Unlocking The Potential: Convertible Notes Ensuring The Protection Of Note Holders

Unlocking The Potential: Convertible Notes Ensuring The Protection Of Note Holders

By Pratyanik Chaudhary and Harman Kaur (Batch of 2026 – IIM Rohtak)

[This Blogpost is a 4th Position Entry of the 1st Edition of the National Blog Writing Competition 2023 organized by Centre For Innovation, Incubation & Legal Entrepreneurship (CIILE) in Association with PANDA LAW (TEAM CODE-14)]


India has the third-largest startup ecosystem in the world, with over 60,000 firms in 642 districts. As of April 2022, India has 65 unicorns across many industries, including significant international investment.[1]

The founder or family and friends usually provide early-stage cash. Despite “crowdfunding” and “incubation” being available, investors prefer hybrid securities due to their security.[2]

One such hybrid security popular among early-stage start-ups and investors is convertible notes. Furthermore, there can be seen the usage of a promissory note instrument of issuance of security named SAFE and its Indian counterpart- iSAFE, used for enterprises in similar stages of the business lifecycle.

In this article, we will delve into the details of convertible notes and try to ascertain the amount of protection convertible notes provides to a note-holder investor, as compared to the other popular instrument, the SAFE and/or iSAFE notes. The rationale is that all these instruments are essentially used for the early-stage enterprise and are used by the investors without a business valuation. Thus, properly ensuring investor protection becomes pertinent in the case of both convertible notes and the SAFE and iSAFE notes.

Convertible Notes Defined

A convertible note is a financial instrument characterised by its debt nature, which has the ability to convert into equity during a subsequent fundraising event. In the context of funding an early-stage or “seed” round, a convertible note is commonly employed, ultimately transforming into preferred stock shares after a successful venture capital financing round. The utilisation of a convertible note in a seed round does not bestow a valuation onto a company, as it is classified as an “unpriced” round due to the convertible note being a debt instrument.[3]

Further, these debt investment instruments are designed as debt instruments- initially while incorporating a provision that allows the investor to convert the principal amount along with accumulated interest into an equity investment upon the occurrence of a certain trigger event.[4]

The Foreign Exchange Management Rules[5] define “Convertible Note” similarly. The definition of a ‘Convertible Note’, according to the FEMA rules of 2019, pertains to a financial instrument issued by a startup company is an instrument where the holder can repay debt at their discretion and convert it into a set number of equity shares of the same company within five years after issuance further its states that the conversion is contingent on certain events and subject to the terms and conditions of the instrument.[6]

Convertible notes have been regarded as a form of “sweetened debt.”[7] However, an argument suggests that convertible notes might be seen as a means of achieving “backdoor equity.”[8] Moreover, it is evident that convertible notes are utilised to distribute a portion, albeit not the entirety, of the risk and reward associated with the firm’s investments to external stakeholders. From this perspective, convertibles might be regarded as pre-existing capital structures. Utilising a single convertible note issuance can serve as a more streamlined and cost-effective approach than distinct debt and equity issuances, enabling the issuer to attain a desired amalgamation of debt and equity within their balance sheet.[9]

Convertible Convenience: Unlocking the Potential

Convertible notes have advantages over traditional instruments. Thus, their popularity has grown in recent years. These securities may appeal to noteholders since they can provide endless financial advantages from the company’s share appreciation. They limit downside risk as well. For example, The “option” element’s value will climb if the company’s shares do over 10 years. Conversely, if the shares fall in value, the option will become immaterial, and the note’s value will fall until it hits the debt-like “safety net”.[10]

Further, as Suri points out, any investor using a convertible note will receive a significant amount of more shares for their money and get compensated for investing early.[11]  Further, a convertible note, essentially being a convertible debt, shall have all the advantages attached to a convertible bond or debenture.[12]  For example, a company does not have to dilute its equity; at the same time, the investor gets the assurance of a debt investment.[13] In furtherance, we will discuss- another kind of instrument of transfer of securities of hybrid natures, generally used by early-stage enterprises- i.e. SAFE and/or iSAFE notes.


The iSAFE, also known as India SAFE, was introduced by the Indian venture capital firm 100X.VC.[14] It is a modified version of the ‘SAFE’ (or Simple Agreement for Future Equity) document initially launched by the US-based fund Y-Combinator.[15] As iSAFE is tailored to Indian investors’ interests and requirements under Indian law, our discussion will focus on it primarily.

SAFEs are essentially promissory notes, which allow investors to acquire a predetermined quantity of shares at a mutually agreed-upon price at a future date.[16] The iSAFE, in its current manifestation, does not resemble SAFE’s structure or conceptual framework. The document in question might be described as an “agreement for issuance” of Compulsory Convertible Preference Shares (hereinafter referred to as “CCPS”).[17] These shares have interest and conversion obligations for the issuing company. The agreement also sets a date for turning shares into equity. The ‘class conversion’ clauses are analogous to the SAFE document’s future equity offering provisions. The SAFE document considers an “Equity Financing” event to trigger preferred stock issuance, while the iSAFE advises converting a class of CCPS to the iSAFE note holder.[18] All these events in both SAFE and iSAFE can be found under the ‘In Event of Liquidity” clause.

On the “Conversion Date” after an Equity Financing event, iSAFE Notes are automatically converted into Shares.  Therefore, iSAFE is an ‘Agreement to issue CCPS’, not debt or equity. Although not ‘Debt’, iSAFE’s ‘Liquidation Preference’ favours it above equity. If the firm fails, iSAFE says investors will receive their money back before equity stockholders.[19] This further puts another question: what is essentially Liquidation Preference (hereinafter referred to as “LP”)?

Pushing-away Preference: A Tale of Liquidation Preference

LP is commonly characterised as the investor’s rights, typically holding preference shares, to receive the initial investment amount along with a certain percentage of the proceeds in the case of a company’s insolvency.[20] The Indian insolvency regime u/s 53 of the Insolvency Bankruptcy Code 2016 (hereinafter referred to as “IBC”) delineates the hierarchical sequence for the distribution of assets in the event of a corporate liquidation.[21] Any contractual arrangement that disrupts the hierarchy specified under the said provision, the IBC empowers the liquidator to disregard such contractual arrangements.[22]

Thus, the remaining after the liquidation will go as per the hierarchy specified u/s 53 of IBC, where preferred shareholders are above the equity shareholders.[23] An important question comes in the case of iSAFE that the securities issued under iSAFE- are CCPSs, which will be compulsorily converted into common equity shares: will the LP clause remain enforceable?

If the LP clause was in the Articles of Association, it would have constituted a voluntary liquidation under the former Companies Act 2013. Whether voluntary or mandatory, IBC liquidation prohibits preference amongst shareholders of the same class.[24] So, if the securities issued under iSAFEs- get converted into common equity shares- LP can not give the added advantage that iSAFE hopes to give to the investor. But what is the insolvency perspective in the case of convertible notes?

Perspective from the Insolvency Regime

As already mentioned, securities issued under convertible notes are essentially convertible debt securities. Going by the definition given under FEMA 2019 rules- the debt securities on their own will convert themselves into shares either at the note holder’s discretion or after the specified period’s completion.[25] Thus, the nature of these securities can be labelled as securities similar to compulsory convertible debenture (hereinafter referred to as “CCD”).

Under IBC, any CCD that has not matured will be treated as a debt, not as equity. Further, an unmatured CCD holder shall even be allowed to be part of the Committee of Creditors as an unsecured creditor.[26]

If the convertible note holder has stated in the fine print that the debt would convert into preferred shares instead of common equity shares, the investor will receive the liquidation priority IBC offers to a preferred shareholder. This shows that convertible notes offer stronger investor protection than iSAFE.


Although our above discussion makes it quite clear that the Convertible notes might be giving the note holder investor better protection as compared to the iSAFEs to deduce, we have assumed securities issued under convertible notes as CCDs. This assumption may or may not stand in a court of law- given that it lacks an authoritative backing. Further, the authority that currently ascertains the position of CCDs under the IBC[27] regime is somewhat contrary to the Apex Court’s decision in Anuj Jain[28], as to the basic element of  debt security.[29] Furthermore, convertible notes also put the enterprise the burden of debt at a very early stage. But in the absence of a basic and proper protection regime under iSAFE, convertible notes possess more potential!


[1] Vipin Sreekumar et. al., India’s startup explosion: more pitfalls than promise?, LSE Blog (Oct 10, 2023, 03:45 PM) https://blogs.lse.ac.uk/businessreview/2022/05/11/indias-startup-explosion-more-pitfalls-than-promise/

[2] Simran Chetwani, Hybrid Instruments For Investments In Startups, Mondaq (Oct 10, 2023, 03:45 PM) https://www.mondaq.com/india/shareholders/1101398/hybrid-instruments-for-investments-in-startups

[3]  Joseph Becker and  Susan Chaplinsky, Convertible Notes: A Form of Early-Stage Financing, University of  Virginia (Oct 10, 2023, 03:45 PM) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3682592

[4] Chiamaka N. Anyanwu, Convertible Notes As A Form Of Debt Financing For Startups, Mondaq (Oct 10, 2023, 03:45 PM) https://www.mondaq.com/nigeria/corporate-and-company-law/1256618/convertible-notes-as-a-form-of-debt-financing-for-startups

[5] Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (hereinafter “FEMA 2019 rules”)

[6] Id. at Rule 2(vi)

[7] E. Brigham, An analysis of convertible debentures: theory and some empirical evidence, 21 Journal of Finance, 35 (1966) https://www.jstor.org/stable/pdf/2977597.pdf

[8] J. Stein, Convertible bonds as backdoor equity financing, 32 Journal of Financial Economics, 3 (1992) https://www.nber.org/system/files/working_papers/w4028/w4028.pdf

[9] Y. Kim, Informative conversion ratios: a signalling approach, 25(2) Journal of Financial and Quantitative Analysis, 229 (1990) https://www.jstor.org/stable/pdf/2330826.pdf

[10] MP Mourell and JN Willoughby, Convertible notes, 21(5) Australian Business Law Review, 338 (1993) https://www.proquest.com/docview/223514732?pq-origsite=gscholar&fromopenview=true

[11] Dhruv Suri, Convertible Notes: Are They Finally A Reality For Indian Startups?, YourStory (Oct 10, 2023, 03:45 PM) https://yourstory.com/2017/01/convertible-notes-finally-reality-indian-startups

[12] The Carta Team, Convertible securities: SAFEs vs. convertible notes, Carta (Oct 10, 2023, 03:45 PM) https://carta.com/blog/convertible-securities/

[13]  UBS Asset Management, The benefits of convertible bonds, USB (Oct 10, 2023, 03:45 PM) https://www.ubs.com/global/en/assetmanagement/insights/asset-class-perspectives/fixed-income/articles/benefits-of-convertible-bonds/_jcr_content/mainpar/toplevelgrid/col1/actionbutton.0206703009.file/PS9jb250ZW50L2RhbS9hc3NldHMvYW0vZ2xvYmFsL2luc2lnaHRzL2Fzc2V0LWNsYXNzLXJlc2VhcmNoL2ZpeGVkLWluY29tZS9kb2MvdGhlLWJlbmVmaXRzLW9mLWNvbnYtYm9uZHMucGRm/the-benefits-of-conv-bonds.pdf

[14] 100X.VC, https://www.100x.vc/isafe (Oct 10, 2023, 03:45 PM)

[15] Carolynn Levy, Safe Financing Documents, Y-Combinator (Oct 10, 2023, 03:45 PM) https://www.ycombinator.com/documents

[16] Danny Adno, SAFE Notes: Capital raising for early-stage start-up companies, Mondaq (Oct 10, 2023, 03:45 PM)  https://www.mondaq.com/Article/1214668

[17] Devansh Parekh and Tanishq Mohta, SAFE Notes: A Novel Funding and ‘Safe’ Method?, Indiacorplaw (Oct 10, 2023, 03:45 PM)  https://indiacorplaw.in/2021/12/safe-notes-a-novel-funding-and-safe-method.html

[18] Tuhin Batra, Decoding iSAFE – Part I, Mondaq (Oct 10, 2023, 03:45 PM) https://www.mondaq.com/india/securities/1330992/decoding-isafe—-part-i#:~:text=The%20SAFE%20was%20initially%20designed,Discount%2C%20no%20Valuation%20Cap

[19] Id.


[21] Insolvency and Bankruptcy Code, 2016, No. 31, Acts of Parliament, 2016 (India), § 53 (1)

[22] Id. at § 53 (2)

[23] Id. at § 53 (1)

[24] Arjya B. Majumdar, The (Un?)Enforceability Of Investor Rights In Indian Private Equity, 41(4) U. Pa. J. Int’l L., 981 (2020) https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=2011&context=jil

[25] Supra note 5

[26] SGM Webtech Pvt Ltd v Boulevard Projects Pvt Ltd CA No 1340 (PB)/2019 in (IB)-967 (PB)/2018

[27] Id.

[28] Anuj Jain v Axis bank 2020 8 SCC 401

[29] Rahul Rajpal, Status of Compulsorily Convertible Debentures Under the IBC, IBC Law Blog (Oct 10, 2023, 03:45 PM) https://ibclaw.blog/status-of-compulsorily-convertible-debentures-under-the-ibc-by-rahul-rajpal/

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