Convertible Notes vs. CCPS: A Startup's Guide to Choosing Instruments

Executive Summary

Early-stage startups raising capital face a fundamental choice: Convertible Notes (Compulsorily Convertible Debentures) or CCPS (Compulsorily Convertible Preference Shares). Both instruments defer valuation and convert to equity at future rounds, but they differ significantly in legal structure, investor rights, tax treatment, and regulatory compliance. This guide helps founders and investors choose the right instrument based on their specific circumstances.

Key Differences:

• CCDs are debt; CCPS are equity (share capital classification)
• CCDs require interest payments; CCPS may have dividends (often nil)
• CCDs have maturity dates; CCPS have conversion timelines
• Tax treatment differs for both companies and investors
• FEMA treatment differs for foreign investors

Introduction

"Should we raise on a convertible note or preference shares?"

This question arises in almost every seed-stage fundraise. Both instruments serve similar economic purposes - delaying valuation while providing capital - but choosing wrong can create tax inefficiencies, regulatory complications, and investor conflicts down the road.

This guide provides a framework for making this decision intelligently.

Section 1: Instrument Fundamentals

Compulsorily Convertible Debentures (CCDs)

Legal Nature:

• Debt instrument (liability)
• Recorded as borrowing
• Must pay interest (can be nominal)
• Has maturity date
• Converts to equity at trigger event or maturity

Key Characteristics:

Compulsorily Convertible Preference Shares (CCPS)

Legal Nature:

• Equity instrument (share capital)
• Recorded as share capital + premium
• May have dividend (often waived)
• No maturity (conversion within 20 years per Companies Act)
• Converts to equity shares at trigger event

Key Characteristics:

Section 2: Detailed Comparison

Legal and Structural

Financial Statement Treatment

CCDs:

Balance Sheet (Pre-conversion):
Equity:
  Share Capital: --
Non-current Liabilities:
  Borrowings:
    Compulsorily Convertible Debentures: ₹X

P&L Impact:
  Interest expense: ₹X × interest rate

On Conversion:
  Borrowings decrease
  Share Capital + Share Premium increase

CCPS:

Balance Sheet (From day one):
Equity:
  Share Capital:
    Preference Share Capital: ₹X (face value)
  Other Equity:
    Securities Premium: ₹Y (premium amount)

P&L Impact (if dividend declared):
  Dividend on preference shares: ₹Z
  (But often no dividend)

On Conversion:
  Preference Share Capital decreases
  Equity Share Capital increases
  Premium adjustments

Regulatory/FEMA Treatment

Section 3: Tax Treatment

For the Company

For the Investor

The Holding Period Advantage

CCDs:

Timeline:
Day 0: Invest in CCD
Month 18: CCD converts to equity shares
Month 30: Sell shares (12 months post-conversion)

Holding Period: 12 months (from conversion)
Tax: STCG if sold before 12 months from conversion
     LTCG if sold after 12 months from conversion

CCPS:

Timeline:
Day 0: Invest in CCPS
Month 18: CCPS converts to equity shares
Month 30: Sell shares

Holding Period: 30 months (from original investment)
Tax: LTCG (held >24 months from investment)

Key Insight: CCPS holding period starts earlier, often resulting in LTCG treatment when CCDs would result in STCG.

Section 4: Economic Terms Comparison

Conversion Mechanics

Valuation Cap:

Discount:

Sample Terms Comparison

Investment: ₹1 crore
Cap: ₹10 crore pre-money
Discount: 20% to Series A

Scenario: Series A at ₹20 crore pre-money, ₹100 per share

CCD Conversion:
- Cap price: ₹10 crore ÷ [shares] = ₹50 per share equivalent
- Discount price: ₹100 × 0.8 = ₹80 per share
- Conversion at: ₹50 (lower of cap/discount)
- Shares issued: ₹1 crore ÷ ₹50 = 2,00,000 shares

CCPS Conversion:
- Same calculation
- Conversion ratio: 1 CCPS = X equity shares
- X determined by same cap/discount math
- Shares issued: 2,00,000 equity shares

Liquidation Preference

CCDs:

• As debt, may have priority in liquidation
• But conversion usually happens before liquidation
• Effective preference depends on conversion timing

CCPS:

• Explicit liquidation preference structurable
• Typically 1x non-participating
• Can be participating (controversial)

Sample Liquidation Preference Clause (CCPS):

Liquidation Preference:

In the event of Liquidation, the CCPS Holders shall receive,
prior and in preference to any distribution to equity
shareholders, an amount equal to:

(i) [1x] times the Original Issue Price per CCPS; plus
(ii) All declared but unpaid dividends on such CCPS

("Liquidation Preference Amount")

After payment of the Liquidation Preference Amount:
[Non-Participating]: CCPS Holders shall not participate further
[Participating]: CCPS Holders shall participate pro-rata with
equity shareholders in remaining proceeds

Section 5: Use Case Recommendations

When to Use CCDs

Best Suited For:

CCD Advantages:

• Interest is tax-deductible (albeit nominal)
• Simpler documentation (no preference terms)
• Clear maturity creates conversion urgency
• May be faster to execute

When to Use CCPS

Best Suited For:

CCPS Advantages:

• Equity classification from day one
• No maturity/repayment risk
• Holding period starts at investment
• Can include voting rights
• Better for debt covenants compliance

Hybrid Approach

Some rounds use both:

• Lead investor takes CCPS (negotiated terms)
• Smaller investors take CCDs (simpler)
• All convert at same trigger event
• Same conversion economics

Section 6: Drafting Considerations

Key CCD Terms

COMPULSORILY CONVERTIBLE DEBENTURE TERMS:

1. PRINCIPAL AMOUNT
   ₹[Amount] in words

2. INTEREST
   [0.01]% per annum, payable annually/at conversion
   [Simple/Compound]

3. MATURITY DATE
   [24] months from Issuance Date
   Extended by mutual consent

4. CONVERSION TRIGGERS
   (a) Qualified Financing (as defined)
   (b) Maturity Date
   (c) Change of Control
   (d) IPO

5. CONVERSION PRICE
   Lower of:
   (a) [Valuation Cap] ÷ Fully Diluted Shares
   (b) [Discount]% discount to Qualified Financing price

6. CONVERSION MECHANICS
   Principal + Accrued Interest → Equity Shares
   Fractional shares: Cash settlement

7. MOST FAVORED NATION
   If Company issues convertible instruments on better terms,
   these CCDs shall automatically be amended to match.

Key CCPS Terms

COMPULSORILY CONVERTIBLE PREFERENCE SHARE TERMS:

1. ISSUE PRICE
   ₹[X] per CCPS
   Face Value: ₹10
   Premium: ₹[X-10]

2. DIVIDEND
   Non-cumulative, non-participating
   [Nil] / [X]% of Face Value
   At Board discretion

3. LIQUIDATION PREFERENCE
   1x Original Issue Price, non-participating
   Prior to equity share distribution

4. CONVERSION
   Automatic on:
   (a) Qualified Financing
   (b) [5] years from Issuance
   (c) IPO
   (d) Mutual agreement

5. CONVERSION RATIO
   1 CCPS = [Y] Equity Shares
   Y = Original Issue Price ÷ Conversion Price

6. CONVERSION PRICE
   Lower of:
   (a) [Cap Price]
   (b) [Discount]% of Qualified Financing price

7. VOTING RIGHTS
   [None] / [Equal to equity on as-converted basis]

8. ANTI-DILUTION
   Broad-based weighted average adjustment
   (Standard anti-dilution clause)

9. INFORMATION RIGHTS
   Quarterly financials
   Annual audited financials
   Board meeting observer rights [optional]

Section 7: Foreign Investment Considerations

FEMA Compliance Matrix

Valuation Considerations

For Both Instruments:

• Valuation must be by registered valuer
• Internationally accepted methodology
• At arm's length
• As of a recent date

Valuation for Deferred Pricing:

Challenge:
Investment is ₹1 crore but conversion price deferred to Series A

Approach:
- Establish minimum valuation (the cap)
- Valuation certificate for cap amount
- Conversion at actual Series A price (if lower than cap)
- If Series A price > cap, no additional compliance needed

Round-Tripping Concerns

Issue:

• Indian promoter invests abroad
• Foreign entity invests in Indian company via CCD/CCPS
• May be perceived as round-tripping

Mitigation:

• Genuine foreign investor with independent substance
• Arm's length pricing
• Clear commercial rationale
• Proper documentation

Section 8: Post-Issuance Management

CCDs: Maturity Management

Maturity Approaching Checklist:

□ 6 months before maturity: Assess conversion readiness
□ 3 months before: Negotiate extension if needed
□ 1 month before: Finalize conversion price
□ At maturity: Execute conversion or extend

If No Qualified Financing:
Option A: Convert at cap price
Option B: Extend maturity by amendment
Option C: Mutual agreement on conversion terms

CCPS: Conversion Management

Conversion Event Checklist:

□ Identify conversion trigger
□ Calculate conversion ratio
□ Prepare board resolution
□ Issue equity shares
□ Cancel CCPS
□ Update share register
□ File with ROC (Form SH-7 for share capital change)
□ File FC-GPR (if foreign investment)

Information Rights

Typical Quarterly Updates:

• Financial summary
• Key metrics
• Cash runway
• Major developments
• Updated cap table

Section 9: Decision Framework

Founder's Decision Tree

Instrument Selection Decision Tree:

Start: Need to raise early-stage capital
       ↓
Is investor foreign?
├─ YES → Proceed to "Foreign Investor Path"
└─ NO → Proceed to "Domestic Investor Path"

FOREIGN INVESTOR PATH:
Is investor tax-sensitive to holding period?
├─ YES → CCPS (earlier LTCG eligibility)
└─ NO → Continue
       ↓
Is quick close critical (<2 weeks)?
├─ YES → CCD (simpler docs)
└─ NO → CCPS (cleaner structure)

DOMESTIC INVESTOR PATH:
Do you want interest expense deduction?
├─ YES → CCD
└─ NO → Continue
       ↓
Is investor institutional/sophisticated?
├─ YES → CCPS (they prefer equity classification)
└─ NO → Either (explain differences)
       ↓
Is long runway to next round likely?
├─ YES → CCPS (no maturity pressure)
└─ NO → CCD (maturity aligns)

DEFAULT: CCPS (cleaner, more standard)

Quick Reference Summary

Section 10: Recommendations

For Founders

1. Default to CCPS: Cleaner, more professional, standard market practice
2. Consider CCDs for Speed: When closing in days matters
3. Understand Tax Implications: Your investor's tax situation may dictate choice
4. Align with Next Round: If Series A is soon, either works; if distant, CCPS preferred
5. Get Legal Advice: Both instruments have nuances worth professional review

For Investors

1. Check Holding Period: CCPS advantage if holding >24 months likely
2. Negotiate Liquidation Preference: Easier in CCPS structure
3. Consider Information Rights: Specify in either instrument
4. Understand Conversion Mechanics: Same economics, different execution
5. FEMA Compliance: Ensure company handles regulatory filings

For Lawyers

1. Standardize Templates: Both instruments frequently used
2. Explain Trade-offs: Clients may not understand differences
3. Tax Coordination: Work with tax advisors on optimal structure
4. FEMA Clarity: Ensure compliance documentation complete
5. Conversion Protocols: Build clear mechanics to avoid disputes

Conclusion

Both CCDs and CCPS are valid instruments for early-stage fundraising. The choice depends on specific circumstances:

Most sophisticated investors and founders prefer CCPS for their cleaner structure and equity treatment. CCDs remain useful for quick bridges and specific tax situations.

The most important thing is ensuring both parties understand the instrument they're using - surprises at conversion time benefit no one.

Sources

• Companies Act, 2013 - Sections 55, 71
• FEMA (Non-debt Instruments) Rules, 2019
• Income Tax Act, 1961 - Capital Gains Provisions
• SEBI (ICDR) Regulations - Preferential Allotment
• Y Combinator - SAFE vs. Convertible Note