Introduction
Convertible Notes and SAFE (Simple Agreement for Future Equity) Agreements are popular
financing tools for startups, offering flexibility to founders and investors alike. However, their
complex legal nature can attract regulatory scrutiny, particularly from the Enforcement Directorate
(ED), which monitors foreign exchange and money laundering violations. This blog explores the legal
framework, stakeholders involved, and key compliance risks associated with these instruments.
Understanding Convertible Notes and SAFE Agreements
A Convertible Note is a debt instrument that converts into equity during future financing rounds,
allowing startups to defer valuation discussions. These notes are recognized under Section 2(76A) of
the Companies Act, 2013, and can be issued for amounts above ₹25 lakhs, repayable or convertible
within five years.
A SAFE Agreement gives investors the right to receive equity in the future, without interest or
maturity terms, but is not explicitly recognized under Indian law. SAFEs may face legal ambiguities as
they can be interpreted as forward contracts or equity-linked instruments.
Legal Framework in India
Convertible Notes are governed by the Companies (Acceptance of Deposits) Rules, 2014, and FEMA
(Foreign Exchange Management Act), 1999. Under FEMA, foreign investors can participate in
Convertible Notes, provided they comply with conditions such as pricing and conversion timelines
outlined in FEMA Notification No. 20(R).
While SAFEs lack clear legal recognition, similar instruments may still be subject to scrutiny under
broader legal frameworks.
Key Compliance Risks and ED Scrutiny
FEMA Violations: Startups receiving foreign funds through Convertible Notes must comply with
FEMA rules. Non-compliance with pricing and conversion requirements can lead to regulatory
action.
Round-Tripping and Money Laundering: Convertible Notes may be used for round-tripping (returning
funds into the country through foreign jurisdictions), triggering action under the Prevention of
Money Laundering Act (PMLA), 2002.
Reporting Obligations: Under Section 42 of the Companies Act, private placements of securities like
Convertible Notes must be reported to the Registrar of Companies (RoC). Failing to do so invites
penalties.
Stakeholders Involved
Startup Founders and Management: Responsible for ensuring compliance with regulatory
frameworks like FEMA and the Companies Act.
Investors: Must be cautious about the legal standing of these instruments, particularly foreign
investors navigating FEMA regulations.
Legal Advisors: Law firm regulatory compliance experts specializing in regulatory compliance play a
crucial role in structuring these instruments to comply with Indian laws and ensuring proper filings
with regulatory bodies.
Recent Legal Update: FEMA Notification on Convertible Notes
In June 2024, the RBI issued a notification amending FEMA rules related to Convertible Notes. The
amendment clarified the pricing guidelines for convertible instruments, requiring startups to provide
greater transparency in how they determine conversion ratios. The new rules also introduce more
stringent penalties for non-compliance with reporting and pricing regulations.
This recent update signals increased regulatory focus on early-stage financing instruments,
particularly in the context of foreign investments. Startups must now be more diligent in their
financial structuring and reporting practices, or they risk severe consequences, including potential
investigations by the ED.
How These Transactions Can Lead to ED Scrutiny
Transactions involving Convertible Notes and SAFEs can attract ED scrutiny in several ways:
Mispricing or Misrepresentation: If the pricing of Convertible Notes during conversion is deemed
non-compliant with FEMA guidelines, the ED may initiate an investigation under FEMA.
Suspicion of Round-Tripping: Startups receiving foreign investment through these instruments may
be flagged for potential round-tripping, which involves using these structures to move money across
borders illegitimately.
Money Laundering Allegations: If Convertible Notes are used as a vehicle for laundering funds,
startups and investors could face action under PMLA. In such cases, engaging a lawyer for money
laundering or a criminal lawyer becomes essential.
Conclusion
Convertible Notes and SAFE Agreements offer startups valuable flexibility but come with significant
compliance requirements, especially for foreign investors. With recent legal updates adding more
oversight, startups need to ensure their financial structures adhere to applicable regulations, with
proper reporting and legal consultant guidance to avoid potential ED scrutiny. Engaging a corporate
lawyer or defence lawyer with expertise in regulatory compliance can be crucial in navigating
potential legal challenges.
