Equity-Based Crowdfunding as an Early-Stage Financing Alternative: Critique of the Regulatory Proposals in India

[The
following guest post is contributed by Shwetha
Chandrashekar,
who is a Senior Associate in Bangalore, India at GameChanger
Law Advisors. She can be contacted on shwetha@gamechangerlaw.com.]
With over 4200 start-ups, India is the
fastest growing start-up ecosystem worldwide. It has the third-largest number
of start-ups in the technology sector following the US and the UK.[1] However,
India is experiencing an exodus of start-ups to jurisdictions with more
favourable regulatory regimes. Singapore, for instance, offers many benefits
for start-ups including less stringent compliance requirements, tax credits for
investors, zero capital gains tax and grants for research and development.[2]
In contrast, Indian start-ups suffer from high taxation on angel investments[3],
weak patent laws[4]
and excessive bureaucracy in both incorporation and fundraising stages.
Recognizing start-ups’ potential in
boosting the economy, the securities market regulator, Securities and Exchange
Board of India (“SEBI”) has
introduced reforms aimed at improving access to funds for start-ups and small-to-medium
enterprises (“SMEs”). SEBI amended
the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”)
to regulate ‘angel funds’. Relaxations in SME listing norms were introduced under
Chapter XB of the SEBI (Issue of Capital and Disclosure Requirements)
Regulations, 2009 (“ICDR Regulations”)
to allow for stock exchanges to have a separate SME trading platform. Keeping
up with this positive trend, in 2014, SEBI released a ‘Consultation
Paper on Crowdfunding in India
’ inviting suggestions from all stakeholders
on regulatory proposals.
This post aims to analyse equity-based
crowdfunding as an early-stage financing alternative in India in light of SEBI’s
proposals. The first part introduces crowdfunding and examines its benefits and
risks, underlining the need for a regulatory framework. It then discusses financing
avenues available to start-ups to study if existing regulatory provisions can
be used to regulate crowdfunding. Finally, it critically analyzes SEBI’s
Consultation Paper to understand if economic objectives of crowdfunding are
fulfilled and provides recommendations on the way forward.
Equity-Based Crowdfunding:
Benefits And Risks
Equity-based crowdfunding involves
solicitation of funds by start-ups from investors through an intermediary
online platform in return for issuance of securities such as equity shares.[5]
Crowdfunding has recently gained traction
as a viable fundraising alternative, with jurisdictions around the world
introducing laws to regulate it.[6]
The recent global economic meltdown has made access to secured loans difficult
for start-ups that have little or no collateral to offer. Private equity (“PE”), venture capital (“VC”) investments and public offerings
are inaccessible to many start-ups which are usually sensitive to a higher cost
of capital and are not far enough in their life cycle for conventional
financial intermediaries to adequately assess risk and commit to an investment.[7]
Therefore, crowdfunding serves
to benefit start-ups by improving much-needed access to early-stage capital. Owing
to the nature of crowdfunding,
investment risk is spread out[8].
On a macro level, providing easier access to funds to start-ups stimulates
economic growth by facilitating capital flow. This triggers positive
socio-economic impact through job creation and can be a much-needed alternative
source of financing in a capital-scare economy. Crowdfunding offers retail
investors a lower cost and potentially high return investment vehicle, helping
them diversify their portfolio.
However, crowdfunding
poses a unique potpourri of regulatory complexities associated with public issue
(such as disclosure and due diligence requirements) coalesced with risks of PE
and VC investments (such as default, failure and fraud).
Failure statistics reveal that nine out of ten start-ups fail.[9]  The most popular example of risks of fraud is
that of Bubble and Balm, a UK-based soap company which was one of the first
companies to be funded through equity-based crowdfunding, which in 2011 after
raising £75,000 abruptly closed its business in 2013 leaving its investors in
the lurch.[10] 
Owing to the absence of a secondary market, investors cannot sell
their securities to recover their investments.[11]
Further, accurate valuation is problematic as financial activities of young start-ups
are difficult to analyse and forecast.
Prohibitive disclosure costs result in a start-up’s inability to
meet high disclosure standards.[12]  The resulting information asymmetry coupled
with lack of investment experience of retail investors is a problematic combination.
Therefore, crowdfunding calls for a finely-balanced
regulation that recognizes the need for raising low-cost capital, facilitating
access to funds and increasing liquidity on the one hand and the importance of ensuring
investor protection and lowering systemic risks on the other.
Existing
Routes of Financing and the Regulatory Regime in India
Presently, the regulated routes
of fundraising in India are:
– Seed or Angel
Investments are regulated under the Companies Act, 2013 (“Act”) for private placement (an offer by a company to a select
group of persons[13]
to subscribe to its securities) for unlisted companies. Listed companies need
to further adhere to the ICDR Regulations.
– PE and VC Funds
are regulated under the Act and AIF Regulations.[14]
– Initial public
offers (“IPO”) or follow-up public
offers are governed by the Act and ICDR Regulations.
The private placement route will not apply
to crowdfunding as the latter entails solicitation of small-sized funds from a large
number of unidentified investors. Smaller retail investors, who are likely to
contribute far less capital per individual, would not meet the minimum
investment criteria stipulated under the current regulations pertaining to PE
and VC.
A public issue involves the appointment of
merchant bankers, filing of a prospectus with SEBI, previous track record requirements,
minimum promoter’s contribution etc., apart from detailed disclosures. An IPO
usually occurs later in the lifecycle of a company, requiring the issuer to
disclose among other things, minimum net tangible assets, distributable profits
and net worth for a historical track record of a certain number of years. In
contrast, crowdfunding being an early-stage fundraising alternative, aims at
helping start-ups kick-start their business ideas. For a young venture with
limited funds, fulfilling these requirements is daunting and impractical.
The existing regulatory climate
necessitates
creating carve-outs from current financing
regulations and formulating a de novo regulatory framework for crowdfunding. It poses avenues for regulatory arbitrage by fraudulent
fundraisers as was demonstrated in a recent Supreme Court case, Sahara India
Real Estate Corporation v. SEBI
.[15]
This case involved one of the biggest investor frauds in India in which Sahara
raised over USD 3 billion from nearly 30 million investors from amongst their intricate
network of associated group companies, employees and other related individuals.
It argued that its capital raising methods were not governed by IPO regulations
because it did not intend to list its securities on any stock exchange.
Therefore the investment route neither qualified as a private placement nor as
a public issue but was akin to a crowdfunding model without the involvement of
any online intermediary platform. In that case, the Supreme Court clamped down
on the funding model used by the companies.
The case highlights the potential and reach of crowdfunding as a
financing alternative and the need for a crowdfunding regulatory regime. It
further exhibits SEBI’s proactive watchdog role prompted by the lack of
knowledge and experience of retail investors.
As a result of the Sahara case, a provision was introduced in the Act
which states that irrespective of whether a company intends to list its
securities, if an offer to allot securities is made to more than fifty persons,
it would be deemed to be an IPO. This would currently bring crowdfunding
squarely under the IPO regulatory umbrella.
Recognizing the potential and need for
crowdfunding as a financing option for start-ups, SEBI floated the Consultation
Paper in 2014 to address the lacuna in current regulations. The next section analyses
the proposals to ascertain whether they adequately fulfil crowdfunding
objectives.   
SEBI
Consultation Paper on Crowdfunding in India, 2014: A Critical Analysis
Some of the key SEBI proposals are:
– Only ‘Accredited Investors’[16]
may invest;
– Qualified Institutional
Buyers (“QIBs”) to hold atleast  5% of issued securities;
– Retail Investor contribution:
Minimum- INR 20,000 and maximum- INR 60,000;
– Maximum number of retail investors-
200;
– Only start-ups less than two
years old eligible to participate;
– Disclosure requirements such
as anticipated business plan, intended usage of funds, audited financial
statements, management details etc.;
– Registered crowdfunding
platform to conduct regulatory checks and basic due diligence of start-ups and investors;
and
– Constitution of ‘screening
committee’ by each platform comprising 10 persons with experience in capital
markets, mentoring start-ups etc.
SEBI’s definitions of ‘Accredited
Investors’, ‘Eligible Retail Investors’[17]
and the requirement for QIBs to collectively hold a minimum of 5% of issued
securities, are contrary to the economic objectives of crowdfunding. While the
intention is to ensure investor protection by permitting investments from only sophisticated
investors, this requirement may render crowdfunding inaccessible to other
classes of retail investors.
VCs and QIBs tend to invest in ventures that
are typically 2+ years into their lifecycle that can provide reasonably
accurate projections and viable business models. The proposals target start-ups
less than 2 years of age, which makes crowdfunding an unlikely investment
opportunity for VCs and QIBs due to information asymmetry. Without achieving the
requirement for QIBs to collectively hold a minimum of 5% issued securities,
the start-up cannot raise capital through the crowdfunding route. Hence, this
stipulation should be deleted as it may defeat genuine fundraising efforts.
To protect the interests of unsophisticated
investors, the maximum investment amount should be in proportion to ERI’s net
income as opposed to net worth. The minimum investment amount requirement must
be removed to facilitate smaller investments from larger number of investors. To
facilitate optimal access to this investor group, the definition of ERIs must
be expanded.
The restriction on maximum number of retail
investors per crowdfunding round contradicts the bedrock concept of
crowdfunding, ‘safety in numbers’. 5000 investors investing USD 100 each is
easier to secure and provides greater individual investor protection than 100
investors investing USD 5000 each. The in-built protection of ‘wisdom of the
crowd’ embodied in crowdfunding, ensures that over time the crowd of
unsophisticated retail investors mostly make sound investments in genuine
ventures weeding out fraudulent ones.  A survey
conducted in the UK reveals that majority of investors in equity-based
crowdfunding are retail investors with no previous investment experience.[18]  Interestingly, New Zealand, one of the most
crowdfunding-friendly jurisdictions, does not differentiate between sophisticated
and retail investors.[19]
SEBI proposals restrict crowdfunding to
only unlisted public companies. In practice, most start-ups in India register
as private limited companies. Therefore, the crowdfunding route should be
expanded to include other types of corporate entities to enable them to
leverage the benefits of crowdfunding.  
The stringent disclosure norms laid out by
SEBI closely resemble existing private placement requirements. While the
importance of adequate disclosures to safeguard investor interests is undisputed,
associated prohibitive costs need careful consideration. Instead, the
crowdfunding platform should bear costs associated with disclosures and recoup those
costs by levying a nominal fee on the investors and start-up, thereby reducing
the burden on start-ups and achieving transparency.
Formulating guidelines with respect to
differential voting rights will help young ventures devise an investment policy
to facilitate subsequent investment rounds. The crowdfunding platform should
have industry-based advisory committees comprising of industry-experts for mentoring
start-ups on long-term fundraising strategy. This combined with appointment of
a trustee to represent the investors’ collective interests and rights will help
adequately balance investor-investee interests.
Owing to the involvement of internet and
social media, crowdfunding could transcend borders where foreign investors could
participate in crowdfunding rounds by Indian start-ups and vice-versa. The
proposals are silent on whether cross-border crowdfunding is proposed to be
permitted. If yes, how will foreign investors be treated vis-à-vis Indian
investors? In case of fraud in foreign jurisdictions, how will Indian investors
be protected?  SEBI must therefore create
adequate safeguards to tackle cross-border crowdfunding issues and
jurisdictional arbitrage.
Conclusion
The emergence of India as a start-up hub
and its burgeoning start-up ecosystem necessitate finding alternate fundraising
modes for these enterprises to start, scale and succeed. The Sahara case experience
demonstrates why the extant fundraising regulatory environment is inadequate and
not aligned to crowdfunding objectives. There is clearly a case for a balanced
crowdfunding regulation that lowers cost of capital and increases liquidity
while ensuring adequate investor protection and minimizing investment risks.
An analysis of the Consultation Paper
reveals a rather cautious approach by SEBI that tends favourably towards
investor protection and falls short in upholding the economic objectives sought
to be achieved by crowdfunding. In order to make equity-based crowdfunding a
viable early-stage financing alternative in India, SEBI must consider making amendments
to its proposals in line with recommendations made in this paper and from other
stakeholders.
– Shwetha Chandrashekar



[1] National Association of Software
and Services Companies, ‘Start-up India – Momentous Rise of the Indian Start-up
Ecosystem’ (Report) (October, 2015)
accessed January 16, 2016.

[2] P. Abrar, ‘India’s Tech Stars
Shifting to Silicon Valley’ The Hindu (June
30, 2015)
.

[3] 33% ‘Angel Tax’ on angel
investments received by the start-ups taxed as ‘Income from other Sources’ in
accordance with Section 56(2) of the Income Tax Act, 1961.

[4] P. Kilbride, ‘Explained: Why
India ranks second last in global IP index and how it can improve’, (February
05, 2016) .

[5] E. Kirby
and S. Worner, ‘Crowd-funding: An Infant Industry Growing Fast’ (IOSCO Research
Department, Staff Working Paper No. [SWP3/2014])
(‘Kirby’).

[6] Title II (Accredited
Crowdfunding) and Title III (Retail Crowdfunding) of the Jumpstart Our Business
Startups Act, 2012 (US); Decreto Crescita Bis, 2012 (Italy); Financial Conduct
Authority Regulation on equity crowdfunding, 2014 (UK); Securities and
Investments Commission, ‘Guidance Note on Crowdfunding’ (2012) [12-196MR ASIC]

(Australia).

[7] Vidhi Centre for Legal
Policy, ‘Responses to SEBI Consultation Paper on Crowdfunding’ (July 16, 2014)
p. 3

(‘Vidhi’).

[8] Kirby (4).

[9] E. Griffith, ‘Why Startups
Fail, According to their Funders’ Fortune
(September 25, 2014) <http://fortune.com/2014/09/25/why-startups-fail-according-to-their-founders/>.

[10] L. Warwick-Ching, T. Powley
and E. Moore, ‘Alarm Bells For Crowdfunding As Bubble Pops For Soap Start-Up’ Financial Times (July 31, 2013)
.

[11] Kirby (20).

[12] R.S. Weinstein, ‘Crowdfunding
in the US and Abroad’ (2013) 46 Cornell International Law Journal 434.

[13] The maximum number of
investors that are permitted to participate in a private placement under the
Companies Act are 50 per investment round or 200 in a financial year.

[14] The PE and VC regulations
call for strict corporate compliance and governance framework with a heightened
focus on investor protection. Some of the mandatory requirements are (i)
Maximum 1000 investors; (ii) Minimum corpus of each AIF fund/scheme must be at
least INR 200 million; and (iii) Minimum investment from each investor must be
at least INR 10 million.

[15]  Sahara India Real Estate Corporation
Limited& Ors
v. Securities
and Exchange Board of India & Anr
(2013) 1 SCC 1.

[16] Accredited Investors under
the SEBI proposals are: (i) QIBs; (ii) Companies with a minimum net worth of
INR 200 million; (iii) High Net Worth Individuals with a minimum net worth of
INR 20 million or more; or (iv) Eligible Retail Investors

[17]Eligible Retail Investor” or “ERI
shall mean a retail investor who has received professional investment advisory
or availed of the services of a portfolio manager and has a minimum annual
income of INR 1 Million and who has filed an income tax statement for atleast
the last 3 financial years.

[18] Nesta, ‘Understanding
Alternative Finance: The UK Alternative Finance Industry Report 2014’ (Report)
(November 2014) <
https://www.nesta.org.uk/sites/default/files/understanding-alternative-finance-2014.pdf>.

[19] Financial Markets Conduct
Act, 2013 (New Zealand) <
http://legislation.govt.nz/act/public/2013/0069/latest/DLM4090578.html?src=qs>.

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.

2 comments

  • Excellent article- Analysis of SEBI's paper is incisive and the recommendations very practical balancing the needs of all stakeholders! Thank you for posting this.

  • Excellent article shwetha,many congratulations for writing such a clear and crisp information on equity based crowdfunding.could you mention,what is the funding gap for start up pre-seed capital that can be fiiled up by equity based crowd funding in Indian Scenario.
    Sufia kamal laskar

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