Convertible Notes and SAFE-Style Instruments in India
Introduction : Early-stage start-ups often struggle to agree upon a price for their equity. Priced rounds are time-consuming and costly, which encourages investors and founders alike to defer valuation. Early-stage financing therefore frequently employs instruments such as the convertible note and the iSAFE to postpone valuation discussions until a later round.
A convertible note is a legally recognised debt instrument that converts into equity upon the occurrence of specified events. Its exclusion from the definition of a “deposit” rests on Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014, while its conversion mechanism operates under section 62(3) of the Companies Act, 2013, and is also governed by the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 for foreign investments. These notes are not open to every company. The issuer has to be a start-up recognised by DPIIT, each investor has to put in at least ₹25 lakh in a single tranche, and the note has to be either converted into equity or repaid within ten years of issue. The iSAFE is India's version of the American SAFE. It takes the form of CCPS and carries neither a fixed maturity date nor an interest coupon; conversion happens only when a qualifying funding round or another agreed trigger event occurs. Founders are commonly told that these instruments make valuation unnecessary. That view is only partly right. What the Companies Act and FEMA actually do is push the valuation exercise to a later point in time. Neither statute removes the requirement altogether.
Legal Provisions
A. Companies Act, 2013
Section 2(31) of the Companies Act, 2013 defines “deposit” broadly to include “any receipt of money by way of deposit or loan or in any other form by a company.” This definition falls within Chapter V of the Act (sections 73–76), which regulates the acceptance of deposits by companies. Most start-ups are incorporated as private companies. Although section 76, which permits public deposit-taking, applies only to eligible public companies, private start-up companies may raise money through convertible notes without that sum constituting a “deposit,” provided the conditions under Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014 are satisfied. The receiving company must be a “start-up company” as defined in the DPIIT notification (G.S.R. 127(E), 19 February 2019). Money raised through a convertible note is excluded from the definition of “deposit” if the amount received from a single person in a single tranche meets or exceeds ₹25 lakh. Following the amendment of September 2020, the company has ten years from the date of issue within which the note must be converted into equity shares or repaid.
Share Issue Rules Applicable to Conversion and CCPS Issue
Section 62(1)(c) of the Companies Act, 2013 covers issues of further shares or convertible securities to persons who are neither existing shareholders nor employees under an ESOP.⁷ Where shares are issued by way of preferential allotment under this provision, section 42 conditions must also be satisfied. Those conditions are two: a special resolution passed by the shareholders, and a valuation report from a registered valuer who is independent of the company.
Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014 (“SCD Rules”) offers two mechanisms for determining the conversion price. Under upfront pricing, the conversion price for future equity is fixed at the time the convertible security is offered, supported by a report of a registered valuer. Under deferred pricing, the price is fixed within thirty days before the date of conversion, with the valuer's report obtained no earlier than sixty days before that date
Under Rule 9 of the SCD Rules, CCPS require explicit authorisation in the Articles of Association and a special resolution of the shareholders. Section 55(2) of the Act further mandates that the maximum tenure of such preference shares shall not exceed twenty years from the date of issue.
Section 62(3) of the Act provides that the procedures prescribed under section 62(1) including the valuation requirements do not apply to the increase of subscribed capital resulting from the exercise of a conversion option attached to existing loans or debentures. The proviso to that sub-section, however, stipulates that this exemption is available only where the terms of the loan or debenture, including the conversion option, were approved by a special resolution of the shareholders before the loan was raised or the debentures were issued.
B. FEMA
Foreign investors may access start-up companies through either a convertible note or a CCPS structured as iSAFE, and FEMA treats these two routes very differently.
“Convertible note” is defined in Rule 2(e) of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) as an instrument evidencing the receipt of money initially as debt, which is repayable at the option of the holder or convertible into equity shares. Rule 18 of the NDI Rules permits a person resident outside India to purchase a convertible note issued by a “startup company,” which Rule 2(an) defines as a private company recognised under the DPIIT notification.
Where the start-up’s sector falls under the government-approval route for foreign direct investment, prior government approval must be obtained. Shares issued on conversion of the note must comply with the applicable pricing guidelines. The Reserve Bank of India requires that Form CN be filed with the Authorised Dealer bank within thirty days of receipt of the investment amount. By the amendment of 12 April 2022 (G.S.R. 295(E)), the period available for conversion or repayment under Rule 2(e) was extended from five to ten years.
The iSAFE, being structured as CCPS, is treated as pure equity from the date of allotment under FEMA. Consequently, the limitations specific to convertible notes do not apply to it. The NDI Rules do, however, impose the following pricing conditions on CCPS
(i) the CCPS must be fully and compulsorily convertible into equity shares; if they are not, they are classified as external commercial borrowing;
(ii) the conversion formula must be fixed at the time of issue;
(iii) the conversion price may not be lower than the fair value of the shares at the time of issue, as determined by an internationally accepted method and duly certified; and
(iv) Form FC-GPR must be filed within thirty days of allotment.
C. Tax
The Finance (No. 2) Act, 2024 omitted section 56(2)(viib) of the Income-tax Act, 1961 with effect from Assessment Year 2025–26, thereby abolishing the “angel tax.” Separately, section 47 of the Income-tax Act, 1961 enumerates transactions that are not to be regarded as a “transfer” for the purposes of capital gains liability. Among these, section 47(x) provides that the conversion of bonds or debentures of a company into shares or debentures is not treated as a transfer, and section 47(xb) extends the same treatment to the conversion of preference shares into equity shares.
Legal Analysis
A. The Domestic Convertible Note: the Only Route Truly Avoiding Valuation
Section 62(1)(c), read with Rule 13 of the SCD Rules, requires that any issue of shares by way of preferential allotment be preceded by a special resolution and a report of a registered valuer. Section 62(3), however, exempts from these requirements any increase in subscribed capital resulting from the exercise of a conversion option attached to an existing loan or debenture, subject to the prior special resolution condition set out in its proviso. Since a convertible note involves the receipt of money initially as a loan, a domestic convertible note issued by a DPIIT-recognised start-up can, upon conversion, avoid the valuation requirement under the Companies Act. Under Indian law, no other financing structure achieves the same result.
B. The Narrow Gate
Residency of the investor does not feature in the Deposit Rules. It becomes important when the foreign person invests money, because FEMA and the NDI Rules then govern. Under the NDI Rules, convertible notes are available only to DPIIT-recognised start-ups (Rules 2(an) and 18(1)), subject to a minimum investment of ₹25 lakh per tranche, government approval where the sector requires it (Rule 18(2)), and Form CN filed within thirty days. Further, under Rule 18(2), shares issued on conversion of a foreign-held note must comply with the prescribed pricing guidelines. Accordingly, even a convertible note held by a foreign investor only postpones valuation; it does not eliminate it. The no-valuation route belongs exclusively to a DPIIT-recognised start-up that takes ₹25 lakh or more from a resident Indian investor in a single tranche. That is a narrow window.
C. iSAFE: Valuation Postponed, Not Removed
An iSAFE may be marketed as something new, but legally it is a CCPS, which makes it equity from the date of allotment. This matters because section 62(3) is limited to conversion options attached to loans and debentures and has no application to preference shares. For a domestic investor, section 62(1)(c) and Rule 13 of the SCD Rules therefore continue to apply in full. The company must fix the conversion price either when the offer is made or within thirty days before conversion, and in either case it needs a registered valuer’s report. Valuation is still required; it just happens later. Foreign money makes things harder. The NDI Rules require the price or the conversion formula to be fixed when the iSAFE is issued, and that price cannot be below the fair value of the shares on that date, so the company has to be valued before it receives the funds. A foreign-funded iSAFE thus requires valuation before the money even arrives. Practitioners call iSAFE a ‘pre-valuation’ instrument that is commercially convenient. But it does not change the legal position.
D. The ₹25 Lakh Threshold
An angel who wants to invest ₹5 to 10 lakh cannot do so through a convertible note. Founders raising cheques of that size have to use CCPS or an iSAFE, which brings valuation fees and regulatory filings at exactly the stage when the company can least afford them. The ₹25 lakh threshold is prescribed by the MCA in subordinate legislation rather than by the Companies Act itself.
This is not a novel concern. In Sahara India Real Estate Corp Ltd v SEBI, the Supreme Court refused to accept the issuer’s private placement label and treated an offer reaching fifty or more persons as a public issue. The same protective logic underlies the ₹25 lakh threshold.
E. Two Regulators, Two Timelines
The Ministry of Corporate Affairs extended the conversion or repayment period for convertible notes in the Companies (Acceptance of Deposits) (Amendment) Rules, 2020 from five to ten years with effect from 7 September 2020. The Department of Economic Affairs made the same amendment to the NDI Rules only on 12 April 2022, approximately nineteen months later. A convertible note of seven-year tenor issued to a foreign investor during this interval would have complied with the Companies Act but contravened FEMA.
F. Commercial Terms within Legal Limits
Valuation caps and conversion discounts appear in both instruments, and the law permits both. Where a foreign investor is involved, however, the NDI Rules set a floor that cannot be negotiated away, and the conversion price may not go below the fair value of the shares at the time of issue. If the discount is steep enough to bring the price below that floor, it would violate the NDI Rules. Thus, it could expose the company and its promoters to compounding proceedings under FEMA. The commercial terms have to work within the legal framework and not the other way round.
Case Laws
No Supreme Court judgment directly addresses the legality of convertible notes or SAFEs as financing instruments. What exists is a body of case law on hybrid instruments generally, and the principles those decisions establish apply here by analogy.
Sahara India Real Estate Corp Ltd v SEBI (2013) 1 SCC 1
Two Sahara group companies raised funds from roughly three crore persons by issuing optionally fully convertible debentures, presenting the exercise as a private placement. The Supreme Court rejected the characterisation outright. It held that an offer to fifty or more persons is a public issue under securities law- the investor protection framework applies regardless of the label attached by the issuer. The relevance of this judgment for the present discussion is that the legal characterisation of a financing instrument depends upon its substance, not upon the name given to it by its issuer. A founder who describes an instrument as a 'convertible note' or 'SAFE' does not, by that label alone, place the arrangement outside deposit law or FEMA.
Practical Implications: Choice of Instrument for the Founder
Situation | Suitable route | What it involves |
DPIIT startup, ₹25 lakh+ in one tranche, Indian investor | Convertible note | Special resolution before issue; conversion under s. 62(3), no valuation; convert or repay within 10 years |
Below ₹25 lakh, or no DPIIT recognition | CCPS / iSAFE | Avoids deposit risk; valuer's report under Rule 13, either at offer or near conversion |
Foreign investor, DPIIT startup, ₹25 lakh+ | Convertible note (FEMA route) | Form CN in 30 days; sector approval if needed; 10-year limit |
Foreign investor, any other case | CCPS / iSAFE | Fair value at issue; price or formula fixed upfront; FC-GPR in 30 days |
US-form SAFE | Avoid | Fits no Indian category; deposit and FEMA risk |
Conclusion
Only a domestic convertible note allows a round to close without any valuation at all, and it is available only to DPIIT-recognised companies raising ₹25 lakh or more from investors resident in India. Every other route, including iSAFE and foreign convertible notes, defers valuation exercise rather than eliminating it. A founder’s choice of instrument must therefore be guided by ticket size, investor residency, and DPIIT recognition status, rather than by the promise of “no valuation”.
Author: Apurva Damle in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney
End Notes
Companies Act 2013 (India), s 2(31).
ibid, ss 73–76.
ibid, s 76.
Companies (Acceptance of Deposits) Rules 2014 (India), r 2(1)(c)(xvii).
Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Notification No G.S.R. 127(E) (19 February 2019).
Companies (Acceptance of Deposits) (Amendment) Rules 2020 (India), G.S.R. 548(E) (7 September 2020).
Companies Act 2013 (India), s 62(1)(c).
ibid, s 42.
Companies (Share Capital and Debentures) Rules 2014 (India), r 13.
ibid, r 9.
Companies Act 2013 (India), s 55(2).
ibid, s 62(3).
Foreign Exchange Management (Non-Debt Instruments) Rules 2019 (India), r 2(e).
ibid, r 18.
ibid, r 2(an).
Foreign Exchange Management (Non-Debt Instruments) (Amendment) Rules 2022 (India), G.S.R. 295(E) (12 April 2022).
Finance (No 2) Act 2024 (India); Income-tax Act 1961 (India), s 56(2)(viib) (omitted with effect from Assessment Year 2025–26).
Income-tax Act 1961 (India), s 47(x).
ibid, s 47(xb).
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