What are Convertible Notes?
A convertible note is a short-term debt instrument that converts into equity (typically preferred shares) at a later date, usually upon the company's next qualified financing round. It allows startups to raise capital quickly without immediately determining a valuation.
Popularized in Silicon Valley and spread through Y Combinator's SAFE (Simple Agreement for Future Equity) and convertible note templates, this instrument has become a standard for seed-stage fundraising. In India, the regulatory equivalent is the Compulsorily Convertible Debenture (CCD).
Key Characteristics
- • Debt First: Starts as a loan with interest and maturity date
- • Equity Later: Converts to shares in future financing round
- • Deferred Valuation: Valuation determined in future round, not now
- • Investor Protections: Cap and discount protect early investors
- • Simple & Fast: Fewer terms to negotiate, faster closing
- • Lower Cost: Less legal complexity than priced rounds
Convertible Note vs Priced Round
| Aspect | Convertible Note | Priced Round (CCPS) |
|---|---|---|
| Valuation | Deferred to future round | Determined now |
| Legal Complexity | Lower (5-10 pages) | Higher (100+ pages) |
| Closing Time | 1-2 weeks | 4-8 weeks |
| Legal Cost | ₹25,000 - ₹75,000 | ₹2,00,000 - ₹5,00,000 |
| Board Rights | Usually none | Often granted |
How Convertible Notes Work
The convertible note lifecycle follows a predictable pattern from issuance through conversion or repayment.
Step 1: Investment
Investor provides capital to the company. Company issues convertible note documenting the investment amount, interest rate, maturity date, cap, and discount.
Step 2: Accrual Period
Investment sits as debt on company books. Interest accrues (typically 4-8% annually). No equity is issued yet. Company operates and seeks to reach milestones for next round.
Step 3: Conversion Event
Upon qualified financing (typically $1M+ or defined threshold), the note automatically converts to equity shares at the lower of: (a) cap price, or (b) discounted round price.
Step 4: Equity Ownership
Note holder becomes shareholder with same class of shares as new investors (typically preferred), enjoying full shareholder rights including liquidation preference.
Example Conversion Scenario
Initial Note Terms:
- • Investment: ₹50 Lakhs
- • Cap: ₹5 Crore
- • Discount: 20%
- • Interest: 6% annually
Series A Terms (12 months later):
- • Pre-money: ₹10 Crore
- • Investment: ₹3 Crore
- • Price per share: ₹1,000
Conversion Calculation:
- • Principal + Interest: ₹50L + ₹3L = ₹53L
- • Cap Price: ₹1,000 × (₹5Cr ÷ ₹10Cr) = ₹500 per share
- • Discount Price: ₹1,000 × (1 - 20%) = ₹800 per share
- • Conversion Price (lower): ₹500 per share
- • Shares Received: ₹53L ÷ ₹500 = 10,600 shares
- • Effective Pre-money Value: ₹5 Crore (not ₹10 Cr)
Key Terms Explained
Understanding these key terms is essential for negotiating convertible notes effectively.
Valuation Cap
The valuation cap sets the maximum company value at which the note converts. It protects early investors by ensuring they get a lower price per share even if the company's valuation increases significantly before the next round.
- How it works: If cap is ₹5 Cr and next round is at ₹10 Cr, note converts as if valuation were ₹5 Cr
- Typical range: Pre-seed: ₹2-5 Cr, Seed: ₹5-15 Cr
- Investor perspective: Lower cap = better protection
- Founder perspective: Higher cap = less dilution
Discount Rate
The discount gives note holders a reduced price compared to new investors in the qualified financing round. It rewards early investors for taking on additional risk.
- How it works: 20% discount means note holder pays 80% of the price new investors pay
- Typical range: 10-30%, commonly 15-20%
- Combined with cap: Investor gets the better of cap OR discount
Interest Rate
Since convertible notes are technically debt, they accrue interest. However, the interest is rarely paid in cash; instead, it adds to the principal amount that converts to equity.
- Typical range: 4-8% annually
- Compounding: Usually simple interest, sometimes compounded
- Purpose: Minimal return if note repaid rather than converted
Maturity Date
The date when the note becomes due if not yet converted. Maturity provisions specify what happens if no qualified financing occurs before maturity.
- Typical range: 12-24 months from issuance
- At maturity options: Repay principal + interest, convert at cap, or extend
- Automatic conversion: Some notes convert at cap if no qualified round
Qualified Financing
The financing round that triggers automatic conversion. Defines the threshold that constitutes a "real" next round versus a small top-up or bridge.
- Typical threshold: ₹1-3 Crore or more in new equity
- Purpose: Prevents conversion on small, non-arm's length rounds
- Below threshold: May be considered "non-qualified" with different conversion terms
Conversion Mechanics
Understanding exactly how conversion works helps both founders and investors model outcomes and negotiate terms effectively.
Conversion Price Formula
The conversion price is the lower of:
- 1. Cap Price: (New Round Price) × (Valuation Cap ÷ New Round Pre-Money Valuation)
- 2. Discount Price: (New Round Price) × (1 - Discount Rate)
Note: If cap applies, discount is irrelevant. If new round valuation is below cap, discount may apply.
Conversion Scenarios
Scenario 1: Next Round Above Cap (Cap Applies)
Note: ₹50L, Cap: ₹5Cr, Discount: 20%
Series A: ₹10Cr pre-money at ₹1,000/share
Cap price: ₹1,000 × (₹5Cr ÷ ₹10Cr) = ₹500
Discount price: ₹1,000 × 80% = ₹800
Result: Cap wins (₹500). Investor gets 2x the shares.
Scenario 2: Next Round Below Cap (Discount May Apply)
Note: ₹50L, Cap: ₹5Cr, Discount: 20%
Series A: ₹4Cr pre-money at ₹800/share
Cap price: ₹800 × (₹5Cr ÷ ₹4Cr) = ₹1,000 (worse than round price, so ignored)
Discount price: ₹800 × 80% = ₹640
Result: Discount wins (₹640).
Regulatory Framework in India
Convertible notes in the US sense are not directly recognized under Indian law. The equivalent instrument is the Compulsorily Convertible Debenture (CCD), which has specific regulatory requirements.
Compulsorily Convertible Debentures (CCDs)
- • Recognized under the Companies Act, 2013
- • Must convert to equity within 10 years (FEMA requirement for foreign investment)
- • Can carry interest until conversion
- • Conversion ratio can be determined at issuance or based on future valuation
- • Requires company board resolution and shareholder approval
FEMA Considerations
Foreign investment in CCDs is governed by FEMA regulations:
- • Pricing must be as per FEMA Pricing Guidelines
- • Valuation certificate required from Category I Merchant Banker or Chartered Accountant
- • Must convert within 10 years of issuance
- • FC-GPR filing after conversion to equity
- • Cannot be issued to NRI or OCI on non-repatriation basis
Companies Act Compliance
- • Section 42 for private placement (if applicable)
- • Board resolution for CCD issuance
- • Filing PAS-3 (return of allotment) for CCD issuance
- • Filing PAS-3 again upon conversion to equity
- • Maintain register of debenture holders
Convertible Notes vs CCPS
Founders often debate between raising via convertible notes (CCDs) versus direct equity (CCPS). Each has advantages depending on the situation.
| Factor | Convertible Note (CCD) | Direct Equity (CCPS) |
|---|---|---|
| Valuation | Deferred | Determined now |
| Speed | Fast (1-2 weeks) | Slower (4-8 weeks) |
| Cost | Lower | Higher |
| Investor Rights | Minimal until conversion | Full from closing |
| Dilution Clarity | Uncertain until conversion | Known immediately |
| Best For | Seed, bridge rounds | Series A and beyond |
When to Use Each
Use Convertible Notes when: Raising a small seed round, need speed, valuation uncertain, raising from angels, doing a bridge round.
Use CCPS when: Raising institutional round, valuation is clear, want clean cap table, Series A with VC, complex terms needed.
Advantages and Disadvantages
Advantages
- • Speed: Can close in days vs weeks for priced rounds
- • Lower cost: Minimal legal fees compared to full equity docs
- • Valuation deferral: No need to agree on value today
- • Less dilution risk: If company grows rapidly, cap limits dilution
- • Simple terms: Fewer points of negotiation
- • Flexibility: Can raise from multiple investors easily
Disadvantages
- • Uncertainty: Dilution unknown until conversion
- • Cap table complexity: Outstanding notes create uncertainty for future investors
- • Stacked notes: Multiple notes with different terms can create issues
- • Interest burden: Accruing interest increases conversion amount
- • Maturity pressure: Clock ticking if no next round
- • Founder unfriendly in down round: Cap protects investors but can over-dilute founders
Accounting and Tax Treatment
Understanding the accounting and tax implications helps with financial planning and compliance.
Accounting Treatment
- • Balance Sheet: CCDs shown as long-term borrowing under liabilities
- • Interest: Accrued interest recorded as expense, added to liability
- • Conversion: Liability extinguished, share capital and premium increased
- • Discount: Beneficial conversion feature may need separate accounting
Tax Considerations
- • Interest: Tax deductible for company (subject to TDS)
- • Withholding: TDS at 10% on interest payments to residents
- • Conversion: Not a taxable event for company or investor
- • Investor taxation: Interest taxed as income; capital gains on eventual sale
- • Angel Tax (Section 56(2)(viib)): Does not apply to CCDs (only shares)