Convertible notes and SAFE notes in India: The dilemma

At times, the founders fail to appreciate that a US-form SAFE (Simple Agreement for Future Equity) is not legally recognized in India and can lead to violation under FEMA or the Companies Act (it can be treated as a “Deposit”). The commercial consequence - founders arriving at a Series A with instruments outstanding that were issued without adequate structuring, which must be regularised before the next round can close.

This piece examines gaps between SAFE and Indian laws. The Indian market has developed two workable responses to the demand for deferred-valuation instruments.

The iSAFE

The iSAFE (India Simple Agreement for Future Equity, "iSAFE"), which is generally in the form of Compulsorily Convertible Preference Shares ("CCPS"), convertible into equity shares at a certain valuation upon a qualifying event- a priced financing round, a liquidity event, or the expiry of a defined period. CCPS is a recognised instrument under the Companies Act and thus iSAFE operates legally.

iSAFE is merely a nomenclature and can be either in the form of CCPS or Compulsorily Convertible Debentures ("CCDs"), provided that both must be compulsorily converted into equity shares and cannot be redeemed. Where redemption option is required, the instrument can be in the form of Convertible Notes (as discussed below) or Optionally Convertible Preference Shares ("OCPS") or Optionally Convertible Debentures ("OCDs"). OCPS and OCDs cannot be subscribed to by a foreign investor under the standard FDI route.

For iSAFE instruments, the company’s authorised capital may need to be increased, investors do not hold voting rights same as equity shares, does not require a fixed pre-money or post-money valuation apart from the valuation for CCPS issuance, which makes it attractive in early rounds where valuation is genuinely contested. In case of foreign investors, FEMA laws apply, which must be addressed at the issuance and not later.

Convertible Notes

Convertible Note ("CN") is recognized under the Companies Act and NDI Rules with certain restrictions:

- Only startups recognised by the Department for Promotion of Industry and Internal Trade ("DPIIT") may issue CNs;

- Minimum investment is Rs. 25,00,000 per investor in a single tranche;

- Must be converted or repaid within 10 years of issuance.

Until conversion, the CN is recognised as debt in the books of the company and must comply with reporting rules under FEMA.

Both these instruments are helpful when valuation is to be deferred, but real challenge lies in arriving at an accurate cap table reflecting the fully diluted shareholding at the priced round.

In their eagerness to close the current round at a deferred valuation, founders often fail to appreciate the mechanics at each end of the cap spectrum, i.e., what happens to agreed lower and higher cap in unpriced round when it is required to be converted in a priced round wherein the valuation of the priced round is either higher or lower than the cap agreed in an unpriced round. If the priced round is higher, the early investors benefit and founders suffer as conversion has taken place lower than the priced round and vice versa. It becomes more tricky where there is anti-dilution protection to the investor because of the which the lower cap may be adjusted depending upon if it is full ratchet or weighted average in case of down round. FEMA presents more complexity in converting to equity shares at a price below FMV depending on whether the instrument is CCPS or CN. The stacking of multiple unconverted instruments across sequential pre-priced rounds compounds this further. Each instrument carries its own cap, discount, and conversion terms. When conversion is triggered, typically at a priced round, the cumulative effect across tranches issued at different times, with different caps and sometimes different conversion mechanics, can produce a cap table at conversion that founders did not foresee when each individual instrument was issued.

In case of CN, if the qualified event (such as priced round etc.) for conversion has not occurred till the contractually agreed maturity date, the investor may require repayment of the investment amount unless some remedies have been negotiated upfront. A provision commonly overlooked by founders is the Most Favoured Nation clause wherein a subsequent instrument issued on better terms, being a lower cap, a larger discount, or additional investor protections, automatically updates the earlier holder's terms to match.

The investor's position on maturity carries its own complexity especially for liquidity and tax concerns. An instrument that converts at an unexpected valuation, on a unplanned timeline or with transfer restrictions that were overlooked at entry, can produce different outcomes as originally, not because the instrument malfunctioned, but because detailing was not done at the beginning.

The pricing at conversion is one of the most consistently misunderstood aspects of these instruments. FEMA provides that the conversion price for equity instruments cannot be lower than the FMV of the shares at the time the instrument was issued, not at the time of conversion. The angel tax position requires specific attention if the startup is not registered with DPIIT because if the instrument converts at a price implying a valuation above FMV, the premium may be treated as additional income of the company under the tax laws.

The terms of both these instruments are different for Resident and non-resident investors which have implications under FEMA and Companies Act.

The conversion trigger is the provision that is of utmost importance and receives the least attention. Both these instruments convert on a "qualified financing event," but if not defined properly, or some bridge round inbetween that is not factored, it may lead to utter chaos about whether conversion has been triggered.

The problems in these documents are overlooked until they surface in due diligence in Series A, which is entirely avoidable if the structuring is done correctly at the outset. These questions are best addressed at the term sheet stage.

About the authors: Madhavan Srivatsan is a Senior Partner at Emerald Law Offices.

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

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