Early-stage startup financing is often structured not as a straight equity issuance but as a convertible instrument, a document that converts into equity at a future funding round. The two most commonly discussed instruments are convertible notes and SAFEs (Simple Agreements for Future Equity). Both are borrowed from the US startup ecosystem; both work well in their home jurisdiction. Both create significant legal complications when used with Indian companies. This article explains the key differences between them, the Indian regulatory framework that applies, and what Indian founders should actually use.
A convertible note is a debt instrument that converts into equity (typically preferred shares or Compulsorily Convertible Preference Shares) at a defined trigger event, usually the company’s next qualifying equity funding round.
Key terms:
- Principal: the amount invested (e.g., INR 50 lakh or USD 50,000)
- Interest rate: typically 8-12% per annum (reflects the debt character of the instrument; accrues but usually converts alongside principal)
- Discount rate: the percentage discount at which the note converts relative to the price paid by the next round investors (e.g., 20% discount means the noteholder gets shares at 80% of the price new investors pay, rewarding them for the earlier, riskier investment)
- Valuation cap: the maximum valuation at which the note will convert (e.g., a note with a USD 5 million cap converts at a USD 5 million valuation even if the next round is at a USD 10 million valuation, protecting the investor’s return)
- Maturity date: if no qualifying funding event occurs by the maturity date, the note may mature and demand repayment; alternatively, conversion is triggered automatically at maturity
What a SAFE Is
The SAFE (Simple Agreement for Future Equity) was created by Y Combinator in 2013 as a simplified alternative to convertible notes. It strips out the debt features:
- No interest rate: SAFEs do not accrue interest, no debt-like burden on the company’s books
- No maturity date: SAFEs have no expiry date, they convert at the next qualifying event, without any timeline pressure on the company
- Valuation cap and/or discount: SAFEs typically include a valuation cap, a discount at conversion, or both
The SAFE converts into preferred equity at the next priced round, on the same terms as the lead investor, subject to the cap and/or discount.
From the founder’s perspective, a SAFE is simpler than a convertible note, no interest obligation, no maturity risk, and fewer terms to negotiate.
The Indian Regulatory Problem
Both instruments create serious complications under Indian foreign exchange law when used with foreign investors.
FEMA 20(R), the foreign investment framework:
Foreign investment in Indian companies is governed by the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (FEMA 20(R)). The rules distinguish between permitted investment instruments and prohibited ones:
Permitted for FDI:
- Equity shares
- Compulsorily Convertible Preference Shares (CCPS)
- Compulsorily Convertible Debentures (CCDs)
- Optionally Convertible Preference Shares/Debentures only when they are repatriable
Convertible notes: Technically a debt instrument. Under FEMA 20(R), foreign investment cannot generally take the form of debt (other than ECBs, which have their own framework). A convertible note from a foreign investor creates legal uncertainty: at the time of issuance, it is debt; it will eventually convert to equity, but the foreign investor has held “debt” in an Indian company in the interim.
However, DPIIT has specifically addressed this: the Startup India notification (as updated) permits DPIIT-recognised startups to receive convertible notes from foreign investors, subject to: (a) the startup having DPIIT recognition; (b) the convertible note amount being at least USD 1,00,000 (approximately INR 83 lakh) per investor in a single tranche; (c) the note converting within 5 years.
This provision has made convertible notes usable for DPIIT-recognised startups specifically, but the conditions must be met, and FC-GPRA reporting is required.
SAFEs under FEMA: SAFEs are not equity, not debt, and not listed in the FEMA 20(R) permitted instruments. The RBI has not issued a clarification specifically addressing SAFEs. This regulatory ambiguity makes SAFEs from foreign investors problematic for Indian companies. Many Indian lawyers advise against using SAFEs for foreign investment until regulatory clarity is obtained.
Domestic Convertible Notes (Between Indian Residents)
A convertible note between Indian residents (e.g., an Indian angel investor and an Indian startup) does not raise FEMA issues. The instrument is valid under the Companies Act, 2013, which permits the issuance of convertible debentures. The terms, interest, discount, cap, maturity, are freely negotiable.
For domestic convertible notes:
- They must be structured as debentures (requiring a debenture trustee if issued to more than 500 investors)
- For individual small-scale issuances (angel investors), they are typically structured as Compulsorily Convertible Debentures (CCDs)
- Stamp duty on debenture issuance applies
The Preferred Indian Instruments
CCPS (Compulsorily Convertible Preference Shares): The standard institutional equity instrument in Indian venture capital. Preferred shares that are compulsorily converted into equity on a specified date or event. Institutional investors prefer CCPS because:
- Treated as equity under FEMA 20(R) (not debt), no regulatory uncertainty
- Can carry protective provisions (liquidation preference, anti-dilution, information rights)
- RBI and SEBI have well-established frameworks for CCPS
CCD (Compulsorily Convertible Debentures): Treated as equity under FEMA 20(R); no end-use restrictions that apply to ECBs; commonly used in pre-Series A rounds to delay valuation discussions.
For foreign angel investors in DPIIT-recognised startups, a convertible note (under the specific DPIIT notification) is now a legally viable instrument provided the USD 1,00,000 per-tranche threshold is met.
Key Terms Founders Must Negotiate
Whether using CCPS, CCD, or a permitted convertible note, the conversion economics matter:
Valuation cap: Founders should negotiate a valuation cap that reflects a realistic valuation for the next round, not one so low that it results in excessive dilution. If the cap is too low relative to eventual valuations, early investors receive a disproportionately large share.
Discount rate: 15-20% discount is standard. Higher discounts disproportionately reward early investors at the cost of later dilution.
Most Favoured Nation (MFN): Some SAFEs include MFN clauses, if later SAFEs are issued on better terms, the existing SAFE holder gets those better terms automatically. Founders should be aware of MFN provisions as they can have significant dilutive consequences.
Pro-rata rights: The right to participate in future funding rounds to maintain the investor’s ownership percentage, commonly requested, and can increase future round complexity.
Key Takeaways
- Convertible notes are debt instruments and SAFEs are neither debt nor equity, both create regulatory complexity under FEMA 20(R) for foreign investment into Indian companies; DPIIT-recognised startups can receive foreign convertible notes subject to the specific conditions of the DPIIT Startup India notification (minimum USD 1,00,000 per tranche, conversion within 5 years).
- For foreign investment in Indian startups without DPIIT recognition, or where the convertible note conditions cannot be met, Compulsorily Convertible Preference Shares (CCPS) or Compulsorily Convertible Debentures (CCDs) are the legally appropriate instruments, they are treated as equity under FEMA 20(R) and avoid debt characterisation.
- SAFEs from foreign investors remain legally uncertain for Indian companies as of 2025, the RBI has not issued specific guidance on their characterisation under FEMA 20(R), and founders are advised to use CCPS, CCDs, or DPIIT-compliant convertible notes rather than SAFEs for international seed financing.
This article is for informational purposes only and does not constitute legal advice. Readers should seek appropriate professional counsel for their specific circumstances.
META TITLE: Convertible Notes vs SAFEs India: What Founders Must Know