Bridging Capital with Compliance: The Venture Debt Playbook in India

Venture debt has become a powerful financing tool for India’s startup ecosystem. It allows founders to raise growth capital without immediate equity dilution, while giving investors predictable returns with potential upside through warrants or convertibles. Yet, unlike venture equity, venture debt in India sits at the crossroads of banking law, securities regulation, and foreign exchange management, creating unique compliance challenges.

The Legal Landscape of Venture Debt in India

Unlike equity investment, which is clearly regulated under the Companies Act and SEBI’s framework for Alternative Investment Funds (AIFs), venture debt does not have a single unified law. Instead, it is governed by a patchwork of:

• Reserve Bank of India (RBI) regulations on lending and debenture issuance.
• Securities and Exchange Board of India (SEBI) rules for AIFs and listed debt.
• Companies Act, 2013 provisions on borrowings, charges, and issuance of debentures.
• Income Tax Act, 1961 rules on interest deductibility and withholding.

 The result is regulatory fragmentation, which venture debt funds must carefully navigate.

Debt vs. Non-Debt Instruments

1. Debt Instruments: Traditional venture debt relies on loans, non-convertible debentures (NCDs), and bonds. These instruments are clearly treated as debt under Indian law. However, hurdles include:

• RBI restrictions – only registered NBFCs and banks can engage in lending as a business. This means unregistered funds cannot directly lend.
• Stamp duty and registration – NCDs require payment of state-level stamp duties, which vary across jurisdictions.
• Trustee requirement – issuance of privately placed debentures often requires appointment of a debenture trustee and creation of charges over assets.

2. Non-Debt Instruments: To replicate debt-like returns, funds sometimes use convertible preference shares or compulsorily convertible debentures (CCDs). These are legally treated as equity (non-debt instruments).

Advantages:

• Avoid RBI’s restrictions on lending.
• Offer upside potential on conversion.

Drawbacks:

• Exit must comply with pricing rules.
• Instruments cannot guarantee fixed IRRs in the same way as loans.

Regulatory Hurdles for Domestic Venture Debt

1. NBFC Licensing: A core hurdle is whether a venture debt fund requires an NBFC licence. Any entity “carrying on the business of lending” in India must be registered as an NBFC with RBI, unless exempt. Registration requires:

• Minimum net owned funds of ₹10 crore.
• Fit and proper criteria for promoters.
• Ongoing compliance with prudential norms, KYC/AML obligations, and reporting.
• For funds not structured as NBFCs, the preferred route is to operate as an AIF Category II, which can subscribe to debt securities but cannot directly lend.

2. AIF Regulations: SEBI’s AIF framework allows Category II AIFs to issue debt instruments such as NCDs to portfolio companies. Key hurdles:

• Concentration limits: AIFs cannot invest more than 25% of their corpus in one portfolio company.
• Leverage restrictions: AIFs cannot borrow funds except for temporary bridging (max 30 days, four times a year).
• Downstream investment rules: if the AIF has overseas investors, its downstream portfolio companies are treated as “foreign-owned” for sectoral compliance.

 Thus, while AIFs are increasingly used for venture debt, the regulations restrict concentration and leverage flexibility.

3. Companies Act Restrictions

The Companies Act imposes several restrictions on issuance of debt instruments:

• Private placement rules: NCDs can only be privately placed to a limited number of investors in one financial year.
• Charge creation: Security over company assets must be registered with the Registrar of Companies.
• Deposit rules – Non-convertible, secured debentures are excluded from the definition of deposits, but unsecured ones risk classification as “deposits,” triggering compliance burdens.

4. Taxation of Interest and Warrants:

• Interest payments on loans and NCDs are deductible for the borrower but taxable in the hands of the fund.
• Withholding obligations apply to companies paying interest, typically at 10% for resident funds.
• Warrants/options issued alongside venture debt may be treated as equity instruments; gains on exercise or sale are taxed as capital gains.
• Tax treatment directly affects the fund’s net returns and must be factored into structuring.

5. Repatriation of Returns within India: For domestic funds, repatriation is less about forex and more about cash flow timing and compliance:

• Redemption of NCDs:repayment must adhere to the debenture terms and SEBI/RBI guidelines.
• Buyback/Redemption of preference shares: subject to Companies Act limits on buybacks and solvency tests.
• Dividend distribution tax regime changes: now dividends are taxed in the hands of investors at applicable rates, increasing tax planning needs.

Practical Challenges

1. Regulatory Overlap: RBI governs lending, SEBI governs AIFs, and the Companies Act governs issuance of debt. Compliance with three regimes can delay deals.

2. Uncertainty on “venture debt” definition: Indian law does not separately recognise “venture debt” as an asset class, leaving funds to operate within NBFC/AIF categories.

3. Security enforcement: enforcement of charges under the Companies Act or SARFAESI is often slow for small-ticket startup loans, making collateral value less reliable.

4. Exit risks: Optionality clauses must comply with Indian contract and company law. Startups cannot guarantee fixed returns beyond statutory caps.

Structuring Strategies to Mitigate Risks

1. Operating as an AIF Category II: Many venture debt funds prefer to register as a Category II AIF. This permits subscription to privately placed NCDs of startups. Structuring NCDs with:
   • Security interests (pledge of shares, charge on IP or receivables).
   • Warrants or equity kickers for upside.
   • Covenants limiting further debt or dilution.
   • This allows the fund to provide debt-like returns without holding an NBFC licence.
2. NBFC-Venture Lending Model: Where scale justifies it, funds may seek NBFC registration. Advantages include:
   • Ability to provide loans directly.
   • More flexibility in structuring repayment schedules.
   • Ability to tap Indian banking lines for leverage.
   • However, NBFCs face significant compliance costs and RBI supervision.
3. Hybrid Structures: Some funds use hybrid instruments combining equity and debt features—for example, CCDs with warrants or NCDs with conversion options. These instruments balance regulatory compliance with the economics of venture debt.
4. Risk Mitigation in Deal Documents:
   • Escrow accounts to ring-fence repayment flows.
   • Financial covenants to prevent over-leveraging by the startup.
   • Event of default clauses linked to governance failures.
   • Drag-along and exit rights to align repayment with liquidity events.

Tax Planning

• Use of trust structures for pooling investments to optimise taxation.
• Careful selection between NCDs (interest income) and CCDs (capital gains treatment).
• Monitoring of warrant pricing to avoid reclassification as disguised equity.

Outlook for Venture Debt Funds

India’s regulatory environment is gradually becoming more supportive of alternative financing. SEBI and RBI recognise the role of venture debt in reducing equity dilution for startups. Recent relaxations in debenture issuance and the growing ecosystem of Category II AIFs point towards greater flexibility.

That said, venture debt remains constrained by the absence of a dedicated regulatory framework. Until such a regime is created, funds must carefully structure themselves within NBFC or AIF categories and rely on hybrid instruments to achieve their objectives.

Conclusion

Venture debt in India is poised for growth, but it is not a plug-and-play model. Funds must navigate a complex matrix of RBI, SEBI, and Companies Act rules, along with taxation hurdles.

The key to success lies in:

• Choosing the right vehicle (AIF vs NBFC).
• Using structured instruments (secured NCDs, CCDs, warrants).
• Embedding protective covenants and escrow arrangements.
• Planning exits and taxation from the outset.

For investors willing to manage these regulatory challenges, venture debt offers a strong opportunity to participate in India’s startup boom while diversifying from pure equity exposure.