Raising capital is a pivotal decision for any startup, and choosing the right investment instrument can influence not only immediate funding outcomes but also long-term business structure, control, and compliance. In the Indian startup ecosystem, three popular fundraising tools are Convertible Notes, SAFE (Simple Agreement for Future Equity), and Equity Financing. Each comes with distinct legal, financial, and strategic implications. 

In this article, CA Manish Mishra talks about Convertible Notes vs SAFE vs Equity: What’s Right for You?

Three Instruments

Convertible Notes:

A convertible note is a short-term debt instrument that converts into equity at a future date—typically during a subsequent funding round. The investor loans money to the startup, and instead of receiving repayment in cash, the note converts into shares of preferred stock at a discount or with a valuation cap. In India, convertible notes gained legal recognition under the Companies (Acceptance of Deposits) Rules, 2014, through an amendment on April 11, 2017, allowing startups to issue them to investors. As per the amended rules, a startup (as recognized by DPIIT) can issue convertible notes up to ₹25 lakhs or more in a single tranche to a person or body corporate.

SAFE (Simple Agreement for Future Equity):

Originally developed by Y Combinator in the US, a SAFE is a contractual agreement where investors give money to a startup with the promise of receiving equity at a future valuation event. Unlike convertible notes, SAFEs are not debt and do not carry interest or maturity dates. SAFEs are simpler and founder-friendly but lack clear legal recognition under Indian company law. There is currently no specific provision under the Companies Act, 2013 or FEMA regulations that governs SAFEs, making them legally ambiguous and potentially risky unless structured carefully.

Equity Financing:

Equity financing is the process of raising capital by issuing shares of the company. It may involve issuing equity shares or preference shares under the provisions of the Companies Act, 2013, primarily Sections 42 (Private Placement) and 62(1)(c) (Preferential Allotment). Equity financing involves immediate dilution of ownership and voting rights, but it is the most straightforward and legally robust method of fundraising in India. It also mandates valuation compliance under Rule 11UA of the Income Tax Rules, 1962, and adherence to FEMA regulations if foreign investors are involved.

Legal Provisions and Compliance Considerations

Convertible Notes under Indian Law:

Convertible notes are legally permissible only for startups recognized by DPIIT and incorporated as private limited companies. The relevant laws include:

• Companies Act, 2013: Does not treat convertible notes as deposits if the amount is ₹25 lakh or more per person and convertible within 10 years.

• FEMA Regulations: Issuance of convertible notes to non-residents is governed by Foreign Exchange Management (Non-Debt Instruments) Rules, 2019. The investment must be reported via Form CN on the RBI's FIRMS portal within 30 days of issue.

• Income Tax Act, 1961: Valuation of convertible notes must be done by a registered merchant banker or chartered accountant to ensure compliance with Section 56(2)(viib).

SAFE Notes and Their Legal Ambiguity:

While SAFE agreements are popular in the US, they are not defined or recognized in Indian law. The major legal concerns include:

• Potential classification as a hybrid instrument or unsecured loan, risking default classification under Companies (Acceptance of Deposits) Rules, 2014.

• Absence of a maturity date or fixed return raises questions on how they are accounted for under the Companies Act.

• From a FEMA perspective, they may be treated as debt instruments, requiring compliance under FEMA (Debt Instruments) Regulations, 2019.

Until explicit guidelines are issued by MCA or SEBI, SAFEs in India should be structured very cautiously, typically in combination with shareholder and investor agreements that spell out conversion triggers, valuation, and dispute resolution clauses.

Equity Financing and Regulatory Mandates

Equity issuance involves:

• Section 42 of the Companies Act, 2013 for private placement, requiring PAS-3 filing within 15 days of allotment.

• Section 62(1)(c) for preferential allotment after special resolution and valuation report.

• Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014 which requires detailed disclosures, including valuation reports.

• Form FC-GPR filing under FEMA for shares issued to non-resident investors, within 30 days of allotment.

• Pricing guidelines to ensure the issue price is not below fair market value, especially when receiving FDI.

• Section 56(2)(viib) of the Income Tax Act which mandates valuation compliance to avoid excess taxation on share premium.

Key Differences: Convertible Notes vs SAFE vs Equity

Recent Updates Impacting Instrument Choice

• Startup India Recognition Push: With DPIIT pushing for wider startup recognition, convertible notes are now more accessible for early-stage companies in India. In Budget 2023, the government increased the maximum period for conversion from 5 to 10 years, giving startups more flexibility.

• SEBI Tightening Disclosure Norms: For equity funding, especially in companies planning to go public, SEBI’s enhanced disclosure requirements (2023) make equity issuance more transparent but also compliance-heavy.

• FEMA Enforcement Trends: RBI is actively scrutinizing FDI inflows, especially through unconventional instruments. Reporting delays on Form FC-GPR or CN can attract compounding proceedings under FEMA Section 13.

• Digital Signatures and MCA V3 Portal: Issuance of securities whether equity or convertible notes must now be digitally executed and reported through the updated MCA V3 platform with greater scrutiny on valuation, disclosures, and timelines.

Which Instrument is Right for You?

• Choose Convertible Notes if you are an early-stage DPIIT-recognized startup looking for a debt-like instrument with future conversion and minimal dilution today. It’s ideal when valuation is uncertain, and compliance can be managed.

• Choose SAFE only if your investor is comfortable with its legal ambiguity in India and you can structure it under a clear contract. It’s founder-friendly but requires careful legal vetting to avoid regulatory pitfalls.

• Choose Equity Financing if your startup has matured to a point where valuation is justifiable, investors want a stake now, and you are ready for formal dilution. This is most suitable for Series A and beyond or startups with stable revenue and growth potential.

Conclusion

Convertible Notes, SAFE, and Equity each serve a specific need in a startup’s fundraising lifecycle. Indian law is increasingly accommodative of convertible notes, especially with the DPIIT-led startup recognition system. SAFE agreements, while efficient globally, remain legally grey in India and require careful handling. Equity, though complex in compliance, is the most established route. Choosing the right instrument depends on your stage of growth, investor profile, legal risk appetite, and regulatory preparedness. Before proceeding, it is advisable to consult legal and financial advisors to align the fundraising instrument with your business goals and compliance obligations.

Frequently Asked Questions (FAQs)

Q1. What is the difference between a Convertible Note and SAFE?

Ans. A Convertible Note is a debt instrument that converts into equity later, usually with interest and a maturity date. A SAFE (Simple Agreement for Future Equity) is a contract to issue shares in the future, without interest or a repayment obligation. While both delay equity issuance, SAFE is not legally recognized in India, whereas convertible notes are allowed for DPIIT-recognized startups.

Q2. Are Convertible Notes legal in India?

Ans. Yes, Convertible Notes are legally permitted in India for DPIIT-recognized startups under the Companies (Acceptance of Deposits) Rules, 2014. They can issue notes of ₹25 lakh or more per investor in a single tranche, convertible within 10 years.

Q3. Is SAFE agreement valid under Indian law?

Ans. No, the SAFE agreement does not have specific legal recognition in India. Its structure may conflict with company law and FEMA regulations, making it risky unless carefully structured through robust contracts and legal consultation.

Q4. What are the compliance requirements for issuing Convertible Notes in India?

Ans. Startups must:

• Be recognized by DPIIT

• Ensure notes are convertible within 10 years

• File Form CN with RBI within 30 days (if issued to foreign investors)

• Comply with FEMA (Non-Debt Instruments) Rules, 2019

• Obtain a valuation certificate at the time of conversion

Q5. When should a startup prefer Equity Financing?

Ans. Equity financing is best when the startup is ready for valuation-based funding and is prepared to dilute ownership. It suits growth-stage companies or those raising Series A and beyond, where legal and tax compliance structures are well-established.

Q6. Is there any tax implication while issuing equity shares to investors?

Ans. Yes. Under Section 56(2)(viib) of the Income Tax Act, 1961, if shares are issued at a premium above fair market value (FMV), the excess may be taxable unless exempted (e.g., DPIIT-recognized startups). Proper valuation reports under Rule 11UA are required to avoid tax disputes.