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Valuing a pre-revenue or low-traction company is difficult. Bridging recognises the urgency often involved in short-term cash flow needs as companies prepare for larger, institutional funding rounds. Detailed valuation or full due diligence are typically not the primary drivers of such bridge financing. The Companies Act, 2013 (act), and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (rules), however, do not permit complete pricing ambiguity, even in interim or bridge financing. Deferred valuation structures must provide commercial flexibility without violating regulations.

The act mandates that private placement share pricing be supported by a registered valuer’s report. The rules require companies to issue equity instruments to non-residents at a price not less than fair market value, determined by internationally accepted methods and certified by a Securities and Exchange Board of India-registered merchant banker or chartered accountant. Such instruments include equity shares, convertible debentures, preference shares and share warrants.

Convertible notes: Startup rules ambiguity

The Companies (Acceptance of Deposits) Rules, 2014, were amended to permit Department for Promotion of Industry and Internal Trade (DPIIT)-registered startups to issue convertible notes without them being classified as deposits. These are debts repayable or convertible into equity within a specified period not exceeding 10 years or earlier on completion of mutually decided milestones. However, the act was not amended, creating ambiguity about convertible note valuation requirements.

The option is limited to DPIIT-registered startup companies in the technology or innovation-driven sectors. Registration is valid for 10 years, or 20 years for deep tech startups, or until the company’s annual turnover is below INR2 billion (USD22 million), or INR3 billion in the case of deep tech startups, whichever is earlier. The rules allow convertible notes to be issued to non-resident investors by registered startups. However, they must be converted within 10 years and the conversion price should at least equal the fair market value of equity shares. These conditions do not make convertible notes attractive.

iSAFE instruments defer equity valuation

The market has embraced convertible equity instruments that defer final equity pricing while embedding valuation mechanisms. These include structures such as simple agreements for future equity (SAFE), contractual instruments used in some overseas jurisdictions. In India, they have been adapted as compulsorily convertible preference shares and are referred to as iSAFE agreements. Such instruments comply with the regulatory framework. They are issued at a price supported by a valuation report but allow the conversion price to be adjusted based on the valuation in a future funding round. To reward early investors, companies offer to convert iSAFEs at a discount to the price offered to new investors in the next round. Commercially attractive, such discounted prices should not breach the minimum pricing requirements under the rules.

Conversion prices often have a floor and a cap, either fixed or based on a predetermined formula. The price floor protects companies from significant dilution because of future underperformance, while a cap guarantees a minimum stake for investors. If valuation-based funding rounds do not occur within a specified period, such formulas often link the company valuations to such metrics as revenue or EBITDA multiples. Companies may thus raise capital without committing to a valuation before business figures or growth trajectories are fully established.

Deferred valuation: Conversion timing compliance

Deferred valuation structures must ensure that deferral is not open-ended. The timing of the equity issues must be set. Triggers, such as automatic conversion on a priced round or mandatory conversion at the initial conversion price on expiry of a defined period, will see conversion.

Although deferred valuation structures offer flexibility in early stage fundraising, they face regulatory rigidity. Valuations may be postponed but the pricing of equity ultimately issued will not escape statutory valuation and pricing norms. This matters most in cross-border transactions. Authorised dealer banks and regulators assess compliance not at the time capital is advanced but at the point of conversion, transfer or exit. Any mismatch between commercial intent and regulatory requirements is then too late to be corrected.

Swathi Girimaji is a partner and Poorna Shree is an associate at Bharucha & Partners