Convertible Notes in Southeast Asia and India: Key Risks and Considerations for Startups

Introduction

A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. This instrument allows startups to raise capital quickly without having to determine a valuation immediately. Convertible notes are particularly popular in Southeast Asia and India due to rapid startup growth, evolving venture capital landscapes and unique regulatory environments. However, startups should be aware that the terms and market practices in these regions can differ significantly from those in the United States.

What are convertible notes?

Convertible notes are agreements where investors lend money to a company, with the expectation that the loan will convert into equity at a later date, usually during the next significant financing round. Key terms include:

• Conversion cap: The maximum valuation at which the note will convert into equity, protecting early investors from excessive dilution. This is especially important in markets where valuations can fluctuate widely.
• Conversion discount: A percentage discount on the price per share at which the note converts, rewarding early investors for their risk. This incentivizes early participation.
• Representations and warranties: Statements of fact and assurances made by the company about its business, legal and financial status. These provide investors with comfort but can create liability for startups.

Key differences in Southeast Asia and India

While convertible notes in US venture practice feature a familiar mixture of terms, the relative lack of market norms and generally investor-favorable dynamics in Southeast Asia and India have given rise to more bespoke and sometimes onerous terms. Key differences include:

• More frequent use of operational and financial covenants.
• Broader and more detailed representations and warranties.
• Jurisdiction-specific regulatory requirements.
• Fewer established market standards, leading to greater variability in terms.

For example, while US notes often feature limited covenants, Southeast Asian and Indian notes may restrict hiring, expansion or additional fundraising without investor approval, which can impact a startup’s agility.

 Operational covenants

Convertible notes in Southeast Asia and India sometimes feature extensive operational covenants, such as restrictions on issuing new securities, amending dividend policies or changing the capital structure. For instance, a startup may be restricted from hiring key personnel or entering new markets without investor consent, potentially slowing growth.

Financial covenants

Financial covenants may include limits on incurring additional debt or requirements to maintain certain financial ratios. These can constrain a company’s ability to respond to changing business needs.

Representations and warranties

Convertible noteholders in these regions may request a more comprehensive set of representations and warranties, similar to those required in equity financings in the US. This increases the risk of “foot faults” – minor, often unintentional breaches that can still trigger default under the note. Startups should not assume that convertible notes are always simple or low risk; careful review and negotiation are essential to avoid unexpected liabilities.

Jurisdiction-specific features

Local regulations can significantly impact the structure and use of convertible notes. For example, foreign exchange restrictions limit the ability to issue notes to foreign investors, so Indian-incorporated companies primarily use convertible notes to raise from onshore angel investors. Other regulatory hurdles may include restrictions on foreign ownership, tax implications and compliance requirements, all of which should be considered early in the fundraising process.

Additional key considerations for startups

• Maturity dates: Be aware of note maturity dates, as they can pressure the company to raise funds or repay early. Set realistic timelines.
• Cap table complexity: Multiple notes can complicate the cap table and deter investors. Aim to consolidate and keep terms consistent.
• Qualified financing thresholds: Ensure the definition of “qualified financing” is realistic, or notes may not convert and could block future deals.
• Amendment provisions: Allow amendments with majority noteholder consent to avoid deadlock, rather than requiring unanimous approval.

Recent trends and market updates

There is increased scrutiny on foreign investment in India, and some Southeast Asian markets have seen a rise in investor-friendly terms due to macroeconomic uncertainty. Common trends include higher interest rates, stricter covenants and shorter maturities. Startups should stay informed about evolving market practices and regulatory changes that may affect convertible note terms, and be prepared to negotiate terms that balance investor protection with operational flexibility.

Conclusion

While convertible notes offer speed and flexibility, startups in Southeast Asia and India must approach them with the same diligence as equity financings. Understanding and negotiating all terms, especially bespoke covenants and representations, is critical to protecting the company’s interests and ensuring long-term success. Treat convertible notes as a serious financing tool – not just a quick fix – to set your company up for sustainable growth.