How Convertible Debentures Work
Before you sign a term sheet, it is critical to understand the moving parts.
- Optionally Convertible Debentures (OCDs)
Investors hold the choice to convert the debentures into equity shares or opt for repayment in cash at maturity. No compulsion exists for conversion.
Example: A startup issues ₹1.5 crore in OCDs to an angel investor. At the end of 18 months, the investor decides to convert into equity at the agreed ratio if the valuation looks promising, or takes back the principal plus interest otherwise.
When to use: When investors seek flexibility to hedge against uncertainty, balancing debt safety with equity potential. Suited for early-stage ventures where future valuation is unpredictable
- Non-Convertible Debentures (NCDs)
These function purely as debt instruments with no conversion option into equity; repayment occurs strictly in cash at maturity.
Example: Your SaaS platform raises ₹3 crore via NCDs from a debt fund. Investors receive fixed interest quarterly, and the full principal is repaid after 4 years, no equity dilution involved.
When to use: When founders prioritize avoiding equity dilution and have steady cash flows for interest and principal repayment. Ideal for bootstrapped or mature startups needing non-dilutive capital.
- Compulsorily Convertible Debentures (CCDs)
These must convert into equity shares, there’s no option for repayment. Conversion is mandatory at a predetermined date or event.
Example: A growth-stage investor gives your fintech startup ₹2 crore via CCDs with a 5-year tenure. At the 5-year mark, the CCDs automatically convert into equity shares based on the conversion ratio agreed upon upfront.
When to use: When you want certainty of equity conversion without the risk of having to repay debt. Ideal for domestic investors and FDI scenarios.
Key Commercial Terms Every Founder Should Know
Principal Amount
The total money raised through the debenture round.
Interest Rate (Coupon rate)
The annual interest that accrues on the debentures. For startups, this is usually payable on conversion, or accrued interest is added with the principal amount, and the entire amount is converted to shares, not as a regular cash outflow, to protect your runway.
Maturity Period
The time window within which conversion is expected (for CCDs) or repayment/conversion must be decided (for NCDs). This could range from 3 to 10 years, depending on structure and regulatory constraints.
Conversion Trigger:
Events that cause conversion, such as:
- A qualified equity round above a defined threshold.
- Reaching a pre-agreed valuation.
- End of maturity period, in case of CCDs.
Security/Ranking
The debentures may be:
- Unsecured (typical for early-stage startup CCDs), or
- Secured against specific assets, more common in structured or venture debt.
- Legal & Regulatory Overlay
For Indian startups, convertible debentures must comply with:
- Board and shareholder approvals.
- Private placement rules (PAS-4, PAS-3, MGT-14 and related compliances).
- FEMA/RBI Regulations (if foreign investors participate):
- Minimum pricing/valuation norms
- Timelines and conditions for conversion.
Why Indian Startups Choose Convertible Debentures
For founders, convertible debentures combine flexibility with structure.
Defer Valuation Fights
At the seed or pre-revenue stage, defending a specific valuation can be painful. CCDs let you raise now and price later, when metrics are stronger.
Speed to Capital
A CCD round typically needs fewer negotiations than a full equity round. With a clean term sheet and standard documentation, you can close faster, which is crucial when the runway is tight and team salaries can’t wait.
Less Immediate Dilution:
Until conversion, you are not issuing equity shares. This means cap table dilution is deferred, and you retain optics of higher founder ownership in the early phase.
Investor Protection
Investors get:
- Priority as debenture holders (for the debt period), and
- Upside via conversion into equity, often at a discount
- Works Well with Staggered Investors:
You can bring in multiple investors into the same CCD series over a period, instead of re-pricing equity every time.
Legal & Compliance Checklist for CCDs in India
Board & Shareholder Approvals:
- Board resolution to approve the CCD issuance.
- Special resolution by shareholders for private placement and issue of debentures.
Private Placement Process:
- Offer letter and private placement rules (Sections 42 and 62 of the Companies Act).
- Maintaining a proper list of identified investors.
Valuation & Pricing (especially with foreign investors):
- Valuation certificate from a registered valuer / CA as required.
- Ensuring conversion pricing complies with RBI’s minimum pricing norms.
ROC Filings:
- Filings like MGT-14 and PAS-3 (return of allotment) and any related resolutions.
FEMA/RBI Compliance:
- Reporting of foreign investment within timelines.
- Classification of CCDs as “equity instruments” for FDI purposes.
Tax & TDS Considerations:
- Treatment of interest on debentures.
- TDS obligations, if interest is payable.
