Taking Foreign Investment: What FEMA Means For Your Term Sheet

The regime in outline

Foreign investment into an Indian company is governed by the Foreign Exchange Management Act, 1999 and the rules made under it, principally the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, with the government's consolidated FDI policy and the Reserve Bank of India's directions on reporting. Three things generally matter to a startup round: whether the sector permits the investment and on what conditions, whether the price at which shares are issued meets the pricing requirements, and whether the transaction is reported correctly and on time.

None of this makes foreign investment difficult. Many Indian startups take it every year, and most technology businesses fall under the automatic route, where no prior government approval is needed. What it does mean is that a term sheet drafted entirely offshore may contain terms that need adjusting, and that the closing has a compliance workstream alongside the legal one.

Which investors count as non-resident?

FEMA distinguishes a person resident in India from a person resident outside India, and the rules apply to investment by the latter. That obviously includes foreign venture funds and foreign companies. It also commonly includes offshore holding vehicles set up by Indian-origin investors, and individual angels who live abroad.

Non-resident Indians and overseas citizens of India are a special case. Investment by them on a non-repatriation basis is generally treated on par with domestic investment, while investment on a repatriation basis is treated as foreign investment. The basis needs to be identified at the start, because it changes pricing and reporting.

Then there is Press Note 3 of 2020. An investment from an entity of a country that shares a land border with India, or where the beneficial owner of the investment is situated in or is a citizen of such a country, requires government approval, even in sectors that are otherwise under the automatic route. Funds with limited partners from those countries can be caught through the beneficial ownership test, so ask the investor to confirm its position in writing early.

Which instruments count as foreign direct investment?

Equity shares, compulsorily convertible preference shares, compulsorily convertible debentures and share warrants are treated as equity instruments. Instruments that are optionally convertible, or not convertible at all, are generally treated as debt and fall under the external commercial borrowing framework, which has different conditions.

That is why Indian rounds with foreign investors are almost always done through compulsorily convertible preference shares. They carry preferential rights such as liquidation preference and anti-dilution, while counting as equity under the foreign investment rules. Convertible notes are permitted for startups recognised by the Department for Promotion of Industry and Internal Trade, subject to conditions, and are sometimes used for small early cheques.

For convertible instruments, the conversion price or formula should generally be fixed upfront at the time of issue, and the price at conversion should not be lower than the fair value worked out at the time of issue. That affects how aggressive an anti-dilution adjustment can be for a non-resident holder.

How does pricing work for a non-resident investor?

When an Indian company issues shares to a non-resident, the price generally must be no less than the fair value determined under an internationally accepted pricing methodology on an arm's length basis, certified by a chartered accountant, a SEBI-registered merchant banker or a practising cost accountant. When a resident transfers shares to a non-resident, the price generally must be no less than fair value. When a non-resident transfers to a resident, the price generally must not exceed fair value.

A worked example. A foreign fund agrees to invest ₹8 crore at ₹400 per share. A merchant banker's valuation, at the time of issue, puts fair value at ₹350 per share. The issue at ₹400 is above the floor and works. If the valuation had come in at ₹450, issuing at ₹400 would fall below fair value, and the price, the valuation or the structure would need to change. Get the valuation done early, and make sure its date is close to the date of issue.

The same rules affect founder transactions. A founder selling a few secondary shares to the foreign investor must sell at no less than fair value. A leaver clause requiring a departing founder to transfer shares to an offshore investor at ₹1 per share may not work as written.

The terms that most often need rework

The recurring theme is guaranteed outcomes. Terms giving a non-resident investor an assured return, or an unconditional right to exit at a pre-agreed price regardless of company performance, sit uneasily with pricing rules premised on the investor bearing equity risk.

This does not mean investors cannot have exit rights. Optionality clauses such as put options are generally permitted for non-resident investors, subject to a minimum lock-in, commonly one year, and an exit price that does not guarantee an assured return and does not exceed the fair value at the time of exit. What is permissible turns on detail and on rules that are periodically revised, which is exactly why this belongs with counsel rather than in a template.

Reporting is a deadline, not a formality

Foreign investment transactions carry reporting obligations with timelines. Shares must generally be issued within 60 days of receiving the investment; if not, the money must be refunded within 15 days after that period. The issue of shares to a non-resident is reported in Form FC-GPR within 30 days of the date of issue. A transfer of shares between a resident and a non-resident is reported in Form FC-TRS, generally within 60 days of receipt or remittance of the consideration. Companies with foreign investment also file an annual return on foreign liabilities and assets, due by 15 July each year.

Missing these is a compliance issue that surfaces later, typically during the next round's diligence or an audit. Late reporting can usually be regularised by paying a late submission fee, but more serious contraventions can attract penalties under Section 13 of FEMA of up to three times the sum involved where it is quantifiable, or compounding proceedings. Remediation is always more painful than compliance.

For founders the practical point is to make sure someone owns this at closing. It frequently falls between the investor's counsel, the company's counsel and the company secretary, and a task everyone assumes someone else is doing is the one that gets missed.

What to do at term sheet stage

• Identify early which investors are non-resident, including through offshore vehicles, and whether any NRI investment is on a repatriation or non-repatriation basis.
• Ask each investor to confirm in writing whether Press Note 3 applies to it, by country or by beneficial ownership.
• Flag any assured return, guaranteed exit price or put option at a fixed value for review.
• Confirm the sector position for your business rather than assuming it is unrestricted.
• Commission the fair value certificate early and time it close to the date of issue.
• Use compulsorily convertible instruments, with the conversion formula fixed upfront.
• Agree who is responsible for each regulatory filing, and by when, in the closing checklist.
• Budget for counsel experienced in cross-border investment rather than general corporate work.

A closing timeline that works

A typical sequence for a round with a foreign lead looks like this. Agree the term sheet with exit terms framed at fair value. Commission the valuation report and run the company law approvals for the issue, including the board and shareholder resolutions needed for a private placement or preferential allotment under the Companies Act, 2013. Sign the definitive documents. Receive the funds through banking channels, with the bank's foreign inward remittance documentation. Issue the shares well within 60 days. File Form FC-GPR within 30 days of issue, along with the Registrar filings for the allotment. Diarise the annual foreign liabilities and assets return for 15 July.

Built into the plan from the start, this adds days, not weeks. Discovered at the end, it can delay closing and the money.

A note on what this guide does not do

Foreign investment rules are detailed, sector-specific and revised periodically. Anything written generally, including this guide, can only tell you where to look and what to raise. It cannot tell you whether a particular structure works for your company in your sector at the time you close.

That is not a hedge for its own sake. It is the actual position, and a founder who treats a general article as clearance is taking a risk that a two-hour conversation with the right advisor would remove.