This article is written by Swati Singh, Abhinav Education Society’s Law College, Savitribai Phule Pune University, LLB, 3rd Year during her internship at LeDroit India
Scope of the Article
This article comprehensively covers the following aspects:
1. Concept and meaning of convertible notes
2. Evolution of startup funding instruments in India
3. Legal framework governing convertible notes in India
4. Key features and structure of convertible notes
5. Comparison with other startup funding instruments
6. Advantages and disadvantages for startups and investors
7. Taxation aspects of convertible notes
8. Case laws and regulatory developments
Keywords
Convertible Notes, Startup Funding, Venture Capital, FEMA Regulations, Debt Instruments, Early-Stage Investment
Abstract
Convertible notes have become a common and adaptable way for startups to get money, especially in the early phases of a company’s life. Positioned at the crossroads of debt and equity, convertible notes allow entrepreneurs to raise funding rapidly while delaying valuation debates until a later stage. In the Indian startup ecosystem, convertible notes obtained statutory recognition through modifications to the international Exchange Management Act (FEMA) regulations, thereby enabling international investors to engage more seamlessly in early-stage financing.
This article provides an in-depth review of convertible notes as instruments for startup finance, evaluating their legal framework, structural features, benefits, and restrictions. It also assesses regulatory requirements, taxes difficulties, and important legal and regulatory changes. Through significant case references and recent legislative trends, the article illustrates how convertible notes have become a crucial tool for fostering innovation, eliminating transactional friction, and promoting entrepreneurship in India.
1. Introduction
Innovation, technology, and entrepreneurial spirit fuel startup growth, a hallmark of modern economies.Early-stage firms have significant financing challenges due to traditional equity funding’s valuation requirements. Discussions can be complex and time-consuming. To circumvent these challenges, businesses sometimes use convertible notes, which start as debt and convert to stock upon certain conditions, such as a subsequent investment round. This enables entrepreneurs to raise cash fast without a fixed valuation, simplifying early-stage fundraising and avoiding negotiation bottlenecks. Convertible notes are a popular financing option for companies in India, allowing them to bridge funding shortages and defer valuation until later stages.
2. Meaning and Concept of Convertible Notes
2.1 Meaning of Convertible Notes
A convertible note is a type of financing instrument where a company raises debt and then converts it into equity rather than repaying the holder in cash. In layman’s terms, investors pay money today in exchange for ownership of the company at a later stage, subject to certain requirements. Under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, a DPIIT-recognised startup issues a convertible note; the holder originally accepts this as debt and retains the option to seek repayment or convert it into equity. Its hybrid nature—combining debt with eventual equity conversion—distinguishes it from typical equity instruments by postponing valuation and ownership dilutions.
2.2 Concept of Convertible Notes
Convertible notes are hybrid financing instruments that start as short-term debt and later convert into equity, usually during a future priced funding round. They help startups raise early-stage capital without immediately fixing a valuation, reducing negotiation and legal complexity. Acting as bridge funding, convertible notes provide runway for growth while offering investors downside protection as debt and upside potential through equity conversion via discounts or valuation caps. This flexibility makes them popular in fast-moving startup ecosystems like India.
3. Evolution of Startup Funding Instruments in India
In India, convertible notes are primarily governed by the Companies Act of 2013, RBI regulations, and DPIIT (Department for Promotion of Industry and Internal Trade) recommendations. Only DPIIT-recognized startups can issue convertible notes to investors. According to the RBI’s FEMA regulations, a convertible note is a document that evidences the receipt of money initially as debt and is repayable or convertible into equity at the holder’s choosing.
Key regulatory provisions include:
- Minimum investment: ₹25 lakh in a single tranche per investor.
- Maturity period: Maximum of 10 years from the date of issue.
- Conversion: Can convert into equity shares or be repaid, subject to agreed terms.
- Foreign investment: Permitted under FDI rules, subject to sectoral caps, pricing guidelines, and reporting requirements (such as filing with RBI).
This framework aims to balance flexibility for startups with regulatory oversight, making convertible notes a compliant and founder-friendly early-stage funding instrument in India.
4. Legal Framework Governing Convertible Notes in India
4.1 Companies Act, 2013
While the Companies Act, 2013 does not expressly define a ‘convertible note,’ the term falls within the broader constitutional framework regulating securities, including instruments that can convert into equity. Under the Act, ‘securities’ include convertible instruments such as debentures and other instruments that may be issued on private placement under Section 42. Professional interpretations also note that Section 62(3) can be relevant for instruments that start as debt and convert to equity, underscoring that where a company issues a convertible instrument, the general provisions relating to debentures, issuance of securities, and private placement under the Act would apply.”
4.2 FEMA Regulations
Convertible notes were officially recognized by the Foreign Exchange Management (Non-Debt
Instruments) Rules, 2019 (NDI Rules). Following these rules:
- Convertible notes are described as an instrument that evidences the receipt of money initially as debt and is repayable at the holder’s discretion or convertible into equity shares within a set time period from the date of issue.
- A person residing outside India (except Pakistan and Bangladesh) can purchase convertible notes issued by an Indian startup firm for ₹25,00,000 or more in a single tranche.
- The instrument must be converted into equity or returned within the time frame specified (usually up to ten years from the date of issue as per updated rules/grants), or it will be subject to deposit regulations under the Companies (Acceptance of Deposits) Rules.
These measures allow Indian entrepreneurs to attract foreign investment in the form of convertible notes without instant valuation or direct equity issuance, subject to FEMA compliance and reporting.
4.3 DPIIT Recognition
Only startups recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) are eligible to issue convertible notes under Indian law. According to the official DPIIT criteria and FEMA NDI Rules:
- A startup company must be recognised under DPIIT’s notification as a private company working towards innovation, scalable business models, and meeting turnover conditions.
- DPIIT-recognised startups can issue convertible notes to resident and non-resident investors subject to FEMA provisions and minimum investment thresholds.
- Investment conditions such as the minimum ₹25 lakh per investor in a single tranche and adherence to prescribed remittance and reporting norms apply only to DPIIT recognised startup.
DPIIT recognition ensures that convertible notes issued are compliant with both corporate law and foreign investment norms, providing regulatory oversight and alignment with startup promotion objectives.
5. Key Features and Structure of Convertible Notes
5.1 Valuation Cap
A value cap establishes an agreed-upon maximum company valuation at which a convertible note will convert into stock, regardless of how high the startup’s valuation rises in subsequent investment rounds. It protects early investors from undue dilution if the company’s valuation increases sufficiently prior to conversion. For example, if a convertible note has a $5 million valuation cap but the company’s next funding round is valued at $20 million, the note will convert as if it were valued at $5 million, providing investors a bigger ownership stake for the same investment.
5.2 Discount Rate
When early-stage investors convert their convertible notes into stock, the discount rate reduces the price of the shares. This is a reward for investing early in the company’s development, which is riskier. For example, with a 20% discount rate, if new investors pay $1.00 per share in a new funding round, note holders convert their investment to $0.80 per share, resulting in more shares for the same principal.
5.3 Maturity Date
The maturity date of a convertible note is the date by which it must be converted into equity or repaid. Maturity durations typically range from 18 to 36 months, but this might vary depending on the negotiation. If a qualifying funding round (that triggers automatic conversion) has not occurred before the maturity date, the parties may agree to extend the note, convert at a predetermined valuation, or, in exceptional situations, demand return of the principal and any accrued interest.
5.4 Conversion Triggers
Conversion triggers are contractual events that automatically convert a convertible note from debt to equity. The most frequent trigger is a qualifying financing round, in which the startup raises a set amount of capital through a priced equity offering, resulting in the automatic conversion of the notes into stock at negotiated conditions. Another key trigger is a change of control, such as an acquisition or merger, which might result in pre-transaction conversion and allow noteholders to participate in exit proceeds. Furthermore, the maturity date serves as a built-in trigger—if no financing or control events occur by this deadline, the note may convert into equity at predetermined conditions or compel repayment, depending on the agreement.”
6. Comparison with Other Startup Funding Instruments
| Instrument | Nature | Valuation Requirement | Risk Level |
| Equity Shares | Equity | Immediate | High |
| Preference Shares | Hybrid | Immediate | Medium |
| Debentures | Debt | Not Required | Low |
| Convertible Notes | Hybrid | Deferred | Medium-High |
Convertible notes stand out due to their flexibility and deferred valuation feature
7. Advantages and Disadvantages
Convertible notes offer a mix of benefits and limitations for both startups and investors, making them a popular yet nuanced funding instrument in early-stage financing.
7.1 Advantages for Startups
Convertible notes offer significant benefits to startups in terms of speed and simplicity. Unlike priced equity rounds, which need detailed valuation conversations and substantial documentation, convertible notes can be executed rapidly, allowing firms to raise funds with little legal fees and complexity. They also enable entrepreneurs to postpone valuation, avoiding the difficulty of determining a reasonable company price during the early, uncertain stages of firm development. Furthermore, because equity is only issued upon conversion, founders frequently face less immediate ownership dilution, allowing them to maintain control as the firm grows.
7.2 Advantages for Investors
Investors profit from the potential upside that convertible notes provide. Delaying equity issuance allows investors to join in future fundraising rounds on more favorable terms — frequently with discounts or valuation caps — potentially leading to a larger ownership position if the firm succeeds. This structure strikes a compromise between debt’s downside protection and the ability to convert to equity as the company’s performance improves.
- Disadvantages
Despite their benefits, convertible notes have several drawbacks. Because they are debt instruments, they may impose a financial burden on the startup’s balance sheet and, if conversion triggers are not fulfilled, repayment may be required, putting cash resources under strain. Convertible note features, such as valuation caps, discount rates, and interest, can be difficult to negotiate and understand, potentially leading to conflicts or cap table confusion during conversion. Furthermore, uncertainty about future valuation and equity dilution can influence both founders’ and investors’ expectations, particularly if the next funding round arrives at an unfavorable price.
8. Taxation Aspects of Convertible Notes
The tax status of convertible notes in India is still developing. Interest earned may be taxable, and conversion to equity may result in capital gains depending on the structure and timing. Clarity from tax authorities is still evolving, so professional assistance is needed.
9. Case Laws and Regulatory Developments
While direct judicial precedents on convertible notes are limited, courts and tribunals have examined hybrid instruments in various contexts.
Landmark Reference
- Vodafone International Holdings BV v. Union of India – Though not directly related to convertible notes, the case highlighted the importance of substance over form in investment structures.
Recent Regulatory Development
- Liberalization of FEMA rules allowing foreign investors to participate in convertible note funding marked a significant policy shift in favor of startups.
10. Conclusion
Convertible notes have emerged as a vital instrument in the Indian startup funding ecosystem. By balancing the interests of startups and investors, they provide a pragmatic solution to early-stage funding challenges. While regulatory and tax uncertainties remain, ongoing reforms indicate a positive trajectory. As India continues to strengthen its startup ecosystem, convertible notes are likely to play an increasingly significant role in fostering innovation and entrepreneurship.
