These instruments, as the name suggests, are hybrid in nature, with dual characteristics. Initially, they act as debt instruments (earning a fixed interest rate or fixed dividend rate) and at a later stage, they get converted into equity – either compulsorily or at the option of the investor – subject to fulfillment of mutually decided conditions.
Since startups, at least in the initial stages operate in cash-preserving mode, the interest/dividend is usually cumulative and converted into equity rather than regular payout in cash. Investment by non-residents in convertible instruments are governed by FDI regulations under FEMA, irrespective of the legal status of the receiving entity. Examples – CNs, CCDs, CCPS.
* Vide notification dated 22 April 2020, the Central Government extended the approval route for making FDI in equity instruments to all countries sharing land border with India. However, in our opinion, since CN does not fall under the definition of equity instruments (which includes CCDs and CCPS); restriction on CN issuance with government approval only applies to Pakistan and Bangladesh citizens/entities.
Non-convertible/optionally/partially convertible debentures and preference shares are governed by the ECB guidelines which have been discussed later in this document.