Foreign Direct Investment in Indian Startup Companies

tax comply
6 days ago
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Foreign Direct Investment (FDI) plays a pivotal role in fueling the growth of India’s startup ecosystem. In recent years, the Government of India has progressively liberalized its FDI policy to make it more conducive for innovation-driven enterprises. Startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) under the Ministry of Commerce and Industry (MOCI) are allowed to raise capital from foreign investors, including via convertible notes. This article presents a detailed understanding of the legal provisions, compliance mechanisms, and strategic considerations involved in FDI in Indian startup companies.

1. Definition and Recognition of a Startup Company

1.1 Eligibility Criteria for Startup Recognition

As per the DPIIT, an entity is recognized as a startup if it fulfills the following conditions:

It is incorporated as a private limited company, partnership firm, or limited liability partnership (LLP).
Its turnover does not exceed INR 100 crore in any of the previous financial years.
It is not more than 10 years old from the date of incorporation.
It is working towards innovation, improvement, or development of products, services, or processes with a potential to create wealth or employment.
It is not formed by splitting or reconstruction of an existing business.
DPIIT Notification GSR 127(E) dated 19th February 2019

1.2 Definition under FDI Policy

Under FDI policy, only a private limited company incorporated under the Companies Act, 2013, and recognized under DPIIT’s startup notification, qualifies as a "startup company" for the purposes of receiving FDI Para 2.1.48 of Consolidated FDI Policy, 15th October 2020

2. FDI Through Convertible Notes

2.1 Meaning of Convertible Notes

A convertible note is a debt instrument issued by a startup company acknowledging the receipt of money, which is either:

Repayable at the option of the holder, or
Convertible into equity shares within a period not exceeding 10 years, subject to occurrence of specified events.
Rule 2(e), FEM (Non-Debt Instruments) Rules, 2019 and Para 2.1.9 of FDI Policy .

2.2 Who Can Invest in Convertible Notes?

A Person Resident Outside India (PROI)—excluding citizens or entities from Pakistan or Bangladesh—may invest in convertible notes issued by an Indian startup.

The minimum investment required is INR 25 lakhs (approx. USD 30,000) in a single tranche.
Regulation 3, FEM (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 [5]

2.3 Sectors Requiring Government Approval

If the startup operates in sectors that require government approval for foreign investment, such approval must be obtained before issuing convertible notes.

Conversion of such notes into equity must comply with the entry route, sectoral caps, and pricing guidelines.
The Reserve Bank of India (RBI) lays down the remittance rules for proceeds on maturity.

3. Payment and Compliance Framework

3.1 Mode of Payment

The investment must be received through:

Inward remittance via banking channels, or
Debit to NRE/FCNR(B)/Escrow accounts as per RBI’s Deposit Regulations.
Regulation 3, FEM (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 [5].

3.2 Repayment of Convertible Notes

Repayment or sale proceeds of convertible notes can be:

Remitted outside India, or
Credited to the investor’s NRE/FCNR(B) account.

3.3 Investment by NRI/OCI on Non-Repatriation Basis

Under Schedule IV of the FEM (Non-Debt Instruments) Rules, 2019, NRIs and OCIs, including companies and trusts controlled by them outside India, can invest in convertible notes on a non-repatriation basis.

Such investments are treated as domestic investments.
Investment is not allowed in:
- Nidhi companies
- Agricultural or plantation activities
- Real estate business
- Construction of farmhouses
- Transfer of development rights
  
  Schedule IV, FEM (Non-Debt Instruments) Rules, 2019.

3.4 Transfer of Convertible Notes

Convertible notes can be acquired or transferred by a person resident outside India, subject to:

Prescribed entry routes
Pricing guidelines

4. Reporting and Regulatory Compliance

Compliance with the Reserve Bank of India (RBI) and Foreign Exchange Management Act (FEMA) is crucial for both issuing and transferring convertible notes.

4.1 Form CN – Initial Issuance

The startup must file Form CN within 30 days of issuance of convertible notes to a foreign investor.

4.2 Form CN – Transfer Reporting

In case of a transfer of convertible notes between residents and non-residents, Form CN must be filed within 30 days of the transaction.

4.3 FLA (Foreign Liabilities and Assets) Return

Every Indian company or LLP that received foreign investment must file the FLA return by 15th July every year.

Regulation 4, FEM (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 .

4.4 SMF (Single Master Form) Filing

To streamline FDI compliance, the RBI has introduced the Single Master Form (SMF), integrating 9 separate forms including:

Form CN
FCGPR (for equity instruments)
FCTRS (for transfer of shares)
DI Form (for downstream investment)

Startups must first create an Entity Master Form (EMF) account on the FIRMS Portal: firms.rbi.org.in

A.P. (DIR Series) Circular No. 30 dated 7 June 2018 [8].

Conclusion

FDI provides Indian startups with access to global capital, enabling them to scale innovations, create employment, and compete internationally. However, availing FDI—especially through instruments like convertible notes—requires careful adherence to India's regulatory landscape. From eligibility to reporting, startups must ensure total compliance with the Reserve Bank of India and FEMA regulations to avoid penalties and operational setbacks.

A sound legal and financial framework, guided by updated compliance and expert consultation, is indispensable for startups aiming to tap into foreign capital. With a proactive approach, India’s startups can leverage FDI not just as funding, but as a strategic partnership for global growth.