Debentures or Preference Shares: What Should Your Startup Actually Raise On?

A founder’s complete guide to the fine print behind two very different fundraising instruments — what they cost you, what they risk, how they hit your cap table, and the questions every founder eventually asks

Introduction

At some point, almost every founder raising capital beyond a friends-and-family round runs into this question — sometimes buried in a term sheet, sometimes raised directly by an investor’s lawyer: should this round be structured as debentures or preference shares? The honest answer is that most founders sign whichever one their investor’s term sheet proposes, without fully understanding what they just agreed to. That’s a mistake worth avoiding, because the choice affects your cap table, your company’s tax bill, how much control you give up, what happens at your next fundraise, and — in a worst-case scenario where your startup can’t pay on schedule — whether an investor can actually push you into insolvency proceedings over it.

This is a genuinely comprehensive guide. It covers the plain-English basics, the real legal backing, cap table and dilution mechanics, governance implications, what each instrument actually costs in fees and process, what happens on conversion or exit, and a founder FAQ addressing the specific questions that tend to come up once a founder actually starts reading a term sheet closely.

The Two Instruments, in Plain English

A debenture is essentially a formal IOU. Your startup borrows money and promises to pay it back, usually with interest, by a certain date. The person who bought the debenture is your creditor — legally, they’re owed money, exactly like a bank that gave you a loan. This is codified under Section 2(30) of the Companies Act, 2013, which defines a debenture as an instrument evidencing debt.

A preference share is a special kind of ownership stake. The investor becomes a shareholder — a part-owner of your company — but with certain privileges over ordinary equity holders: typically a fixed return (a “preference dividend”), and priority over common shareholders (though not over creditors) if the company is wound up. This is governed by Section 43 of the Companies Act.

That one distinction — creditor vs. owner — is the root of almost every practical difference between the two, and it’s worth keeping firmly in mind as you read the rest of this.

Why Startups Actually Encounter Both

If you’ve raised a VC round, you’ve almost certainly encountered Compulsorily Convertible Preference Shares (CCPS) — the dominant instrument for Indian startup equity rounds, from seed through growth stage. It’s how most institutional investors structure their investment: preferred economic terms now, mandatory conversion to ordinary equity later.

But debentures show up too, usually in a different context: venture debt. If your startup has some revenue predictability and wants to extend runway, fund working capital, or bridge the gap between two equity rounds without diluting your cap table, a venture debt fund will typically structure that as Non-Convertible Debentures (NCDs), sometimes with warrants attached giving the lender a small equity kicker. Occasionally you’ll also see Compulsorily Convertible Debentures (CCDs) — a genuine hybrid, discussed below — used specifically to delay a valuation conversation.

Where Convertible Notes and iSAFE Instruments Fit In

Founders often ask where instruments like convertible notes or iSAFE notes (India’s adaptation of the US SAFE) sit in this picture, since they’re commonly discussed in the same breath.

• A Convertible Note is technically a debt instrument (available only to DPIIT-recognised startups, with a ₹25 lakh minimum ticket and up to a 10-year tenor) that converts into equity at a future priced round — so it behaves like a debenture until conversion, then behaves like equity.
• An iSAFE is, despite its SAFE-style branding, actually structured as CCPS under Indian company law (since a bare US-style SAFE has no direct legal recognition here) — so legally, it’s much closer to a preference share than to a debt instrument, notwithstanding how it’s marketed.

Both exist specifically to defer the valuation conversation to a later date, and both are genuinely useful at the earliest, angel/pre-seed stage. But once you’re negotiating a proper priced round or a venture debt facility, you’re almost always choosing squarely between CCPS and NCDs — which is what the rest of this guide focuses on.

What Each Option Actually Costs Your Startup

The Tax Angle

Interest paid on a debenture is a deductible business expense. It reduces your taxable profit before tax is calculated — meaning debt financing is genuinely cheaper on an after-tax basis, provided your startup has taxable income to offset it against.

Dividends paid on preference shares are not deductible. They come out of profits that have already been taxed — so, purely from a cost-of-capital standpoint, preference shares are more expensive for a profitable company than debt would be.

A Simple Worked Example

Say your startup raises ₹2 crore, and the agreed return is 10% annually.

• As an NCD, you pay ₹20 lakh in interest each year. If your startup is profitable, that ₹20 lakh reduces your taxable income before tax is computed — a real tax shield.
• As CCPS, if there’s a preference dividend obligation, that ₹20 lakh comes out of profits you’ve already paid tax on — no equivalent shield.

But here’s the catch for most startups: if you’re pre-revenue or not yet profitable — which describes the overwhelming majority of startups raising seed or Series A capital — this tax deductibility advantage is largely theoretical. You don’t have taxable profit to shield in the first place. This is one reason CCPS remains the dominant instrument at early stages.

The Cost of Issuing Each

Both instruments are typically issued via private placement under Section 42 of the Companies Act, so the core process (offer letter, board/shareholder resolution, PAS-3 filing) is similar either way. Two differences worth knowing:

• Debentures historically required a Debenture Redemption Reserve (DRR) — a portion of profits set aside specifically for repayment. This has been substantially relaxed: listed companies, NBFCs, and HFCs no longer need a DRR at all, and unlisted companies (which describes almost every startup) need only 10% of the outstanding debenture value set aside — a much lighter burden than it used to be.
• Preference shares require a Capital Redemption Reserve (CRR) where redemption is funded out of profits rather than a fresh share issue — a comparable, though not identical, reserve obligation.

Neither instrument carries a dramatically different stamp duty or registration cost at issuance for a private company — the real cost difference between the two is the tax treatment discussed above, not the paperwork.

How Each Instrument Actually Hits Your Cap Table

This is the part founders most often get wrong in their heads, so it’s worth being precise.

Debentures (NCDs) do not touch your cap table at all, for as long as they remain outstanding. No new shares are issued, no existing shareholder’s percentage ownership changes, and your ESOP pool’s relative size is completely unaffected. The debenture holder shows up on your balance sheet as a liability, not on your shareholder register.

Preference shares (CCPS) do affect your cap table — but not immediately in the way founders sometimes assume. At issuance, the investor becomes a preference shareholder, holding a class of shares separate from ordinary equity. The real dilution event happens on conversion — typically triggered by your next priced round, an IPO, or a specified date — when the CCPS converts into ordinary equity shares at a pre-agreed ratio (often tied to the price of that future round, sometimes with a discount or valuation cap). Until conversion happens, the CCPS holder’s voting impact on ordinary shareholder matters is usually limited, but their presence is very much on your cap table from day one, including in any fully-diluted ownership calculation an investor or acquirer will look at.

A genuinely important founder takeaway: when a VC shows you a “fully diluted cap table” during due diligence for your next round, your outstanding CCPS is counted as if already converted — but your outstanding NCDs generally aren’t, unless they’re specifically convertible. This is a real, practical reason NCDs are described as “non-dilutive” capital, while CCPS is not, even though neither involves an immediate share issuance to a brand-new class of ordinary shareholders at signing.

Governance and Control: What Investors Actually Get

A debenture holder generally gets no governance rights in the ordinary sense — no board seat, no voting rights on company matters, no veto over your decisions — because they’re a creditor, not a member of the company. What they typically do get, especially in a venture debt deal, is a set of financial covenants: minimum cash balance requirements, restrictions on taking on further debt, reporting obligations, and sometimes security over specific company assets. Breach a covenant, and even without a missed payment, the lender can often accelerate the debt or take other contractually agreed action.

A CCPS holder, by contrast, typically negotiates real governance rights as part of the round — a board seat or observer rights, protective provisions (veto rights) over major decisions like a new fundraise, a sale of the company, or amendments to the Articles, and information rights to regular financial reporting. This is a genuine trade-off: CCPS investors take more of an ownership-style interest in how the company is run, in exchange for taking equity-style risk rather than a lender’s fixed-return risk.

For a founder, this means the “cost” of each instrument isn’t just financial — an NCD from a venture debt fund is usually far less intrusive into your day-to-day decision-making than a CCPS round from a VC, even where the two might cost a similar amount economically.

What Happens If Your Startup Can’t Pay — The Part Founders Skip Over

This is, in practice, one of the most important legal differences for a founder to understand, and it was only definitively settled by the Supreme Court recently.

If you issue NCDs and your startup misses an interest payment or fails to redeem on time, the debenture holder is a creditor. Depending on the amount involved, they may be able to pursue insolvency proceedings against your company under the Insolvency and Bankruptcy Code — a serious, company-threatening escalation path that exists specifically because debenture holders are owed money, full stop, regardless of whether your business is having a rough quarter.

If you issue CCPS and your startup can’t redeem them on schedule (in the rare case they’re structured as redeemable rather than purely convertible), the Supreme Court has now made clear — in *EPC Constructions India Ltd. v. Matix Fertilizers and Chemicals Limited (2025) — that a preference shareholder cannot* use a missed redemption to drag your company into insolvency proceedings. The Court’s reasoning: redemption of preference shares can only legally happen out of distributable profits or a fresh share issue, so if your company genuinely doesn’t have that money available, it isn’t “in default” in the same unconditional sense a debt obligation carries.

What this means practically for a founder: taking on debentures is a genuinely higher-stakes commitment for a cash-constrained startup than issuing preference shares. A bad quarter with debt outstanding carries real insolvency exposure in a way that CCPS simply doesn’t.

What Happens on an Exit or Acquisition

This is worth thinking through before you sign, not after an acquirer shows up.

• Outstanding NCDs generally get paid off first, as a straightforward debt obligation, out of the sale proceeds — an acquirer typically wants all debt cleared or refinanced at closing, and the NCD holder has no further claim once repaid.
• CCPS holders, on the other hand, typically hold a liquidation preference — a right to receive a defined multiple of their investment (commonly 1x) before ordinary shareholders (including founders) receive anything, and only after that do they participate (via their as-converted equity) in whatever’s left, depending on whether the preference is structured as participating or non-participating. On a strong exit, this rarely matters much — but on a modest or disappointing exit, the liquidation preference can mean founders and ordinary shareholders receive far less than the headline sale price would suggest, while CCPS investors are made whole first.

A genuinely useful founder question to ask before signing a CCPS term sheet: what does my payout actually look like in a mediocre exit scenario, not just a great one? Model it with real numbers, not just the round’s headline valuation.

Typical Market Terms in India (For Context, Not as a Benchmark to Demand)

While every deal is negotiated individually, founders should know roughly what’s typical so they can sense-check a proposed term sheet:

• CCPS liquidation preference: 1x, non-participating is the standard at seed and Series A in India; participating preference is possible but should be treated as a red flag worth pushing back on at early stages.
• CCPS dividend: often nominal or waived in practice, since investors are underwriting equity upside through conversion, not the dividend itself.
• NCD/venture debt interest rates: vary considerably with the lender and the startup’s risk profile, but are generally priced meaningfully higher than a conventional bank loan would be, reflecting the higher risk venture debt funds take relative to a bank.
• NCD tenor: commonly 18 to 36 months for venture debt, often timed to bridge to a specific expected future equity round.
• Warrant coverage on NCDs: venture debt deals frequently include warrants (the right to purchase a small amount of equity later, typically 5-15% of the loan value) as a kicker for the lender — this is a small, delayed dilution event, distinct from the loan itself.

A Founder’s FAQ

Can an NCD later convert into equity?

Not unless it’s specifically structured as convertible (a CCD) — a plain NCD stays debt for its entire life and is simply repaid. If you want the option of a debt-to-equity conversion path, this needs to be built into the instrument from the start, not assumed.

Does issuing CCPS dilute me immediately?

Not your voting control in the way an ordinary equity issuance might, but it does add to your fully diluted share count from day one — which matters for how your company is valued and how much of the pie you actually hold once conversion eventually happens.

What if I want capital without giving up any control, and I don’t have predictable revenue yet?

This is a genuinely hard combination to solve for — venture debt lenders want to see revenue predictability before extending an NCD, and most equity investors will want CCPS with at least some governance rights. At the earliest stage, an iSAFE or convertible note (deferring the valuation and governance conversation to your next priced round) is often the most realistic middle path.

Can I mix instruments within the same round?

Technically yes, but it’s a common structuring mistake. Mixing an iSAFE with a separately priced CCPS tranche in the same round creates real ambiguity about effective ownership on a fully diluted basis, and complicates every subsequent round or acquisition. Pick one instrument per round wherever possible.

Will taking venture debt hurt my next equity round?

Not inherently — many investors view a modest, well-structured venture debt facility as a sign of financial discipline. What can hurt you is excessive leverage relative to your revenue, or restrictive covenants that constrain the flexibility a new equity investor wants to see.

Do I need my existing investors’ consent to take on debentures?

Very possibly — check your existing Shareholders’ Agreement. Many SHAs include protective provisions requiring investor consent before the company takes on new debt above a specified threshold, precisely because new debt affects the risk profile of existing equity holders.

What happens to unredeemed preference shares if my startup never has another priced round?

This is a genuine structuring risk worth negotiating upfront — a CCPS agreement should specify a longstop date or fallback mechanism (mandatory conversion at a defined valuation, for instance) rather than leaving conversion open-ended and contingent entirely on a future round that may never happen.

Is one of these “safer” for my company overall?

In terms of insolvency exposure if things go badly, CCPS is structurally safer for a cash-constrained company than NCDs, per the case law discussed above. In terms of long-run dilution and control, NCDs are “safer” for founders who successfully repay them. There’s no universally safer option — it depends on your confidence in near-term cash flow.

Can I use debentures to raise from friends and family, or does it have to be institutional?

There’s no legal requirement that debenture holders be institutional — friends, family, or angels can hold debentures too. What matters is that the private placement process under Section 42 is followed correctly regardless of who the investor is, and that whoever holds the debenture understands they’re a creditor with the associated (if unlikely-to-be-exercised) rights that come with that status.

Does my startup need a credit rating to issue NCDs?

Not for a private placement to a specific, known investor like a venture debt fund — credit ratings become relevant mainly for a public NCD issuance, which is a different, considerably more formal process most startups will never need to consider.

What happens to the interest rate or dividend if my startup’s fortunes change dramatically?

An NCD’s interest rate is fixed by contract and doesn’t adjust for how your business is doing — you owe it regardless. A CCPS dividend, even where notionally agreed, is only payable out of distributable profits, giving you real breathing room in a bad year that a debt obligation doesn’t provide.

When Debentures (or Venture Debt/NCDs) Actually Make Sense for a Startup

1. You want to extend runway without diluting your cap table.
2. You have some revenue predictability, since lenders want a credible repayment path.
3. You’re bridging between two equity rounds, avoiding a premature, dilutive priced round.
4. You want to avoid “down round” optics during a rough patch.
5. You’re financing something specific and asset-backed — inventory, receivables, or equipment.

When Preference Shares (CCPS) Actually Make Sense for a Startup

6. You’re raising from a VC or institutional investor — this is simply the market standard.
7. Your cash flow is genuinely unpredictable, and you don’t want a fixed, unconditional payment obligation.
8. You want to preserve borrowing headroom for later conventional or venture debt.
9. Your investor wants equity-like upside, not just a fixed return.
10. You want the lower insolvency-risk downside scenario discussed above.

A Simple Decision Framework

If your situation is…	The better fit is usually…
You’re raising a priced round from a VC	CCPS — this is the market standard, and it’s what your investor will propose regardless
You want to extend runway without diluting further	NCDs / venture debt
Your revenue is unpredictable or pre-revenue	CCPS — avoid fixed debt obligations you may not be able to meet
You have predictable revenue and want cheaper, tax-efficient capital	NCDs, provided you’re at least approaching profitability
You’re bridging to a bigger round at a higher valuation	NCDs (often convertible, to roll into the next equity round)
You want to avoid insolvency exposure if cash gets tight	CCPS — post EPC Constructions v. Matix Fertilizers, missed redemption alone doesn’t expose you to an IBC petition the way missed debt payments can
Your investor is a growth-stage equity VC	CCPS — this is simply what they’re structured to invest through
Your investor is a dedicated venture debt fund	NCDs — this is their entire business model
You want minimal governance intrusion	NCDs — covenants, but generally no board seat or veto rights
You’re at the very earliest, pre-priced-round stage	Consider an iSAFE or convertible note instead of committing to either fully

 

Conclusion

For most founders, the honest, practical answer to “debentures or preference shares” is: it depends far more on who’s writing the cheque, your stage, and your revenue predictability than on which instrument is objectively “better.” A VC fund will almost always want CCPS; a venture debt fund will almost always want NCDs. What actually matters is understanding, before you sign anything, that these aren’t interchangeable variations on the same idea — one makes your investor a creditor with real legal teeth if you can’t pay, and the other makes them a shareholder whose return is tied, by law, to whether your company actually has the profits to support it, but who typically wants a real say in how you run things in exchange. Model both the upside and the mediocre-exit scenario, check what your existing SHA already commits you to, and negotiate the terms inside whichever instrument you’re being offered with your eyes fully open.

This article is intended for general informational purposes and does not constitute legal or financial advice. Founders should have their specific fundraising structure and instrument choice reviewed by qualified legal and financial counsel before signing a term sheet.

 

If you’re structuring a fundraise and deciding between debentures and preference shares, or need your term sheet or instrument documentation reviewed, feel free to reach out to VNC Corporate & Legal, Advocates & Solicitors.