Call and put option structure: A practical guide to investing in foreign-parented start-ups

Indian Alternative Investment Funds (AIFs), the SEBI-regulated vehicles that pool capital from sophisticated investors to invest in start-ups, venture-stage companies, and other alternative assets, have long sought exposure to the best Indian start-ups. In today's ecosystem, many of the most promising Indian start-ups operate through a 'flipped' structure: an Indian operating subsidiary (Indian Opco) is wholly owned by a foreign holding company (referred to here as the Foreign Entity). This 'flip' is often preferred by founders and global investors to facilitate international fundraising and potential overseas listings.

The challenge for Indian AIFs is straightforward: SEBI permits AIFs to invest overseas, but subject to aggregate industry-wide limits. As of today, that overseas investment limit is exhausted, meaning an AIF cannot simply write a cheque directly into the foreign entity without first obtaining SEBI's prior approval, a process that typically takes four to six months and carries no guarantee of success. In a fast-moving funding round, waiting six months is simply not an option.

To navigate this regulatory bottleneck, the Indian fund ecosystem has developed a widely used structural workaround: the call and put option structure.

At its core, the call and put option structure allows the AIF to invest in the Indian Opco (a domestic transaction requiring no SEBI overseas approval) while preserving, through a web of contractual rights, the economic and governance parity that the AIF would have enjoyed had it invested directly in the foreign entity.

Step 1 — Invest in the Indian Opco

The AIF subscribes to equity shares or compulsorily convertible preference shares (CCPS) of the Indian Opco. This is a routine, domestic investment transaction that requires no special regulatory approval (beyond sector-specific approvals, if applicable).

Step 2 — The call option

Contemporaneously, the parties execute a set of definitive agreements that embed a call option in favour of the foreign entity. A call option is a right, but not an obligation, granted to the foreign entity (or its designee) to purchase the AIF's Indian Opco shares at a pre-agreed price formula upon a specified trigger event, typically a Liquidity Event such as an IPO, M&A transaction, or secondary sale at the foreign entity level.

The key is the pricing formula. The consideration upon exercise of the call option is not a fixed number, it is computed to be economically equivalent to what the AIF would have received had it held shares in the foreign entity directly and participated in the same liquidity event. The mechanism that achieves this is the swap ratio: a pre-agreed ratio that determines how many foreign entity shares correspond to the AIF's Indian Opco shareholding, mirroring the economic exposure the AIF was intended to have.

Step 3 — The put option

A put option is the mirror right: it grants the AIF the right, but not the obligation, to require the foreign entity or the Indian Opco to purchase the AIF's Indian shares at the same economically equivalent consideration. The put option is typically exercisable in more scenarios than the call, not only on a liquidity event, but also upon events of default, material breach of representations, or failure to consummate an IPO within agreed timelines. It functions as the AIF's downside protection mechanism: if the promoters or the foreign entity do not honour their obligations, the AIF can compel a purchase of its position.

Step 4 — The swap right

As a third lever, the definitive agreements typically also grant the AIF a swap right: the right to exchange its Indian Opco shares for shares in the foreign entity, at the agreed swap ratio, subject to regulatory approvals (principally RBI approval under the Overseas Direct Investment framework). If and when SEBI/RBI restrictions ease, the AIF can convert its indirect exposure into a direct shareholding in the foreign entity, unlocking full statutory rights as a shareholder.

The call and put option structure is only as good as the contractual parity it creates. Well-negotiated definitive agreements will ensure the following:

Economic parity: Exit proceeds (whether via call, put, or swap) are calibrated using the swap ratio to mirror the per-share proceeds at the foreign entity level, adjusted for liquidation preferences, anti-dilution protections, and participation rights.

Governance parity: The AIF receives information rights, affirmative vote rights, and anti-dilution protections at the Indian Opco level that mirror its notional rights as a Foreign Entity investor. Critically, the AIF's deemed consent is often required for key decisions at the Foreign Entity level that would affect its economic position.

Tag-along and drag-along parity: These rights are structured to operate at the Indian Opco level but trigger in tandem with liquidity events at the Foreign Entity level, ensuring the AIF is neither forced into nor excluded from transactions on unfavourable terms.

The call and put option structure is a commercially established and market-accepted practice. However, it carries several legal risks that investors and their counsel must carefully evaluate.

Enforcement risk: The AIF's rights are purely contractual. They lack the statutory backbone of direct shareholding. Enforcing a put option against a US company from India, or vice versa, across two jurisdictions is time-consuming and expensive. The risk is best mitigated through offshore arbitration clauses, carefully chosen governing law, and specific performance obligations backed by asset nexus planning.

Regulatory recharacterisation: SEBI and RBI have historically taken a dim view of equity instruments that provide assured or minimum returns. A put option that effectively guarantees the AIF a fixed IRR over its invested capital could be recharacterized as a disguised debt instrument, potentially rendering the structure non-compliant with FEMA's pricing norms for equity. The put option must therefore be structured as a contingent right, not a guaranteed return mechanism.

Insolvency risk: The AIF holds shares of the Indian Opco, not the foreign entity. If the Indian Opco becomes insolvent before exit, the AIF's position ranks as equity, with all the associated subordination risk. This is a structural vulnerability that direct investment in the Foreign Entity would not carry.

Valuation disputes: The swap ratio, the cornerstone of the economic parity mechanism, is fixed at the time of investment. If the Indian Opco and the foreign entity diverge in value post-investment (due to, for example, a separate fundraise at the Indian Opco level), disputes on the exit consideration can arise. Robust, formula-based swap ratio definitions and waterfall alignment between the two entities are essential.

Tax inefficiency: Exit proceeds received by the AIF from the foreign entity (upon call option exercise) may attract Indian capital gains tax and risk double taxation depending on structuring. Tax advice is essential before implementation.

The call and put option structure is the most time-efficient solution for immediate investments. However, depending on the AIF's mandate and time horizon, three alternatives are worth evaluating:

IFSC fund (GIFT City): Setting up a fund in India's International Financial Services Centre at GIFT City allows direct investment in foreign entities without overseas investment limits, with significant tax concessions. The trade-off is setup time (three to six months) and compliance overhead.

SEBI approval for direct investment: The cleanest legal structure, with the AIF directly holding foreign entity shares with full statutory rights. However, the four-to-six-month approval timeline and valuation risk (the Foreign Entity may be worth significantly more by approval date) make this impractical for time-sensitive rounds.

OCRPS + simultaneous SEBI application: A hybrid approach where the AIF invests in optionally convertible redeemable preference shares of the Indian Opco while applying for SEBI approval in parallel. Capital is deployed and earning a preferred return while the approval process runs. The key risks are liquidity at the point of OCRPS redemption and the double regulatory burden.

The call and put option structure has emerged as the default solution for Indian AIFs seeking exposure to foreign-parented start-ups in a regulatory environment where direct overseas investment is constrained. When carefully implemented, with a clearly defined swap ratio, robust governance mirroring, well-drafted put option mechanics, and offshore dispute resolution, it is a commercially sound and market-accepted arrangement.

That said, it is not without risk. The contractual nature of the AIF's rights, the spectre of regulatory recharacterization and the complexity of cross-border enforcement demand careful legal and tax structuring. As the regulatory landscape around overseas investments by Indian AIFs continues to evolve, market participants will do well to keep a close watch on SEBI and RBI pronouncements in this space.

About the author: Akshay Kumar Mishra is a Senior Associate at SKS Advisor.

Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.

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