STRATEGIC RISK MANAGEMENT WITH CONVERTIBLE NOTES IN INDIA'S STARTUP FUNDING LANDSCAPE

Author- Bivek Das, Marwadi University

Abstract

Convertible notes have developed as the go-to funding instrument for pre-series startup capital raising in India, having a place at an interesting nexus of laws – company law, securities law, foreign exchange regulations, and income tax law. These are debt-based instruments which have provisions for converting into equity on the occurrence of some specified events such as qualified funding or maturity, which enable the founders to postpone dilution while providing the investor with interest accrual and equity upside through valuation discount or cap. The regulatory aspects of these convertible notes extend to a range of statutes such as the Companies Act 2013, the Companies (Acceptance of Deposits) Rules 2014, the FEMA Non-Debt Instruments Rules 2019, the ICDR Regulations of SEBI, and the Income Tax Act 1961, each having its own compliance obligations regarding approval from boards and shareholders, private placements, foreign investment notifications, and taxation on conversion or premium valuation. Recent changes in the regulations like the RBI notification dated January 2025 on remittance channels and 2025 changes in the FIRMS portal have made foreign investments more frictionless, although there is continuous scrutiny on valuations and sectoral limits.This blog provides an analysis of the law around convertible notes, the process of issuance and conversion of such notes, and the considerations that have to be taken into account by entrepreneurs and investors while dealing with the instrument so as to strike a balance between flexibility and legal risk.

Keywords: Convertible Notes, Startup Funding, FEMA NDI Rules 2019, DPIIT Recognition, SEBI ICDR Regulations, Foreign Direct Investment, Corporate Finance Law, Equity Conversion

Introduction

In India, convertible notes are an increasingly popular form of early-stage funding for startups, as they are viewed as one of the most effective ways to raise funds for your business. Convertible notes are essentially hybrid instruments that sit at the junction between the four major areas of law relating to corporate finance: Corporate Law, Securities Law (including the Indian Companies Act and SEBI Regulations), Foreign Direct Investment Law (under the Foreign Exchange Management Act) and Taxation Law. The more pertinent question for entrepreneurs and investors alike is not "What are convertible notes?" but rather, "What do convertible notes mean in term of the way we manage our exposure, and share with each other the risk, value, and regulatory burden of our businesses in the current environment of law?"

Defining Convertible Notes

Convertible notes are hybrid instruments that start with a debt component but will convert into an equity component based on specific triggering events, such as a "qualified funding round" or maturity. As specified in the Companies (Acceptance of Deposits) Rules, 2014, under Rule 2(1)(c)(xvii), amounts received by DPIIT-recognised startups, which are ₹25 lakh or more, are exempt from depositing rules if they meet certain conditions: convertible to equity or repayable within ten years. Likewise, the FEMA (Non-Debt Instruments) Rules, 2019, provide for this same definition by regarding convertible notes as debt acknowledgments that may convert into equity based on specific triggering events, within a similar ten-year period. Both definitions allow startup companies access to flexible sources of capital while providing an underlying level of protection for investors like a loan, plus the potential for appreciation as shares become available once the investments convert to equity.

Strategic Advantages for Startups and Investors

Convertible notes allow companies to reduce the amount of documentation required and expedite the closing process of their deal(s) significantly. In addition to addressing many of the common bottlenecks for most early-stage start-ups, convertible notes permit the founders to defer any immediate dilution of ownership while providing the investor(s) a degree of interest compensation (accrued interest) and the ability to receive repayment from the converting of the convertible note into equity through either a discount and/or cap on their note. The risk of using this analytical framework results from the fact that the ultimately determined value of the convertible note rests heavily on the valuation of the final financing round of the company; a company receiving a down round of financing may still be partially protected by a downside cap associated with the convertible notes issued for that round of financing. As a result of the critical nature of the convertible notes for balancing the interests of the founders and those of the investors during term sheet negotiations, both parties will need to take care when negotiating the terms of the convertible notes.

Core Legal Framework

Regulatory requirements are governed by the Companies Act, 2013, the Foreign Exchange Management Act NDI Rules, 2019, SEBI Regulations, and the Income Tax Act, 1961. A startup must obtain DPIIT recognition, obtain board approval through a Section 179 resolution, and, in the situation of equity conversion, obtain a special resolution under Section 62(1)(c) that indicates the pricing rationale behind the equity conversion. Private placement requires submission of Form PAS-4 offer letters and the submission of Form PAS-3 allotment return within 15 days of allotment to the Registrar of Companies (RoC). For foreign investors, the FEMA Regulations provide that at least ₹25 lakh is required for each tranche of investment, that if required, they must obtain sectoral approvals for Foreign Direct Investment (FDI) registration, and that the Form CN must be filed within 30 days from the date that funds were received in India. After conversion of the investment, the Form FC-GPR will be required. The SEBI (ICDR) Regulations provide disclosure requirements pertaining to such issues as: rights, triggers, and pricing of a company listed on Stock Exchanges, and the applicability of takeover risks in the case of an Open Offer in terms of Section 2(1) of the SEBI (ICDR) Regulations, as the Open Offer triggers once investors exceed 25% of voting rights after conversion. With respect to taxation, Section 47(x) protects the conversion from taxation under the Capital Gains Tax and Section 56(2)(viib) will tax the fair market value of premiums above ₹25 lakh for purposes of calculating taxable income.

Filing Requirements in Detail

Issuance of shares starts with board and shareholder approval and getting PAS-4 issued in the required timeline to file PAS-3 with ROC on the same day as the MGT-14. When foreign funds are received by an Indian entity, they will fill out Form CN through an Approved Dealer, now covered under the NDI Reporting Amendments effective January 1, 2025. They will allow the use of rupee vostro accounts or SNRR accounts for remittances. Any conversion of shares will require a new PAS-3 and FC-GPR to be filed with the ROC within 30 days of the conversion and subsequently submit updates in the FIRMS System for bulk filings and/or corrections for instances of errors that occurred prior to July 2025. Non-compliance will result in a recharacterisation of deposits, Fema Penalty, and/or Tax Disallowance which emphasises the importance of proper sequencing of receipt of money, allotment of shares, and reporting.

Recent Developments Shaping the Landscape

RBI’s January 2025 Foreign Exchange Management (Mode of Payment and Reporting on Non-Debt Instruments) (Third Amendment) Regulations expanded the number of channels available for remittance. They now allow for foreign currency accounts and Special Non-Resident (NSR) Rupee accounts, which has made it easier to send money across borders for convertible notes. The changes to the FIRMS portal during July and August 2025 allow for an easy uploading of bulk Foreign Currency-Gross Borrowing Payment Requests (FC-GPR) and error correction. These two developments are lowering the friction on compliance for startups with multiple investors. Additionally, SEBI continues to modify its ICDR and startup rules (including allowing Employee Stock Option Plans to be converted into equity). These developments indicate that there is support for the overall ecosystem, with the angel tax exemption also continuing for entities registered with DPIIT. Together, these developments create a very positive outlook on enhancing liquidity for participants in the private equity space, and for participants to execute deals in a timelier fashion than they currently do; however, there continues to be an increased level of scrutiny on pricing and sectoral caps, and this will require strong valuation support.

Analytical Roadmap for Issuance and Conversion

The process of structuring will begin with confirmation from the Department for Promotion of Industry and Internal Trade (DPIIT) and finalising the details such as interest rates, caps, discounts and triggers. This is immediately followed by passing resolutions and couriering out the PAS 4 form. Once funds have been received, allotee notes will be issued and PAS 3 and Company Nominal Register filed along with monitoring the total investment over the 10-year horizon. At time of conversion all equity holders will re-calibrate their pricing based upon the minimums set out in FEMA, FMV and Approval of the allottee notes before filing PAS 3 form and FC-GPR form. Redemption will only take place as an additional payment of principal and interest until a trigger occurs, which will define how an investor can redeem their investment. When structuring the dilution model, Founders should consider the number of shares and percentage of the company that they will hold at any given time, while Investors should include covenant(s) giving them access to the information related to defaulting events; otherwise, a single misstep down this path could lead to extensive regulatory exposure, thus necessitating legal due diligence.

Conclusion

Convertible notes provide an effective way of balancing the opposing needs of founders and investors through the process of seed financing in India, providing flexibility and agility which is not possible to achieve through conventional means such as equity or debt instruments. However, the effectiveness of this tool is only possible with strict compliance with regulations related to corporate, securities, foreign exchange, and tax laws, which operate in a diverse regulatory structure. The recent liberalization through expanded options for remittance and the FIRMS portal process points towards a regulatory environment favorable towards capital formation through startups, despite continued stringent monitoring of price considerations and sectoral compliance. Overall, the use of convertible notes requires appropriate timing of money inflow, allocation, and reporting process.

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