Convertible Securities Explained: What Investors And Founders Need To Know For Successful PE/VC Deals

INTRODUCTION

Private Equity (PE)/Venture Capital (VC) investments in the first half of 2025 totalled $26.4 billion across 593 deals, marking an 11% increase from the second half of 2024, which totaled US$23.8 billion. This positive shift showcases the interest of the investor, the need of the market, comfort, and trust amongst the parties. As the deal volume increases, the importance of documentation, structuring, and compliance of these deals as per the needs of the parties cannot be ignored. Convertible securities have recently been a topic of discussion, offering flexible solutions for traditional debt and equity financing, as well as traction in the Indian PE and VC segments.

These instruments have been meaningfully advantageous when determining the valuation of a company is premature due to its early stage. For companies, these instruments/securities enable capital raising without immediate dilution of shareholding, which is generally crucial for preserving control and driving operational growth by the founders. These types of instruments allow for securing funding at lower interest rates than the non-convertible debt, which reflects the value being added through the option for conversion.

These days, angel investors and investment firms find these instruments appealing, as they offer a structured path to equity ownership while providing certain downside protections. The debt component serves as a safety net, providing a return of principal investment, and interest on the investment amount is ensured if the conversion to equity does not materialise according to the agreed-upon terms.

This blend in itself showcases these convertible instruments as a flexible tool while navigating the risks and benefits of investment by an investor. Interestingly, Compulsorily Convertible Debentures (CCDs), Compulsorily Convertible Preference Shares (CCPS), and Convertible Notes (CNs) have recently been the go to instruments of investors and founders, depending upon risk, stage of a company, exit objectives, and prospects of the parties, in addition and conjunction to these there are specific nuances that the founders and the investors must ponder upon to select right instrument which would also match their objectives.

Let's discuss and understand what fits whom!

Understanding CCDs, CCPS and CNs

A lot depends on how these instruments are construed by regulatory bodies and courts. Let's see how they see these instruments.

Interpretation of Convertibles as 'Debt' or 'Equity'; The 'Repayment of Principal' Test

While CCPS are considered equity instruments. The conundrum primarily lies with respect to debt-equity instruments, such as CCDs and CNs. The Indian courts and regulatory bodies have consistently utilised the repayment of principal test to understand the nature of these instruments. This test aims to determine the true economic nature of an instrument, regardless of its label. This test states that if the terms of the convertible instrument stipulate that the principal amount must be repaid, it is considered a debt instrument. On the other hand, if the terms do not require repayment of the principal amount and conversion into shares is required, it is an equity instrument. But before making a decision, you should also look into all the nuances of this test.

In Narendra Kumar Maheshwari v. Union of India (1990 Supp SCC 440, decided on May 3, 1989), the Supreme Court came up with a test to determine whether a convertible debenture would be regarded as 'debt' or 'equity'. The test is simple: Do the terms of the convertible debenture postulate repayment of the principal amount? If the answer is yes, then the convertible debenture is treated as a debt instrument, since a compulsorily convertible debenture does not require any repayment of principal. Even a debenture that is only convertible at option has been regarded as a 'hybrid'. Conversely, if the convertible debenture's terms do not contemplate repayment of the principal amount (i.e. conversion into equity shares upon maturity is mandatory), it is to be regarded as an equity instrument. This foundational test has been consistently applied in subsequent rulings to classify instruments like CCDs and CCPS.

The 'repayment of principal' test laid down in Narendra Kumar Maheshwari also finds mention in the Supreme Court's judgment in Sahara India Real Estate Corporation Limited v. Securities and Exchange Board of India ('SEBI') (2013 1 SCC 1, decided on August 31, 2012). The Supreme Court, while analysing the main issue of whether issuance of hybrid securities was through private placement or an invitation to the public, noted the findings of SEBI pertaining to the nature of OFCD.

The Regulator considered the issue of whether OFCDs would be regarded as 'debt ' or 'equity', relying on the test in Narendra Kumar Maheshwari. The Regulator had noted that there was an option for repayment of the principal amount upon maturity; thus, it concluded that OFCDs, by definition, design, and characteristics, are intrinsically and essentially a debenture and would be treated as debt, coupled with an option.

In the matter of Agritrade Power Holding Mauritius Ltd. v. Ashish Arjunkumar Rathi (2023 SCC OnLine NCLT 22129, March 17, 2023), the NCLT Mumbai bench adopted an approach based upon the terms on which CCDs were issued. Based on the facts and terms of CCDs, the tribunal opined that financial debt refers to a debt accompanied by interest. It also noted that the CCDs in the present case is a debt so long as they are not converted into equity. Accordingly, until the date of the mandatory conversion, CCDs were considered in the nature of debt. According to the terms at which CCDs were issued, the mandatory conversion date arises upon the winding up, dissolution, or liquidation of the company (or any analogous event), and the tribunal considered the resolution process contemplated under the IBC to be an analogous event in the present case. Additionally, the terms stated that the conversion was mandatory only for the principal amount. Thus, interest accrued thereupon until the date of conversion was considered a financial debt, and the principal was considered equity.

This ruling introduced a timing-based nuance, treating CCDs as debt prior to conversion.

Later, the Supreme Court, in IFCI Ltd. v. Sutanu Sinha (Civil Appeal No. 4929/2023, decided on November 9, 2023), observed that the NCLT had examined the classification of CCDs under the IBC. The CCDs in this case were issued pursuant to a Debenture Subscription Agreement (DSA). The Supreme Court noted that the DSA expressly provides the terms of the issue and explicitly defines the nature of CCDs, and these terms do not change nature of CCDs even upon the occurrence of an event. The Court observed that commercial agreements are always vetted by experts; thus, reading into them or adding to what is stated in the document about CCDs would be futile.

The Court referred to the case of Nabha Private Limited v. Punjab State Power Corporation Limited ( CIVIL APPEAL No.179 of 2017, October 05, 2017), where the Penta Test of interpreting contracts was provided. Placing reliance on this judgment, the Supreme Court stated that a contract means as it reads. It is not advisable for a court to supplement it or add to it. Thus, the court agreed with NCLT that the CCDs were in the nature of equity instruments in the current set of facts.

Having discussed issues surrounding the nature and interpretation of terms on which CCDs being issued in different contexts, let's now turn our focus to the Registrar of Companies' (RoC) order concerning Convertible Notes (CNs). This order offers significant insights into how CNs should be treated under the law

The RoC, Mumbai in the matter of Wurknet Private Limited ('Wurknet') (ROC(M)/CMC/NJN/ADJ-ORDER/5319 TO 5321/RD-57 – Adjudicating Order, decided on November 17, 2023) sheds light on the question of whether the procedure relating to debt or equity is to be followed for issuance of CNs under the Act.

In this matter, Wurknet, a startup company, raised funds by issuing CNs. It issued the CNs by following the procedure prescribed under section 62(1)(c) of the Act that deals with preferential issue of shares. The RoC examined the issuance and concluded that Wurknet had issued the CNs under the wrong provision of law. The RoC held that Wurknet should have followed the procedure prescribed under Section 62(3) of the Act. Later on, the Wurknet along with its directors appealed before Regional Director (RD) against the aforementioned order of the RoC. The RD dismissed the appeal which underscores that CNs are essentially a debt instruments until (and if) they convert into equity shares.

So, the bottom line is that the Indian courts anchor convertibles to the repayment-of-principal lens, interpreting terms on an as-is basis and understanding conversion through conversion events. CCDs and CCPS skew equity where principal repayment is absent; CNs sit on the debt side until conversion. Prior to conversion, enforceable interest on CCDs or CNs may be considered a financial debt; after triggering or maturity, the principal is removed from the debt bucket.

Practical Deal Structuring: Which instrument to choose, when to choose and why?

Choosing between an optionally convertible instrument and a compulsorily convertible instrument depends on various business, legal, and regulatory considerations. Let's discuss them below;

Early-Stage, Uncertain Valuation, Consider Convertible Notes: Startups in their seed stage often struggle to agree on a valuation with investors. In such cases, convertible notes are preferred. Why? They allow deferring the valuation to a later priced round (typically Series A). The note acts as debt in the interim, often with a conversion at a discount or cap, providing early investors with a fair upside for their risk without locking in a valuation at present.

From a legal standpoint, convertible notes (being debt), postpones the need for a valuation report at issuance and can be executed relatively quickly (simpler documentation than a full shareholders' agreement). While only DPIIT recognised startups can use 'convertible notes' per se, and each note must be INR 25 Lakh or above. Within that sphere, they are faster.

Example: A startup incubated for 2 years, no revenue, raises INR 1 Crore from angels via convertible notes, because pricing equity was too contentious. The note states it'll convert at a 20% discount to Series A or repay in 2 years with 10% interest if no Series A. This structure aligns incentives (investors want the company to reach Series A so that the notes can convert; founders avoid giving away equity at a lower valuation at the time of issuance). If the startup fails, note holders might receive some money back (though often startups can't repay; however, they legally have the right to demand it).

Convertible debt also simplifies cap tables during the interim; there are no new shareholders to deal with until the conversion. If the startup winds up, noteholders are creditors (which might help in insolvency or recovery, though practically, assets are few). So, convertible debt shines in speed, simplicity, and valuation deferral.

A. Later Stage or High Growth, Prefer CCPS/CCDs: By the time a company reaches Series A or later, investors and founders typically negotiate a valuation and invest via equity or convertible preferred stock (CCPS/CCDs). Most investors (VC/PE funds) want to be sure their money will convert into equity, as they are not looking to be repaid like a lender. CCDs/CCPS are preferred in such cases for a few reasons;

1. Alignment with Equity Ownership: These guarantee that the investor will eventually convert their investment into equity shares, allowing them to fully participate in the company's growth and potential increase in value.
2. Avoiding Deposit Complications: They offer a simple structure, free from the regulatory hurdles associated with deposits, as they are explicitly exempt from The Companies (Acceptance of Deposits) Rules, 2014 (Deposit Rules) .
3. Governance and Rights: Investors often demand and get a Shareholders' Agreement (SHA) in place, which treats them as equity partners from day one in terms of governance rights (board seats, veto, etc.). It's cleaner to structure rights assuming they will be shareholders.

Example: A Series B PE fund invests INR 50 Crore in a growth-stage company via CCDs at a valuation implying each CCD will convert at ₹200 per share into equity within 18 months (perhaps timed with a next round). The fund chooses CCD instead of equity shares for possibly two reasons –

1. They negotiate an interest of say 5% on the CCD, giving some fixed return if timelines drag (which equity couldn't give),
2. If the company fails to perform, the CCD terms may include protective provisions, such as conversion adjustments.

To better appreciate the nuances of each convertible instrument, the following comparative table outlines their key features across valuation, process, founder and investor perspectives, exit considerations, and other relevant aspects. This comparison provides clarity on how CNs, CCDs, and CCPS differ in design and suitability.

While the above analysis highlights the functional distinctions among these instruments, practical implementation carries its own set of challenges. Let's discuss common pitfalls and a best practices checklist to ensure that deals involving convertibles are both legally sound and commercially effective.

Pitfalls and Best Practices Checklist

When structuring and executing deals involving convertible instruments, several common pitfalls can lead to delays, legal invalidity, or disputes. Here's a checklist of best practices to avoid those pitfalls:

1. Ensure Eligibility and Align Structure with Law: Before opting for a structure, confirm you're allowed to use it. For example, if using convertible notes, confirm that the company is a DPIIT-recognised startup and that each investment is at least INR 25 If not, issuing a "convertible note" would violate Deposit Rules. Instead, maybe issue CCDs or CCPS. Always verify sectoral laws as well (e.g., an NBFC issuing convertible debentures may require RBI approval).
2. Draft Clear and Compliant Conversion Terms: Avoid any ambiguity in conversion ratio, price, timeline, and conditions. Do not use phrases like "terms to be decided later", regulators expect a formula or fixed price. Spell out triggers (qualified financing, maturity, IPO, etc.) and what happens on each. Include a default scenario: if triggers don't occur, do we convert at a floor price or redeem? Clarity here prevents future disputes.
3. Adhere to compliance requirements: Companies must ensure that they have a robust framework to monitor all compliance requirements, necessary limits, and thresholds under the Act. Additionally, if there is any sectoral compliance, companies should address it first.
4. Validate Pricing: Get a Registered Valuer's or Merchant Banker's report to support your pricing. This is not just a checkbox; it protects you from future shareholder disputes or tax issues. If the conversion formula is complex, have the valuer opine that it's fair or set a baseline Fair Market Value.
5. Use Conditions Precedent (CP) and Subsequent (CS) in Agreements: In the investment agreement, include CPs like "Shareholders' approval by ", "Obtaining in-principal approval from sectoral regulator",". And include CS like "filing of forms, compliance and share proof with investor", "Update articles of association to include terms of securities or investor rights" (if not already adequate). Often, companies forget to amend the Articles of Association (AoA) to reflect rights given to investors, while it is not mandatory to specify terms in the AoA, if you give any special rights that will attach to equity (like affirmative vote matters, liquidation preference), those should ideally be recognised in the AoA to be binding on all shareholders. It's best practice to update AoA at the time of issuance or conversion to enshrine key rights.
6. Keep Investors Informed and Aligned: Many post-deal disputes arise from miscommunication. For instance, if a founder treats a convertible note as equity psychologically and starts making decisions without consulting the note holder, it can sour relationships. Conversely, note investors should respect they are not yet equity and not try to micro-manage beyond agreed covenants. Setting clear governance expectations in the term sheet/agreements (such as whether note holders receive observer rights or financial reporting on a monthly basis) helps prevent conflict.
7. Plan for Conversion and Exit Events: Utilise a tickler system to plan this; ideally, conversion coincides with a funding round, before an IPO or the IPO itself. If it's a note expecting a subsequent round, the company should trigger conversion promptly when that round closes and also align the conversion timeline with major events, legally.
8. Monitor Post-Investment Covenants: After issuing convertibles, comply with any covenants you agreed to (e.g., not raising further debt, not changing business plan radically, etc., without consent). If circumstances change and a covenant needs to be waived, discuss it with the investor early and obtain a written waiver or amendment. Breaching a covenant can give investors the right to call default or demand immediate conversion or redemption, depending on the contract, which could derail the company if done at a sensitive time.

By following this checklist and being proactive at each step, parties can help avoid transaction delays or invalidity. Many of these points are low-hanging fruit, purely procedural, yet non-compliance can completely unravel a deal. Thus, in conclusion, while convertibles provide great flexibility, they come with compliance strings attached. Diligence in following the law's letter and spirit, and crafting clear agreements, ensures that these instruments serve their purpose, aligning the interests of investors and founders without legal snags. By learning from past pitfalls and adhering to best practices, one can harness the benefits of both debt and equity worlds that convertibles offer in a legally sound manner.

Conclusion

A sophisticated interplay of corporate law and requirements of the parties involved characterises the landscape of convertible instruments in Indian PE/VC transactions. Each category serves as a vital tool for capital raising, particularly for growth-oriented companies seeking to bridge valuation gaps and offer structured investment avenues. However, navigating this terrain demands meticulous attention to detail. Common pitfalls, such as ambiguous "mutually agreed later" conversion clauses, pose significant risks of invalidation and disputes, underscoring the need for clear, formula-based terms determined upfront or at a pre-specified time. No compliance may carry penalties, highlighting the necessity of robust internal tracking mechanisms for companies.

BIBLIOGRAPHY

Legislation

• Companies Act, 2013, No. 18, Acts of Parliament, 2013.
• Companies (Acceptance of Deposits) Rules, 2014.
• Companies (Share Capital and Debentures) Rules, 2014.

Cases

• Narendra Kumar Maheshwari v. Union of India, 1990 Supp. SCC 440, decided on May 3, 1989
• Sahara India Real Estate Corporation Limited v. Securities and Exchange Board of India, (2013) 1 SCC 1, decided on August 31, 2012.
• Agritrade Power Holding Mauritius Ltd. v. Ashish Arjunkumar Rathi, 2023 SCC OnLine NCLT 22129 , decided on March 17, 2023.
• IFCI Ltd. v. Sutanu Sinha, Civil Appeal No. 4929/2023, Supreme Court of India, decided on November 9, 2023.
• Nabha Private Limited v. Punjab State Power Corporation Limited, Civil Appeal No. 179 of 2017, decided on October 5, 2017.
• Registrar of Companies, Mumbai v. Wurknet Private Limited, ROC(M)/CMC/NJN/ADJ-ORDER/5319 TO 5321/RD-57 , decided on November 17, 2023.

Reports

• EY & IVCA, PE/VC Investments in India Reach USD 26.4 Billion Across 593 Deals in 1H 2025, available at: https://www.ey.com/en_in/newsroom/2025/07/pe-vc-investments-in-india-reach-us-dollor-26-point-4-billion-across-593-deals-in-1h-2025-ey-ivca-report .

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.