Convertible Notes vs. SAFE Agreements: What Works Under Indian Law

Convertible notes and SAFE (Simple Agreement for Future Equity) agreements have become popular instruments for early-stage fundraising in the US startup ecosystem. Indian startups and investors have increasingly sought to use similar instruments. However, the regulatory framework in India creates specific constraints that affect how these instruments can be structured and used.

What Is a Convertible Note

A convertible note is a debt instrument that converts into equity at a future date, typically on the occurrence of a qualifying financing round or at a maturity date. The investor lends money to the company, which is repayable if no conversion event occurs. The key economic terms are the principal amount, the interest rate, the conversion discount (a reduction in the price paid by the noteholder on conversion compared to the price paid by new investors in the qualifying round), and the valuation cap (a ceiling on the valuation at which the note converts, protecting the noteholder from excessive dilution if the company's valuation has risen sharply by the time of the next round).

The Indian Regulatory Position on Convertible Notes

The RBI and FEMA framework governs how foreign investment can be made into Indian companies. Prior to 2017, convertible notes issued to foreign investors were in a regulatory grey area, because they are debt instruments that convert into equity and did not fit neatly into either the ECB (external commercial borrowing) framework or the FDI framework.

The DPIIT and RBI clarified the position in 2017 by permitting Indian startups that satisfy the DPIIT recognition criteria to issue convertible notes to foreign investors. The key conditions are that the startup must be recognised by the DPIIT, the convertible note must have a minimum investment of Rs. 25 lakh from a single investor in a single tranche, and the note must convert into equity or be repaid within five years from the date of issue.

SAFE Agreements in India

SAFE agreements, developed by Y Combinator in the US, are not debt instruments. They are agreements that give the investor the right to receive equity in a future financing round, without the company incurring a present debt obligation. They have no interest rate and no maturity date in the traditional sense.

The challenge with SAFE agreements in India is that they do not fit into the existing FEMA framework for either debt or equity. They are not ECBs, because there is no debt obligation. They are not FDI, because shares are not being issued at the time of investment. This creates regulatory uncertainty about how inbound foreign investment via a SAFE should be reported and classified.

In practice, some Indian startups have used SAFE-like instruments with foreign investors, but the regulatory position has not been definitively clarified by the RBI, and there is a risk that such investments may be treated as non-compliant with FEMA. Startups considering this structure should take careful legal advice on the current regulatory position and the reporting obligations.

Domestic Convertible Instruments

For purely domestic investment (Indian investors investing in Indian companies), the Companies Act framework applies rather than FEMA. Convertible instruments issued to domestic investors must comply with the provisions of the Companies Act relating to issue of securities and the rules made thereunder. The terms must be set out in the instrument and appropriate board and, where required, shareholder approvals must be obtained before the instrument is issued.

Which Structure Works Best

For foreign investment into DPIIT-recognised startups, a properly structured convertible note is the cleaner instrument from a regulatory perspective. For domestic investment, both convertible notes and SAFE-like instruments can be used, subject to compliance with the Companies Act requirements. For companies that have not obtained DPIIT recognition, foreign investment at the early stage is typically better structured as a priced equity round, even if small, to avoid the FEMA complications associated with convertible instruments.