Convertible Notes for Startups

Convertible Notes for Startups: The Complete Legal, Tax and FEMA Playbook for 2026

A convertible note lets a DPIIT-recognised Indian startup borrow money from an investor today and repay that debt — not in cash, but in equity shares — at the next priced round. Because the note is legally excluded from the deposit rules under the Companies Act 2013, the startup avoids the heavy compliance burden of a full equity round while the investor gets a contractual discount or valuation cap as compensation for taking early risk. Done correctly, a convertible note round can close in three to four weeks. Done carelessly, it creates cap-table chaos that poisons your Series A.

What a Convertible Note Is — The Legal Foundation

A convertible note (CN) sits at the intersection of two regulatory frameworks. Under Rule 2(1)(c)(xix) of the Companies (Acceptance of Deposits) Rules, 2014, an instrument issued by a DPIIT-recognised startup that is repayable or convertible within 10 years of issuance is explicitly excluded from the definition of a "deposit." This exclusion matters enormously: it means the startup is not subject to the deposit-acceptance rules under Section 73 of the Companies Act, 2013, which would otherwise require cumbersome Credit Rating Agency assessments and mandatory deposit insurance.

On the foreign investment side, the FEMA Non-Debt Instruments Rules, 2019 treat a convertible note as a permissible instrument for a DPIIT startup to receive foreign funds, subject to the minimum subscription threshold and reporting obligations described later.

The practical definition: a convertible note is a written agreement under which the investor pays a lump sum to the company, the company acknowledges the amount as an instrument convertible into equity shares (equity, CCPS or a hybrid), and conversion is triggered by a qualifying priced round, a maturity date, or a change-of-control event. Until conversion, the amount either carries a coupon (interest) or does not, depending on the term sheet.

Minimum subscription per investor: Rs. 25 lakh in a single tranche. You cannot split a Rs. 25 lakh note into five tranches of Rs. 5 lakh each and remain within the regulatory exclusion. Each investor must write a single cheque of at least Rs. 25 lakh.

Who Can Issue a Convertible Note: The DPIIT Eligibility Gate

Convertible notes are not available to every startup. The issuing company must satisfy all of the following at the date of issuance:

• Incorporated as a Private Limited Company under the Companies Act, 2013 (LLPs cannot issue convertible notes under the DPIIT framework).
• DPIIT recognition is active and current — check your certificate's validity date on the Startup India portal. If your recognition has lapsed, even a day, you are outside the exemption.
• Incorporated within the last 10 years from the date of issue.
• Annual turnover not exceeding Rs. 100 crore in any prior financial year.
• Working towards innovation, improvement of products/services, or scalable business models.

If your company does not hold DPIIT recognition, you cannot issue a convertible note under this framework. Your alternatives are Compulsorily Convertible Debentures (CCDs) or Compulsorily Convertible Preference Shares (CCPS) — instruments that carry heavier documentation and valuation requirements but are available to any private company.

The Three Commercial Terms That Shape Every Deal

Every convertible note term sheet reduces to three numbers. Negotiate these right, and everything else follows.

1. Valuation Cap

The valuation cap is the maximum pre-money valuation at which the note converts into equity, regardless of what the next round's investors pay. If you raise at a Rs. 20 crore pre-money valuation and the cap is Rs. 8 crore, the convertible note holder converts as if the company were valued at only Rs. 8 crore — buying far more shares per rupee than the new investors.

Caps in Indian seed deals in FY 2026-27 typically run between Rs. 5 crore and Rs. 20 crore, depending on sector and traction. Set the cap too high and it provides the investor no real protection; too low and you are giving away material dilution before you have established value.

2. Discount Rate

The discount is a percentage reduction applied to the next-round share price. If Series A investors pay Rs. 10,000 per share and the note carries a 20% discount, the note holder converts at Rs. 8,000 per share. Market practice in 2026 sits at 15%–25%; notes that have been outstanding for more than 18 months sometimes carry a higher effective discount to compensate for extended holding.

Most agreements give the investor the better of cap and discount at conversion — whichever produces more shares.

3. Interest Rate and Maturity

The coupon is not equity return; it is compensation for the period between funding and conversion. Typical rates in 2026 bridge deals are 8%–12% per annum, often structured as simple interest accruing on the principal. At conversion, the accrued interest either converts alongside the principal (increasing the share count) or is paid out in cash at the option of the company.

Maturity dates of 18–24 months are standard. Include a clear fallback: if no qualifying round has occurred by maturity, the note should either auto-convert at the cap valuation or require a majority-investor vote to extend.

Worked Example: A Rs. 50 Lakh Bridge Round

Facts: EdTech startup, DPIIT-recognised, raises Rs. 50 lakh from a single angel investor in March 2026. Terms: valuation cap Rs. 8 crore pre-money; 20% discount; 10% p.a. simple interest; 24-month maturity; qualified financing threshold Rs. 3 crore.

Series A closes in October 2026 (7 months later) at Rs. 15 crore pre-money, raising Rs. 4 crore. At closing, the company has 1,00,000 shares outstanding.

Step 1 — Series A share price: Rs. 15,00,00,000 ÷ 1,00,000 = Rs. 1,500 per share

Step 2 — Accrued interest: Rs. 50 lakh × 10% × 7/12 = Rs. 2.92 lakh

Step 3 — Total converting amount: Rs. 50 lakh + Rs. 2.92 lakh = Rs. 52.92 lakh

Step 4 — Cap conversion price: Rs. 8,00,00,000 ÷ 1,00,000 = Rs. 800 per share

Step 5 — Discount conversion price: Rs. 1,500 × (1 − 20%) = Rs. 1,200 per share

Step 6 — Investor takes the better of cap and discount: Rs. 800 < Rs. 1,200 → cap applies

Step 7 — Shares allotted: Rs. 52,92,000 ÷ Rs. 800 = 661.5 shares → rounded per agreement to 661 shares

Counterfactual: The same Rs. 52.92 lakh invested at the Series A price (Rs. 1,500) would have purchased only 353 shares. The cap delivered 308 additional shares — an 87% premium. This is the economic logic that makes convertible notes attractive to early angels willing to take on pre-revenue risk.

Convertible Note vs. CCPS vs. CCD: Choosing the Right Instrument

The core reason founders choose convertible notes over CCPS is speed and the absence of an upfront valuation exercise. CCPS requires a valuation certificate from a SEBI-registered merchant banker or a CA with the relevant certificate, which takes time and money. When you need Rs. 50 lakh to meet payroll while you close a larger round, a 4-week CCPS process is not useful. The convertible note closes in days once the term sheet is agreed.

Step-by-Step: Issuing a Convertible Note (Domestic Investors)

1. Confirm DPIIT recognition — verify on the Startup India portal that your certificate is active. Download a copy and attach it to the board pack.
2. Board resolution — pass a resolution authorising the issue, specifying the maximum amount, terms (cap, discount, interest, maturity) and authorising a director to sign the agreement. File nothing yet.
3. Shareholders' special resolution — under Section 42 (private placement) and Section 62(1)(c) of the Companies Act, 2013, if the note is convertible into equity above the authorised share capital limit or beyond the scope of existing shareholder authority, a special resolution (passed at an EGM or through postal ballot) is required before taking in money.
4. Execute the convertible note agreement — both parties sign; the investor transfers funds only after execution.
5. Receive funds — funds must be received in the company's bank account (not founders' personal accounts).
6. File Form PAS-3 — on conversion of the note into shares (not at the time of taking money), the company must file the Return of Allotment in Form PAS-3 on MCA V3 within 30 days of allotment (or 15 days if issued via private placement route under Rule 14(3)). Late filing attracts an additional fee of Rs. 100 per day of delay beyond the prescribed period.

FEMA Compliance When Your Investor Is Non-Resident

If any single investor is a foreign national, a Non-Resident Indian (NRI) on a non-repatriable basis, or a foreign entity, the transaction enters FEMA territory.

Form CN on the FIRMS Portal: Under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, the startup must report the receipt of convertible note proceeds through the FIRMS (Foreign Investment Reporting and Management System) portal in the prescribed format (commonly referred to as Form CN or the convertible note reporting format under the Single Master Form regime). The deadline is 30 days from receipt of funds.

What you need to file: investor details, instrument terms, amount received, bank account details, and a copy of the executed convertible note agreement.

Pricing freedom: unlike CCPS, there is no mandatory Discounted Cash Flow (DCF) or comparable transaction valuation at the time of issuance. Pricing is set by the commercial terms (cap, discount). Valuation is determined only at conversion, and at that point the conversion price must be not less than the fair value as determined by a SEBI-registered merchant banker or chartered accountant — consistent with the pricing guidelines under the NDI Rules.

Failure to file Form CN on time is a FEMA violation. Delays are compounded under the FEMA Compounding Rules — the compounding fee is calculated on the unreported amount and the duration of default. File on time; set a calendar reminder the day you receive funds.

Tax Treatment: What Founders and Investors Both Need to Know

Interest Deductibility for the Company

Interest paid or payable on a convertible note is a business expenditure under Section 36(1)(iii) of the Income-tax Act, 1961, deductible in the year it is paid (cash basis for most startups) or accrued (if mercantile accounting is used). However, interest accrued but not paid during FY 2026-27 will be disallowed under Section 43B unless actually paid before the filing of the tax return for AY 2027-28.

TDS Obligations

If the investor is a resident individual and the interest payable exceeds Rs. 5,000 in a financial year, the company must deduct TDS at 10% under Section 194A before making payment. Missing TDS makes the startup liable for the disallowance of the interest deduction plus interest and penalty under Sections 201 and 271C. Many early-stage founders overlook this because the amount seems small — do not.

No Capital Gains on Conversion for the Investor

When the note converts into equity shares, the investor does not recognise a capital gain at that point. Section 47(xb) of the Income-tax Act excludes the conversion of a bond or debenture (including an instrument treated as such) of a company into shares of the same company from the definition of "transfer." Capital gains arise only when the investor subsequently sells those shares, at which point the cost of acquisition is the original amount paid for the convertible note (principal + any interest that was capitalised into equity).

Accounting Classification

Under Ind AS 32 and Ind AS 109, a convertible note with a fixed conversion rate is classified as equity; a note converting at a variable price (discount-to-next-round pricing) may be classified as a financial liability, with the conversion feature as an embedded derivative. Your statutory auditor will test this classification at each year-end. Get clarity from your auditor before you issue the note, not after. The difference between equity and liability classification materially affects your balance sheet leverage ratios.

Common Mistakes That Derail Convertible Note Deals

1. Letting DPIIT recognition lapse before closing. DPIIT certificates have validity tied to the startup's age and turnover thresholds. If it expires between term sheet and closing, you are outside the deposit exemption. Check the certificate's current status every time you are about to issue.

2. Stacking uncapped notes. Multiple notes with no caps, issued at different times with different discounts, create a conversion pile-up at the next round that is impossible to model cleanly. Institutional Series A investors frequently demand that all outstanding convertible notes be capped and standardised as a condition of term sheet. Fix this before you need to.

3. Skipping the shareholders' special resolution. Founders assume a board resolution is enough. It is not. Section 42 private placement requires a prior special resolution. Doing a post-facto resolution to regularise the issue is possible but messy and leaves the allotment technically invalid until regularised.

4. Missing the FIRMS CN deadline. Thirty days disappears quickly during a busy fundraise. One founder receives funds on day one, issues a term sheet to the next investor on day five, and files Form CN only on day 45 because "the CA was busy." The RBI compounding process is survivable but avoidable. Build the filing into your closing checklist.

5. No qualified financing threshold definition. If the agreement simply says "converts at the next equity round," a Rs. 10 lakh friends-and-family round technically triggers conversion — often at an absurdly low price. Define qualified financing as a minimum amount (e.g., Rs. 3 crore) raised from institutional or lead investors in a priced round.

6. Ignoring TDS on interest payments. A Rs. 50 lakh note at 10% generates Rs. 5 lakh of interest per year. TDS at 10% = Rs. 50,000 to deduct and deposit before the 7th of the following month. Small number, real penalty for non-compliance.

Drafting the Convertible Note Agreement: Eight Clauses You Cannot Skip

A well-drafted convertible note agreement is 12–18 pages. It should contain:

1. Defined conversion events — automatic conversion on qualified financing, optional conversion at investor's discretion, mandatory conversion at maturity fallback.
2. Conversion price formula with an annexed worked example — ambiguity here is litigation risk at Series A.
3. Qualified financing definition — minimum round size, lead-investor requirement, and minimum implied post-money valuation.
4. Most-Favoured-Nation (MFN) clause — if you issue subsequent notes to other investors at better terms before conversion, earlier investors step up to those better terms automatically.
5. Change-of-control provision — on an acquisition before conversion, the investor either receives a cash return (typically 1x–2x principal) or converts at the cap valuation.
6. Information rights — quarterly financials, annual audited accounts, and the right to attend board meetings as an observer (not a member).
7. Anti-dilution mechanics on down-rounds — weighted-average broad-based anti-dilution, not full ratchet, is the market standard.
8. Statutory filing covenants — an express obligation on the company to file Form PAS-3 within the statutory deadline and Form CN within 30 days of receipt. This gives the investor a contractual remedy if the company is slow.

Key Takeaways

• DPIIT recognition is the gate — verify your certificate is active before taking any money. Without it, the deposit exemption disappears and you face a regulatory violation, not merely a filing delay.
• The economics live in three numbers: valuation cap, discount rate, and interest rate. Model all three against your next-round scenario before agreeing to terms.
• The Rs. 25 lakh minimum per investor is non-negotiable under the regulatory framework — do not split tranches to accommodate smaller cheques.
• Form CN on the FIRMS portal is due within 30 days of receipt of foreign funds — missing this deadline triggers FEMA compounding. Build the filing into your wire-receipt checklist.
• Form PAS-3 is filed at conversion (allotment), not at issuance — within 15–30 days of the allotment date depending on the route; late filing costs Rs. 100 per day in additional MCA fees.
• Section 47(xb) protects the investor from capital gains tax at conversion — gains crystallise only on the eventual share sale, with cost of acquisition being the original note amount.
• Stacked uncapped notes destroy your Series A negotiation — cap every note, define qualified financing with a minimum round size, and insist on an MFN clause so your early investors are protected against better-deal latecomers.