage of the portfolio company which is prior to arriving at the valuation for the next investment round.
c) Rate of Interest: Since the CCDs are issued at a discounted price to investors, the rate of interest payable by the portfolio company is generally lower than the rate of interest paid on Non-Convertible Debentures. Further, the CCDs come with a tax benefit whereby the interest paid to a CCD holder is allowed as a deduction at the time of computation of the portfolio company’s taxable income.
d) Preferential Payment: Any CCD holder shall have a preferential right of payment over other stakeholders of the portfolio company purely because CCDs are a hybrid instrument essentially in the form of debt rather than equity until the time they are converted to equity shares.
e) Cap Table: If compared with the traditional form of investment against equity, the portfolio company’s promoters and existing shareholders face immediate dilution upon receiving the investment due to equity allotted to the investor, however in case of an investor investing through CCDs such dilution in the cap table of the portfolio company is deferred till the time the CCDs are not converted into equity shares.
d) Debenture Reserve: The Companies Act, 2013 requires creation of a Debenture Redemption Reserve, executing a debenture trust deed, appointing a debenture trustee, etc. in order to secure the payment to be made at the time of redemption of a Non-Convertible Debenture. However, for the purpose of issuance of CCDs no such conditions are required to be fulfilled by the portfolio company.
An analysis of the FDI (Foreign Direct Investment) trends in India in the past decade mirrors that there has been an evident phenomenal shift from traditional form of equity investment in portfolio companies to investment via convertible instruments in such companies and more so via CCDs. This change in the FDI trend has largely occurred due to the flexibility offered by CCDs as envisaged herein.