Guide on Convertible Notes

Guide on Convertible Notes for DPIIT Startups: 2026 Edition

A convertible note issued by a DPIIT-recognised Indian startup is a debt instrument that automatically converts into equity shares on a qualifying funding round — or is repaid at maturity. Under Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014, the minimum ticket is ₹25 lakh in a single tranche, the maximum tenure is ten years, and the instrument sits outside the definition of a "deposit," which keeps the heavy Section 73–76 compliance at bay. Foreign investors access the same structure through Regulation 9A of the FEMA Non-Debt Instruments (NDI) Rules, 2019, with reporting via Form CN.

Who Can Issue a Convertible Note — and Who Cannot

Not every startup can issue a convertible note. The issuing entity must be DPIIT-recognised at the date of issuance. That single requirement carries a chain of conditions.

DPIIT Eligibility Checklist

To hold a valid DPIIT recognition in FY 2026-27, your entity must satisfy all of the following:

• Incorporated or registered as a private limited company, a registered partnership firm, or an LLP in India
• Not more than ten years have elapsed since the date of incorporation or registration
• Annual turnover has not exceeded ₹100 crore in any previous financial year
• Working towards innovation, development, or improvement of products, processes, or services — or a scalable business model with high employment or wealth-creation potential
• Not formed by splitting or reconstructing an existing business

A sole proprietorship or an unregistered partnership cannot issue a convertible note. A public company cannot issue one either. If your company turned 11 years old last month or crossed ₹100 crore in turnover, the convertible note exemption no longer applies — and the funds you raise could be reclassified as deposits, attracting penalties under Section 73(3) that reach ₹10 crore for the company plus an obligation to repay with 18% interest per annum.

What DPIIT Recognition Protects You From

Recognition gives you two critical protections when issuing convertible notes: (a) the instrument is explicitly carved out of the deposit definition, avoiding procedural overheads of Section 73–76, and (b) it gives you access to the angel-tax safe harbour under Section 56(2)(viib) of the Income-tax Act, 1961 (discussed in detail below). Maintain your recognition certificate, and renew the annual self-declaration on the Startup India portal — lapses in recognition are not cured retroactively.

The Anatomy of a Convertible Note: From Term Sheet to Conversion

Issuance Phase

The sequence in practice is:

1. Parties sign a term sheet covering principal, nominal interest rate (often 6–8% p.a. or zero), valuation cap, discount rate, qualifying-financing threshold, and maturity date.
2. The investor wires funds. At this stage, no shares change hands — the company receives debt, not equity.
3. The board passes a resolution acknowledging the instrument and records it under the convertible notes register.
4. For a non-resident investor, the company's AD Category-I bank files Form CN with the Reserve Bank of India within 30 days of receipt of funds, along with a KYC report and the convertible note agreement. This step is non-negotiable and is commonly missed by founders dealing with their first foreign angel.

Conversion Phase: Cap vs. Discount Rate — Understanding the Mechanics

Two levers determine how many shares the note holder receives at conversion:

Valuation cap — the maximum pre-money valuation at which the note converts, regardless of how high the Series A valuation goes. If the cap is ₹8 crore and the Series A is priced at a ₹12 crore pre-money, the note converts as if the company were worth ₹8 crore.

Discount rate — a percentage reduction from the Series A share price. A 20% discount on a ₹12-per-share Series A gives the note holder a conversion price of ₹9.60 per share.

Standard practice: the note converts at whichever price is lower, maximising the note holder's return for taking early risk.

Maturity: Fallback Scenarios

If no qualifying round occurs by the maturity date:

• Repayment in cash — the principal (plus accrued interest if any) is returned.
• Extension by mutual consent — requires a written amendment; do not let this lapse verbally.
• Conversion at a fallback valuation — a pre-agreed formula, often a capped discount to the last valuation report from a registered valuer.

Under the Companies (Acceptance of Deposits) Rules, the maximum tenure is ten years. You cannot contractually extend beyond that without restructuring the instrument.

Worked Example: ₹50 Lakh Note Converting in a Series A

Facts:

• Startup Trikona Analytics Pvt. Ltd. raises ₹50,00,000 from an angel investor via a convertible note in July 2025.
• Terms: 7% p.a. interest, ₹8 crore valuation cap, 20% discount, maturity July 2035.
• Qualifying financing defined as: equity round of ₹1 crore or more.
• Trikona raises a Series A of ₹2 crore at a ₹12 crore pre-money valuation in April 2027.
• At the time of Series A, there are 1,00,000 equity shares fully diluted.

Step 1 — Calculate the Series A share price: ₹12,00,00,000 ÷ 1,00,000 shares = ₹1,200 per share

Step 2 — Calculate the cap-implied price: ₹8,00,00,000 ÷ 1,00,000 shares = ₹800 per share

Step 3 — Calculate the discount-implied price: ₹1,200 × (1 − 0.20) = ₹960 per share

Step 4 — Apply the lower of the two: ₹800 < ₹960 → the note converts at ₹800 per share.

Step 5 — Calculate shares issued to the note holder: Principal ₹50,00,000 + accrued interest (7% × ~21 months ≈ ₹6,13,699) = ₹56,13,699 ÷ ₹800 = 7,017 shares (rounded per the agreement).

A Series A investor putting in the same ₹56 lakh at ₹1,200 per share would receive only 4,678 shares. The note holder's early-risk reward is the 2,339 additional shares — roughly 33% more equity for the same rupee amount.

After conversion, Trikona must:

• Allot the 7,017 equity/CCPS shares and file Form PAS-3 with the Registrar of Companies within 30 days of allotment.
• If the angel investor is a non-resident, file Form FCGPR with the AD bank within 30 days of the allotment date.
• Obtain a valuation report from a SEBI-registered merchant banker or registered valuer supporting the conversion price of ₹800 per share — this is the documentary anchor for angel-tax safe harbour.

Regulatory Compliance: The Three Filings Founders Most Often Delay

Form CN — FEMA Reporting on Receipt of Foreign Investment

When a non-resident investor wires money into a convertible note, the startup's AD Category-I bank submits Form CN to the RBI within 30 days. The form captures the investor's identity, source of funds, sectoral classification, and note terms. Failure to file in time attracts FEMA compounding proceedings — the penalty is computed by the RBI's compounding matrix and is typically a function of the amount involved and the delay period. Even a modest ₹25 lakh note can generate compounding fees in the range of ₹50,000–₹2,00,000 for a 6-month delay; larger notes compound more steeply. File on time, not retrospectively.

Form PAS-3 — Return of Allotment Under the Companies Act

On conversion and allotment of shares (equity or preference), the company must file Form PAS-3 on the MCA V3 portal within 30 days of the date of allotment. The filing includes the list of allottees, number of shares, consideration, and the board resolution. Late filing attracts additional fees under the MCA's progressive fee structure, and persistent defaults can invite scrutiny of the entire note issuance.

Form FCGPR — Foreign Currency Transaction Reporting on Conversion

For a non-resident note holder, conversion into shares triggers a fresh FEMA reporting event. Form FCGPR is filed through the AD bank within 30 days of allotment. It includes the valuation certificate, the KYC of the investor, and evidence that the sectoral FDI cap has not been breached. Mismatches between the Form CN amount and the FCGPR consideration (because interest has accrued) should be reconciled explicitly in the covering letter.

Angel Tax and Section 56(2)(viib): Where Risk Remains in 2026

Finance Act 2024 significantly rationalised Section 56(2)(viib). DPIIT-recognised startups with a valid notification under the DPIIT angel-tax exemption are protected: the excess of the consideration received for shares over Fair Market Value (FMV) is not taxable in the hands of the company. This safe harbour covers both resident and, as clarified post-2023, eligible non-resident investors.

The risk re-emerges at conversion, not at issuance. When the note converts at ₹800 per share (as in our example) and the Series A FMV determined by the merchant banker is also ₹800, there is no excess consideration — no angle tax exposure. But if a valuation report is not obtained before conversion, the Assessing Officer can determine FMV independently, potentially creating a deemed income in the hands of the company for AY 2027-28 or the relevant assessment year.

Practical rule: commission the valuation report before you issue the board resolution for conversion, not after. The report must use either the DCF method or the Net Assets Value method as prescribed under Rule 11UA of the Income-tax Rules, 1962, and must be from a SEBI-registered merchant banker (for unlisted companies without specified asset backing) or a registered valuer.

Term Sheet Clauses That Decide Real Outcomes

Qualifying Financing Definition

This is the clause most founders draft loosely. Define "qualifying financing" as a specific minimum equity raise — for example, "a bona fide equity or CCPS round raising at least ₹1,00,00,000 from investors who are not existing shareholders." Without a floor, a ₹5 lakh friends-and-family top-up can technically trigger conversion, forcing the cap-table waterfall before you are ready.

Most Favoured Nation (MFN) Clause

An MFN clause entitles early note holders to automatically adopt the more favourable economic terms of any subsequent convertible note issued within a defined period — typically 12 to 18 months. For example, if you offer the next note holder a lower cap (₹6 crore instead of ₹8 crore), MFN holders can elect to step down to ₹6 crore.

MFN clauses are investor-friendly and market standard for early-stage notes. The founder's protection is the sunset provision — MFN typically expires on the earlier of (a) the qualifying financing or (b) a fixed date. Ensure the sunset is included; without it, an MFN clause technically survives indefinitely.

Pro-Rata Rights

Pro-rata rights give the note holder the right to participate in a future equity round up to their then-current percentage ownership. These rights are negotiable and matter more as the company matures. For a seed-stage ₹25–50 lakh note, founders often resist pro-rata rights; institutional note holders at ₹1–5 crore will typically insist.

Interest Treatment at Maturity or Conversion

Decide upfront whether accrued interest (a) converts into shares alongside principal, (b) is paid in cash at conversion, or (c) is waived on a qualifying financing. Each treatment has tax implications for both parties. Conversion of interest into shares is the most common approach — it preserves the startup's cash — but increases the note holder's share count, which must be modelled in your cap table.

Conversion on Liquidation Event

If the startup is acquired before a qualifying financing, does the note convert at the cap or is it repaid? Founders typically prefer repayment (at 1× non-participating); investors prefer conversion into equity to participate in the acquisition proceeds. Resolve this scenario in the note itself, not during M&A due diligence when leverage is asymmetric.

Common Mistakes and Pitfalls to Avoid

1. Issuing below ₹25 lakh. A note for ₹20 lakh from a single investor does not qualify under Rule 2(1)(c)(xvii) and may be characterised as a deposit. Split tranching across dates with the same investor to reach ₹25 lakh does not cure this — the rule requires ₹25 lakh in a single tranche.

2. Skipping DPIIT confirmation before issuance. Recognition certificates lapse or are suspended if the startup violates eligibility conditions after recognition. Verify your status on the Startup India portal the week before closing, not the month before.

3. Stacking notes with mismatched caps and no MFN sunset. Three notes at ₹8 crore, ₹6 crore, and ₹5 crore caps, all with open-ended MFN, means every holder ratchets down to ₹5 crore on conversion — a surprise dilution event that can make your Series A terms effectively unfundable if the cap is too low relative to current valuation.

4. Missing the 30-day Form CN window. Founders often assume the investor's CA handles FEMA reporting. The obligation is the company's, executed through its AD bank. Set a calendar reminder the day funds arrive.

5. Failing to get a valuation report before conversion. Angel-tax safe harbour is conditional on proper documentation. A post-conversion valuation report does not cure this — the contemporaneous evidence requirement is strict.

6. Using a US SAFE template. A SAFE is not recognised under Indian company law. If you issue an instrument titled "SAFE" in India, a court may treat it as either an unregistered debenture or an unenforceable agreement. Use an Indian-law convertible note agreement drafted against the Companies Act and FEMA framework.

7. Leaving the "fallback valuation" blank. If your maturity scenario is "convert at a valuation to be mutually agreed," you have no enforceable fallback. Specify a formula: for example, "the lower of the last external valuation or ₹X crore, as certified by a registered valuer at the time of maturity."

Convertible Note vs. CCPS vs. SAFE: Matching the Instrument to the Round

Compulsorily Convertible Preference Shares (CCPS) become the dominant instrument once you cross ₹5–10 crore because institutional investors (VCs, AIFs) need statutory liquidation preference, anti-dilution ratchets, and board representation rights that are harder to enforce through a note agreement alone. The procedural overhead — special resolution, Form SH-7, stamp duty — is worth paying for larger cheques.

Compulsorily Convertible Debentures (CCDs) are similar to CCPS in protection level, commonly used in debt-heavy structures and for structuring FEMA-compliant investments in sectors with FDI caps, because the foreign investment caps on debt instruments differ from equity caps in certain sectors.

For your first ₹25 lakh to ₹2–3 crore, the convertible note is genuinely the right tool: fast to close, cheap to document, and regulation-light when properly structured. Do not force CCPS on an angel investor who wants simplicity, and do not force a convertible note on a Series A institutional investor who needs covenant protection.

Key Takeaways

• DPIIT recognition is the on/off switch. Without it, the instrument may be a deposit, and the penalties under Section 73 are severe. Confirm recognition on the portal before every issuance.
• ₹25 lakh in a single tranche is a hard statutory floor — it cannot be constructed via multiple tranches from the same investor.
• The cap and discount together determine dilution. Run the numbers across multiple Series A valuation scenarios before you sign. A ₹5 crore cap on a company now worth ₹4 crore feels founder-friendly; a year later at ₹20 crore it can be painfully dilutive.
• Form CN (FEMA, within 30 days) and Form PAS-3 (Companies Act, within 30 days of allotment) are non-negotiable filings — both are the startup's responsibility, not the investor's.
• Get the valuation report before conversion, not after. This is the single most important step for protecting the angel-tax safe harbour under Section 56(2)(viib) for AY 2027-28 and beyond.
• MFN clauses without a sunset can cascade. Every subsequent note at a lower cap resets earlier holders to that lower cap. Build in a clear expiry date for MFN rights.
• Use Indian-law documentation. A US SAFE agreement has no statutory footing under the Companies Act 2013 or FEMA NDI Rules and will not survive due diligence by an institutional investor at your Series A.