Convertible Notes

What follows is the position as of July 2026, written for founders deciding how to take early money and for the investors providing it. The State Bank's borrowing framework and the tax rules cited here change often enough that the bracketed confirmations are part of the work, not an afterthought.

A convertible note is a loan with a conversion right stapled to it. That one sentence does most of the analytical work in Pakistan, because everything that is true of a loan — tax on the return, restrictions on who may lend across the border, the creditor's remedies, the possibility of security — is true of the note from the day it is signed, long before anyone thinks about shares. Founders who reach for a note because it feels like "equity later" are often surprised to be running a regulated borrowing in the meantime. Investors who treat it as a SAFE with a deadline are usually the ones who drafted the deadline badly.

Debt first, equity maybe

Between signing and conversion, the noteholder is a creditor. The note is a contract enforceable under the Contract Act, 1872; at maturity the principal, and any accrued return, is a debt the holder can sue for; in an insolvency the holder ranks with the company's unsecured creditors — or ahead of them, if secured — and in every case ahead of the shareholders. This is the note's genuine advantage over a SAFE for the investor, and its genuine burden for the company: the instrument has an ending, and the ending is a liability.

The return needs a design decision at the start. Pakistani practice offers three shapes: a conventional interest coupon; a markup structure, common in local documentation; or a zero-coupon note where the investor's return comes entirely through the conversion discount. The choice drives tax — payments of profit on debt attract withholding under the Income Tax Ordinance, 2001, at rates that change with Finance Acts [CURRENT WITHHOLDING PROVISIONS AND RATES — TO BE VERIFIED BY REVIEWING LAWYER] — and it intersects with the wider riba transition in Pakistani law, which remains in motion and should be checked as of the signing date [STATUS — TO BE VERIFIED BY REVIEWING LAWYER]. Many startup notes avoid the entire topic by carrying no running return at all.

One more local threshold question: the Companies Act, 2017 restricts how companies may raise borrowings and deposits, and a friends-and-family note round — many small lenders, loosely papered — is where those restrictions are most likely to bite [APPLICATION TO PRIVATE COMPANY BORROWINGS FROM INDIVIDUALS — TO BE VERIFIED BY REVIEWING LAWYER]. A handful of sophisticated lenders on proper documents is a different instrument, legally, from the same rupees crowdsourced.

Foreign lenders: the State Bank's gate

When the noteholder is outside Pakistan, the note becomes foreign borrowing, and the governing regime is the Foreign Exchange Regulation Act, 1947 as administered through the State Bank's framework for private-sector foreign currency loans. The framework prescribes the eligible categories of lender, ceilings on pricing, permissible tenors, and — critically — registration of the loan through the company's authorised dealer before the money is drawn [CURRENT FRAMEWORK, INCLUDING ANY STARTUP-SPECIFIC PROVISION FOR CONVERTIBLE DEBT — TO BE VERIFIED BY REVIEWING LAWYER]. Registration is not a stamp of prestige; it is what makes the debt visible to the system that will later have to approve money flowing out. An unregistered foreign note leaves the lender with no reliable path to repayment across the border and no clean path to repatriable shares on conversion, and it leaves the company with an exchange-control defect that every future investor's counsel will find.

Conversion adds a second exchange-control moment. Extinguishing a registered foreign debt in exchange for shares changes the investment's character from loan to equity, and that change must itself be handled through the authorised dealer under the prescribed treatment so that the resulting shares carry repatriable status [CONVERSION MECHANICS UNDER THE FE MANUAL — TO BE VERIFIED BY REVIEWING LAWYER]. Plan both moments at signing. The deals that go wrong here go wrong at the second step, years after everyone stopped paying attention.

Converting the loan into shares

The conversion is a fresh issue of shares by a Pakistani private company, and it passes through the same statutory machinery as any other issue: the pre-emption principle in section 83 of the Companies Act, 2017, the shareholder authority required to issue to an outsider through the prescribed route, authorised capital headroom, allotment, and the return filed with the SECP [MECHANISM UNDER THE FURTHER ISSUE REGULATIONS FOR PRIVATE COMPANIES — TO BE VERIFIED BY REVIEWING LAWYER]. Two features are specific to notes. First, the consideration: the shares are issued against cancellation of the debt rather than fresh cash, which makes the issue one for consideration otherwise than in cash, with its own disclosure and, in some cases, valuation consequences in the filing [REQUIREMENTS — TO BE VERIFIED BY REVIEWING LAWYER]. Second, the arithmetic: the cap and discount set the conversion price by contract, but company law sets a floor — shares generally cannot be issued below face value without satisfying the Act's conditions — so the model should be run at signing to confirm the promised price is lawfully deliverable [DISCOUNT CONDITIONS — TO BE VERIFIED BY REVIEWING LAWYER].

The discipline that makes conversion boring, in the good sense, is front-loading: pass the resolutions and collect the pre-emption waivers when the note is signed, keep the headroom under review as other instruments stack up, and give the conversion a stated timeline with remedies — the Specific Relief Act, 1877 shapes what a court can order in kind — if the company fails to perform.

Maturity without a round

Every convertible note contains a small time bomb, and it is the maturity date. The standard startup assumption — a qualifying round will arrive before maturity — fails often enough that the maturity clause is the most-litigated-in-spirit provision in the instrument, even where nothing reaches a court. When the date arrives with no round closed, the parties hold mismatched positions: the holder owns a debt claim against a company that cannot pay it; the company needs a forbearance the document may not require the holder to give.

Good drafting resolves the standoff in advance by stating the waterfall: extension by mutual consent on defined terms; conversion at maturity into shares at the cap, at the holder's election or automatically; and only then default, with its consequences spelled out. Founders should also resist vanity maturity dates — a twelve-month note signed into an eighteen-month fundraising market schedules its own crisis. And both sides should diarise the date: the cheapest restructuring of a note happens six months before maturity, the most expensive one six days after.

Choosing the note against the alternatives

The note earns its place when its debt nature is a feature: an investor who wants downside standing and a deadline; a bridge into a round already forming, where maturity is a formality; local money, where the exchange-control overlay does not apply and the tax questions are manageable. The SAFE earns its place when the parties want no maturity pressure and accept a pure contractual claim. The priced round earns its place sooner than founders think — once the corporate approvals must be assembled anyway, the incremental cost of pricing the equity honestly can be smaller than the deferred ambiguity of stacked convertibles. And where the investors are foreign funds insisting on native instruments, the real question stops being note-versus-SAFE and becomes whether the company raises through a foreign holding structure at all — a decision with its own exchange-control consequences for resident founders, taken with advice and never by default [HOLDING-STRUCTURE TREATMENT FOR RESIDENTS — TO BE VERIFIED BY REVIEWING LAWYER].

Whichever instrument wins, the same habit applies: model every outstanding convertible at its cap in one fully diluted table, because notes and SAFEs dilute silently until the day they all convert loudly, together, in the round that was supposed to be the easy one.