Published on 15 September 2024
Introduction
India has a long history of using contributions and other methods to raise money from the public for a variety of objectives. Crowdfunding is a similar strategy but with the usage of web- based platforms. It has earned worldwide acclaim for its benefits to the growth of small enterprises. IOSCO Staff Working Paper has categorized crowdfunding under four types [1] which has been widely accepted by many jurisdictions including India. Under equity crowdfunding, funds are solicited from investors in consideration of issue of equity shares of the company to investors.[2]
In contrast to other countries like the United States, which have passed the Jumpstart Our Business Startups Act (jointly referred to as the "JOBS Act"), India lacks any kind of legal framework for equity crowdfunding.
In this blog piece, I will analyze the opportunities and legal framework around equity crowdfunding (EC). I will examine the implications of the new laws and how entrepreneurs may capitalize on equity crowdfunding platforms. Finally, I will conclude with my opinion on the adjustments that need be made in the regulations for the proper working of EC.
Opportunities and Risks
Equity crowdfunding allows businesses to raise money from a wide range of investors, democratizing the investment landscape. Equity crowdfunding, as opposed to traditional fundraising methods such as venture capital or angel investors, allows organizations to obtain smaller investments from a larger number of people. This strategy has several substantial benefits, including access to a larger investment base, diversification of funding sources, market validation, and an active investor base.
Despite the benefits listed above, equity crowdfunding carries a number of risks, which raises concerns of SEBI and makes it unlawful. On these unregulated sites, some of these risks include the possibility of fraud and money-laundering activities. As per the statistics, more than 50% of start-ups are prone to failure in their initial five years.[3] As a result, SEBI, which has been tasked with investor protection, does not want to place investors in a position where they have no method of recovering their investment if a company fails. In a crowdfunding system, the public may not have such knowledge and skill to judge whether an enterprise is capable of generating revenue. The issuing business may also fail to give complete disclosures for investors to verify, resulting in knowledge asymmetry that may hurt investors. The absence of secondary market in case of crowdfunding, makes the securities offered through it, illiquid. This also takes away the option of immediate exit to the investors in case the issuing company defaults or commits fraud putting them in a disadvantageous position.
Existing Legal Framework
Crowdfunding entails small investments from a large number of people, yet such fundraising has been hampered by securities restrictions. Under the new Companies Act, even though the smaller companies have been allowed to raise funding from up to 200 investors in exchange of securities in a financial year but it restricts their ability to disseminate their offer in public because of restriction on advertisements accompanied with private placements[4].
Furthermore, the definition of crowdfunding calls for "small financial contributions," whereas the minimum contribution requirements for VCFs (Venture Capital Funds) and AIFs (Alternative Investment Funds), namely INR 500,000 and INR 10 million respectively, are prohibitively high for raising funds through crowdfunding. They also have a diverse investment portfolio that is not limited to early-stage enterprises and cannot sell their units to the general public. SEBI has recognized the incapacity of early-stage enterprises to raise capital under such rules, but has failed to solve their funding needs. As a result, crowdfunding is impossible to place in either VCF or AIF.
Looking at the present regulatory environment, it is clear that equity-based crowdfunding has been tightly controlled in India by imposing onerous conditions on public offerings of securities. The regulatory structure is designed in such a way that it protects investors while obscuring the case of crowdfunding platforms in India. Equity crowdfunding had been reduced to impossible.
It is difficult to place crowdfunding under either “public offer” or “private placement” route or as VCF or AIF. If we imagine a scenario where a start-up or SME approaches large number of investors who are a part of general public on a crowdfunding platform but restricts the number of investors to 50, then such an offer cannot be categorised into either public offer or private placement.[5] Thus, crowdfunding is a fresh concept that falls somewhere between the extremes of public offer and private placement. As a result, this unorthodox way of fundraising necessitates a whole distinct legal framework.
As a result, SEBI brought up the consultation paper in 2014[6] (SRCP), discussing the prospects of crowdfunding and its implementation in India. Its major concern was balancing the growth of small businesses and the protection of investors.
Following a close examination of the consultation document, two difficulties emerge: (i) the impossibility of retail investors to participate in the EC due to regulatory framework requirements, and (ii) the inability of emerging crowdfunding platforms to meet with regulatory requirements.
The goal of EC is to allow a large number of investors to make small investments. This enables (i) companies that are not publicly listed to raise equity money, and (ii) investors who are not publicly listed to participate in this fundraising. The SRCP limits EC participation to Accredited Investors or Qualified Institutional Buyers ("QIB"), corporations registered in India with a net worth of INR two hundred million or more, and people with a net worth of INR two million or more (excluding principal residence). Individuals who do not fit this condition may join provided their gross annual income is less than INR one million. [7] It is important to note that if these qualifying standards are not completed, Information Asymmetry will result in a number of inexperienced small investors investing in extremely volatile enterprises. While this classification is necessary for financial stability, it may exclude retail investors who do not fit into these groups. Furthermore, Accredited investors base their investment on a review of the company's social and financial position, which may not be available for risk-based start-ups. As a result, many start-ups and SMEs may be unable to obtain finance through EC. Moreover, following the Companies (Prospectus and Allotment of Securities) Rules, 2014, the SRCP allow for the maximum number of investors (excluding QIBs, companies, and employees) involved in an EC company to be limited to two hundred. [8]The Private Placement Offer Letter submitted by the issuer is circulated online only to selected accredited investors who are registered with the crowdfunding platform[9] and can contribute at least twenty thousand to the company. This prevents the business's power from dissolving, but it may establish a hierarchy of retail investors who can subscribe to equity shares based on their income.
SEBI's suggestions failed to address the difficulties that existed in India's existing regulatory regime. In fact, it has returned to an earlier regime with tougher rules on the scope of investors and the platform's obligations. Its suggestions ignore the core definition of crowdfunding, which is "small financial contribution from a large number of investors." By capping the category and number of investors, SEBI has removed the vital "crowd" from crowdfunding.
Way Forward
SEBI must strike a balance between small business interests and investor interests in order to prevent fraudulent firms from exploiting investors. However, SEBI has exclusively focused on investor protection, with no regard for the growth of small firms.
Other countries aiming to regulate the early stages of EC, such as the UK, have minimum income requirements for certain retail investors, yet there is also room for small investors to participate in the EC. This is achievable because Crowdfunding platforms evaluate investors to confirm their solvency and knowledge requirements. This model, I think, would be a superior type of regulation since it provides for flexibility in determining a possible retail investor rather than excluding a huge sector of the public based on their income requirements. This also helps new and inexperienced start-ups to attract investors while preventing investors from subscribing to highly volatile shares. The UK model is more suited to India since it (i) meets the goal of financial inclusion in FinTech regulation and (ii) ensures that regulation is appropriate to the risk posed by the financial service. This methodology is more adaptable and achieves the goal of proportionality by assessing potential dangers on an individual basis rather than imposing a blanket prohibition.
In addition to these legal changes, should also strive to (i) create a compelling pitch, (ii) set realistic financing objectives, (iii) develop a solid marketing strategy, (iv) maintain an active online presence, and (v) offer lucrative incentives to investors while maintaining transparency.
*Kuldeep Gautam is a Third Year B.A. LL. B (Hons.) student at National Law Institute University, Bhopal.
[1] Eleanor Kirby & Shane Worner, Crowd-Funding: An Infant Industry Growing Fast, IOSCO SWP3, (2014), <https://www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf> accessed on 10 October 2023.
[2] Ibid.
[3] Erkki K. Laitinen, Prediction of Failure of a Newly Founded Firm, 7 JOURNAL OF BUSINESS VENTURING 7 323, 340 (1992).
[4] The Companies Act, 2013 § 42 (8).
[5] Dr. Manoj Kumar Joshi, Crowdfunding for Startups in India, 24 AWESHKAR REVIEWED R. J. 37, 40 (2018), <http://welingkar.stageisobar.com/sites/default/files/pdf/we-research-aweshkar-research- journal/aWEshkar_March_2018.pdf#page=39> accessed on 12 October 2023).
[6] SEBI Consultation Paper 2014.
[7] SEBI Consultation Paper, Para 9.1.4.
[8] The Companies (Prospectus and Allotment of Securities) Rules, 2014 r 14(2)(b).
[9] SEBI Consultation Paper, Para 9.3.3.