Fund raising is one of the most important processes of
developing a startup. But selecting an appropriate method of raising funds can
be perplexing, more so for initial-time founders. In India, two of the most
popular instruments for startup fund raising are convertible notes and equity
financing. Both have their pros and cons, and the selection largely depends on
the stage of the company and what it aims for in the future.
This blog will make it easier for you to grasp the
biggest differences between convertible notes and equity in easy-to-understand
language, so you can determine what works best for your startup's development.
What Is Startup Funding and Why It Matters
Startup capital is the capital entrepreneurs use to
establish, operate, and expand their companies. Startups in the initial stages
most often don't have sufficient revenue, so they use other people's money to
finance products, recruit employees, market, and operate.
There are varying funding rounds:
Pre-seed stage:
When the concept is in the process of being conceived.
Seed stage:
When an MVP is developed and tested.
Series A and beyond:
When the startup is ready to scale or grow.
Selecting the optimal funding instrument can keep
founders in control of their company, raise funds quicker, and plan more
effectively for the future.
What Is Convertible Notes?
A convertible note is an early-stage loan provided to
a startup by an investor with the assurance that the loan will be converted
into equity (ownership) sometime in the future. This conversion typically
occurs in a subsequent funding round. Instead of fixing a valuation at the
outset, the investor receives shares at a discounted price or with some
advantage in the future.
Major Features of Convertible Notes:
No need to determine the valuation of the startup
during investment.
A debt instrument that converts into equity in the
future.
It has conditions such as an interest rate, maturity
date, discount rate, and occasionally a valuation cap.
Advantages of Convertible Notes:
Quicker to raise:
Less paperwork than equity rounds.
Puts off valuation:
Best when too early to properly value the startup.
Attracts early investors:
Provides discounts or benefits to reward early faith in the startup.
Disadvantages:
Becomes debt until it is converted; if conversion does
not occur, it must be repaid.
Can lead to confusion if terms are not well
established or if more than one note is issued.
Legal conditions in India: Convertible notes can be
issued only for DPIIT-recognized startups with a minimum investment of ?25
lakhs.
What Is Equity Financing?
Equity financing provides a portion of your company's
ownership to an investor for cash. The investor is a shareholder as soon as the
contract is signed, and shares are allocated according to a mutually agreed
value.
Characteristics of Equity Financing:
A proper valuation process needs to be done by the
startup.
The investor is a co-owner and tends to participate in
decision-making.
The raised capital is not repayable—it's for giving up
ownership.
Benefits of Equity Financing:
No debt burden:
You won't owe them the money.
Long-term partnership:
Investors tend to contribute experience, contacts, and counsel.
Ownership clarity:
Everyone understands who owns what from day one.
Downsides:
Dilution of ownership:
Founders lose some of the company too soon.
Valuation pressure:
You must put a valuation in place upfront, even if the company is too early for
one.
Complex legal process:
Equity deals often involve detailed shareholder agreements and regulatory
filings.
Convertible Notes vs Equity: Key
Differences Explained
The primary difference lies in timing and structure.
With equity, the ownership structure is decided right away based on the current
valuation. With convertible notes, that decision is delayed until a future
round.
Convertible notes are easier and faster to issue,
particularly useful when startups require funds quickly or when it is difficult
to determine the business accurately. In contrast, equity financing is more
formal, confers immediate ownership on the investors, and is used for
established startups with the intention of scaling.
The other distinction is that convertible notes act
like debt until they are converted, while equity never has to be repaid.
If you don't mind early dilution and cumbersome
paperwork, convertible notes could be more suitable. But if you have traction
and you want to raise from long-term investors, equity might be more
appropriate for your plans.
When to opt for Convertible Notes by
Startups
Convertible notes are perfect for extremely
early-stage startups, particularly those that are still working on their
product or piloting the market. If you don't have definite revenues, customer
information, or good valuation metrics, convertible notes permit you to raise
money without having to set a company value right away.
It's also handy when:
You want cash urgently to hit your next milestone.
You have a limited number of early investors.
You want to offer incentives like discounts or
valuation caps to early believers.
When Should Startups Choose Equity
Financing?
Equity financing is better when the business has
achieved certain milestones like product-market fit, stable revenue, or strong
customer feedback. This is often during the seed stage or Series A round.
It makes sense when:
You can clearly justify your company’s valuation.
You’re ready to give investors a long-term stake in
the business.
You want the investor’s guidance, mentorship, or
industry connections.
You’re raising a large sum and want to avoid dealing
with multiple conversion terms later.
What About SAFEs?
SAFEs (Simple Agreement for Future Equity) are
essentially convertible notes without interest or repayment terms. They're
quicker and easier but are used infrequently and are not recognized under
Indian legal systems. Convertible notes are more prevalent and regulated in
India, particularly for DPIIT-registered startups.
Legal and Tax Considerations in India
For Indian startups, it's important to know the legal
structure. Convertible notes are permitted under the Companies Act and RBI
rules only if:
The startup is DPIIT-approved.
The investment is a minimum of ?25 lakhs in one
tranche.
The note is converted to equity within 5 years.
Equity issuance needs to comply with valuation
principles, appropriate shareholder arrangements, and tax compliance, such as
capital gains and startup relief under the Income Tax Act.
A professional CA firm has a large role to play here.
From document drafting and valuation determination to cap tables management and
MCA and RBI compliance—your CA advisor is your vital partner in your funding
process.
How a Chartered Accountant Can Help
Selecting the correct funding model isn't all about
finance—it's about legal compliance, long-term strategy, and financial
well-being. A Chartered Accountant can provide help with:
Business valuation and financial modeling.
Preparing and reviewing term sheets and agreements.
Tax planning for funding structures.
Compliance with Indian legislation and startup rules.
If in doubt, a CA firm can assist you in comparing
both courses of action depending on the stage of business, objectives, and
investor expectations.
Conclusion: What's Best – Convertible
Notes or Equity?
There is no one-size-fits-all solution. Convertible
notes are great if you need speed and ease. Equity is more appropriate if your
startup is further along and you're ready to recruit long-term collaborators.
If you're new and not sure of your valuation,
convertible notes can provide leeway. If you're sure of your growth and need
serious investors, equity is the solution.
Whatever you decide, ensure you take advice from a CA
expert to stay out of legal or financial trouble.
FAQs
Q1. What is the major distinction between
convertible notes and equity?
Convertible notes begin as loans which get converted
into shares in the future. Equity provides ownership rights immediately.
Q2. Are convertible notes legal in India?
Yes, but only for DPIIT-approved startups and with a
minimum of ?25 lakh investment.
Q3. Is convertible note superior to equity
for early-stage startups?
Yes, it enables startups to postpone valuation and
access money quickly.
Q4. In what ways can a CA firm assist in
startup funding?
A CA firm can assist with valuation, legal
documentation, tax planning, compliance, and structuring transactions.
Q5. What do I opt for if I require funding
urgently but don't wish to relinquish ownership immediately?
Convertible notes could be the better choice in this
instance.