Capital Raising Prospects for Startups: India and US Compared

[The
following guest post is contributed by Surya
Kumar Gheda
, a final year law student. The author can be contacted at [email protected]]
Last week, two capital market regulators, the
Securities Exchange Commission (SEC) in the United States (US) and the Securities
Exchange Board of India (SEBI), have announced frameworks to enable startups to
obtain easy access to capital through the securities markets. The SEC has come
out with final
rules
, often referred as Regulation A+, to implement Title IV of the Jumpstart
Our Business Startups (JOBS) Act, 2012, and SEBI released a discussion
paper
on Alternative Capital Raising Platform for startups. Both the
frameworks are aimed at easing regulatory requirements for the startups in
accessing capital markets.
The framing of Regulation A+ was mandated
by the JOBS Act to revive the framework of Regulation A which was an exemption from
SEC registration requirement provided to small and medium sized companies to
raise $5 million by selling securities in a 12- month period. However,
companies issuing securities under Regulation A were still required to prepare
and file a prospectus with SEC, along with complying with the registration
requirements of applicable state securities laws (“blue sky laws”). The costs
of compliance with these requirements – combined with the $5 million limitation
on offering size – had made Regulation A offerings unattractive. Title IV of the JOBS Act required the
SEC to authorize exempt offerings under Regulation A of up to $50 million of
securities, subject to new regulatory conditions. Title IV also authorized the SEC
to formulate regulations to preempt the blue sky laws therefore reducing the
cost of compliance for Regulation A offers. It is in this backdrop, now SEC
has come out with final rules referred as Regulation A+.
SEBI in October,
2013 issued the Listing
of Specified Securities on Institutional Trading Platform Regulations, 2013

to enable small and medium enterprises and startups to get their securities
listed on the institutional trading platform (ITP) without carrying out an IPO
by complying with the SEBI (Issue of Capital and Disclosure Requirements)
Regulations, 2009 (the ICDR Regulations). Until now, companies listed on the ITP
can raise capital through private placements and right issues of their
securities. The recently released SEBI discussion paper has proposed a
framework under which professionally managed startups having an innovative
business model and belonging to knowledge-based technology sector can bring an
IPO to get their securities listed on the ITP.
Interests of Retail Investors
Each capital
market regulator is the sentinel of the interests of small and unsophisticated
investors. Market regulators ensure that only companies with a good track
record can have access to the nation’s capital markets. Investment by the general
public in startup companies could prove a very risky proposition given the high
rates of failure associated with the startups.
Regulation
A+ provides a two tier system to raise funds; under Tier 1, companies can raise
funds up to $ 20 million in a 12-month period, and under Tier 2, companies can
raise funds up to $ 50 million in a 12-month period. Tier 1 requires SEC
qualification along with state approval, whereas Tier 2 requires only SEC
approval. Regulation A+ allows unaccredited
investors
to invest under Tier 2 the greater of 10% of income or 10% of net
worth, on the basis of self-certification. However, there is no such limitation
on the investment to be made by unaccredited investors under Tier 1. Since Tier
1 is subjected to blue sky laws, the protection of unaccredited investors is
taken care of by the respective state laws. Companies can raise funds on the
basis of reviewed financial statements under Tier 1, but Tier 2 requires
audited financial statements.
SEBI’s proposed
framework recognizes the need for an alternative capital raising platform, but
at the same time it bars Retail Individual
Investors
(RIIs) from investing in the offers for listing on the ITP. SEBI
has proposed that only Qualified Institutional Buyers (QIBs) and Non-institutional
investors
(NIIs) should be eligible to participate in the offers for
listing on the ITP. The minimum application size for the offers has been
proposed to be Rs. 10 lakhs. These provisions not only bar RIIs, but at the
same time they ensure that only high net-worth individuals can participate in
the offers.
Eligible Issuers
SEBI has
proposed that only professionally managed startups having an innovative
business model and belonging to knowledge-based technology sector will be qualified
as eligible issuers. A startup in which no person (individually or
collectively) holds 25% or more of the pre-issue share capital, will be
considered as a professionally managed startup. Often, the holding of promoters
in startups after many rounds of funding comes down to below 25% thus
qualifying as professionally managed startups.
Regulation
A+ does not restrict the issuers only to the knowledge based technology sector.
Development stage companies with a specific plan or purpose are eligible issuers.
Lock-in Requirements
Listing is
the most preferred exit route for venture capital investors (VCs). In a regular
IPO, VCs sell their stake to the general public at the listing price therefore
reaping the benefits of high valuation of securities at the time of public
offer. The ICDR Regulations exempt VCs from lock in requirements.[1] The
ICDR Regulations also require at least 20% of post issue capital should be
locked in for three years post public issue.
SEBI has
proposed that entire pre-issue share capital should be locked in for six
months, and this requirement will apply uniformly to all shareholders. This
proposal bars VCs from selling their stake at the time of the offer. VCs will
be able to sell their stake after the cooling off period of six months, perhaps
with adequate time for the frenzy surrounding the offer to subside.
Regulation
A+ mandates that
at the time of an
issuer’s first Regulation A+ offering and within the following 12 months all
existing shareholders cannot sell securities worth more than $ 6 million under
Tier 1, and not more than $ 15 million under Tier 2. The final rules also limit
secondary sales by affiliates that occur following the expiration of the first
year after an issuer’s initial qualification of an offering statement to no
more than $6 million, in the case of Tier 1 offerings, or no more than $15
million, in the case of Tier 2 offerings, over a 12-month period.[2]
SEBI has
ensured that proceedings of offer should only result in capital for the startup
companies by locking-in entire pre-issue share capital for six months, and
existing shareholders can offload their holding only through trading on ITP
following the expiration of six month period. Whereas, SEC has allowed existing
shareholders to make secondary sales of securities during Regulation A+
offering, but at the same time it has ensured that affiliates shareholders i.e.
the promoters remain invested at least for two years by imposing the limitation
on secondary sales of shares for two years.
Disclosure Requirements
SEBI has
proposed that a prospectus for the offer needs to be in compliance with the
various ICDR Regulations, subject to few proposed exemptions. The proposed
framework has provided relaxation in the matters of objects of the issue,
pricing of the issue, disclosure on litigation, disclosure on creditors etc. to
make disclosures apposite to the startups’ needs, and at the same time ensuring
prospective investors make informed decision. Startups bringing the offer do
not need to outline objects of the issue in greater details as required in
regular IPO, they, rather, can indicate general corporate purposes as their
object in offer document. The proposed framework confers greater autonomy upon
startups in the pricing of their issue, except there cannot be any forward
looking statement while disclosing the basis of the pricing of the issue.
Issuers under
Regulation A+ need to file form 1-A with the SEC for its approval. Form 1-A is
the shorter version of form S-1 which is required to be filed with SEC for a regular
IPO. The Form 1-A offering statement contains itemized information similar to
Form S-1 for registered IPOs, but is scaled back. It has three parts:
notification, offering circular, and exhibits. The SEC staff would review and
comment on it. And companies cannot use an offering circular for sales until
the SEC approves. Generally, two years of financial statements are required,
but only Tier 2 offerings require audited statements.
Conclusion
World over, startups
are increasingly being recognized as the next big employment generator as big
corporates are often compelled to focus on increasing their margins to keep up
with the expectations of stock markets. But, the funding for these startups is
still a vexed issue. Though there are many parallels between the two
frameworks, only time will tell the efficacy of these frameworks. While the
framework of Regulation A+ is the second attempt by the SEC to meet the funding
requirements of startups, the obvious question from an Indian perspective is – will SEBI get it right in its first attempt?
Surya Kumar Gheda



[1] Proviso to Regulation 37 of ICDR Regulation, 2009.
[2] Rule 253(a) of Regulation A+

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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