Whalesbook
What Happened
Many Indian startups look to adopt 'SAFE' notes (Simple Agreement for Future Equity) to raise funds quickly, a popular method in the United States that delays deciding the company’s valuation until a later date. However, Indian law does not legally recognize SAFE notes in the same way. When a startup uses a US-style SAFE note in India, it may be classified as an illegal deposit under the Companies Act or violate Foreign Exchange Management Act (FEMA) regulations. This creates significant complications for startups, especially when they reach the due diligence stage for a Series A funding round, where investors and auditors scrutinize the legal validity of all past funding instruments.
The Legal and Regulatory Trap
The primary issue is that Indian corporate law requires specific types of instruments for capital infusion. Because SAFE notes do not fit into the standard categories, they are often treated as debt that does not meet the necessary regulatory criteria. This can lead to a 'regulatory trap.' If a company accepts foreign investment through an improperly structured instrument, it may face scrutiny from regulators regarding FEMA compliance. Furthermore, startups that are not registered with the Department for Promotion of Industry and Internal Trade (DPIIT) face additional risks. Without proper structure, the premium paid by investors could potentially be flagged under 'Angel Tax' rules, where the difference between the investment price and the fair market value of shares is treated as taxable income.
Indian Alternatives: iSAFE and Convertible Notes
To navigate these laws, Indian startups have adapted. The most common alternative is the 'iSAFE' (India Simple Agreement for Future Equity), which is usually structured as Compulsorily Convertible Preference Shares (CCPS). These are shares that the company is legally obligated to convert into equity later. Because CCPS is a recognized instrument under Indian company law, it operates within a legal framework. Another option is the formal 'Convertible Note' (CN). These are recognized for startups that have official DPIIT recognition. Convertible Notes allow a company to take money as debt with the expectation of converting it to equity later, but they come with strict rules, including a minimum investment amount of Rs. 25 lakh and a requirement to convert or repay within 10 years.
The Complexity of Cap Tables
For investors, the biggest practical challenge of using these deferred-valuation instruments is the impact on the 'cap table,' or the record of who owns what percentage of the company. When a startup raises multiple rounds of funding using different agreements—some with different conversion caps or discount rates—calculating the final ownership percentage becomes difficult. If the valuation in a future priced round differs significantly from the terms in the early, unpriced rounds, the math can lead to unexpected dilution for both founders and early investors. Managing these terms requires precise legal documentation to ensure that when conversion happens, the equity split is exactly what all parties intended.
What Investors Should Track
Investors should prioritize a thorough review of the funding instruments during the term sheet stage. It is essential to confirm whether the instrument used is legally compliant with the Companies Act and FEMA, especially for foreign investors. Tracking the 'conversion trigger'—the specific event or date that forces the instrument to turn into equity—is also critical. Investors should also monitor whether the company has the necessary authorized capital to issue the promised shares upon conversion. Proactive legal structuring at the start, rather than waiting for a major funding round, is the best way for both startups and investors to avoid expensive and complex regularization processes later.