Convertible Notes for Indian Startups: RBI Relaxation, Process

What is a Convertible Note?

A Convertible Note (CN) is a debt instrument where the lender has the option (or obligation) to convert the loan into equity shares of the company at a future date or upon a triggering event (next equity round, IPO, etc.).

Until conversion, CN is a loan with interest. Upon conversion, the lender becomes a shareholder.

RBI relaxation for DPIIT startups

For DPIIT-recognised startups, RBI has relaxed FEMA rules to allow Convertible Notes:

• Foreign investors can invest via CN in DPIIT-recognised startups (otherwise CNs face FEMA restrictions)
• Minimum investment: ₹25 lakh per investor per tranche
• Maximum tenure: 5 years — Must convert to equity OR be repaid within 5 years
• Conversion price: As per pre-agreed formula (discount, cap)
• Pricing guidelines applicable at conversion (FEMA fair value norms)
• Reporting: File CN intake separately (Form CN — similar to FC-GPR)

Structure and key terms

• Principal amount: Investment amount
• Interest rate: Typically 8-12% p.a. (accrued, not necessarily paid)
• Maturity date: 18-36 months typical
• Conversion trigger: Next priced equity round of ≥ certain size (e.g., ₹2 crore)
• Valuation cap: Max valuation for conversion calculation
• Discount: 15-25% on next round price
• Default conversion: If no equity round happens before maturity, convert at predetermined price OR repay

Process for issuance

1. Pass Board Resolution approving CN terms
2. Pass Special Resolution at EGM (75% shareholder approval)
3. File MGT-14 within 30 days of special resolution
4. Execute CN agreement with investor
5. Receive funds in company bank account (dedicated separate account if multiple investors)
6. File MCA Form PAS-3 / PAS-5 as applicable
7. For foreign CNs: File Form CN with RBI within 30 days
8. Account in books as 'Convertible Note Liability' (debt)

Conversion event

When CN converts (typically at next equity round):

1. Compute conversion price using formula (cap, discount)
2. Calculate number of shares to issue
3. Pass Board resolution approving conversion
4. Allot shares — File PAS-3 within 30 days
5. For foreign investor: File FC-GPR for converted shares within 30 days
6. Remove CN liability from books; create equity in books
7. Issue share certificates to investor

Tax implications

• For startup (issuer): CN is debt; interest paid is tax-deductible business expense. Conversion is not taxable event.
• For investor: Interest received is taxable. Conversion to equity is not a taxable transfer (Section 47(x)). Capital gains arise when equity is sold later.
• Discount on conversion: Generally NOT taxed at conversion time (in India). Tax arises at sale of equity.