Equity Crowdfunding

By: Avilash Kumbhar

Early start-up companies do not have easy access to venture capital and other public fundraising options, primarily due to the uncertain nature of the business as well as the risk involved in it, which became increasingly difficult after the 2008 financial crisis. In order to support inventive business ideas and ventures, crowdfunding has rapidly become a feasible and attractive substitute for fundraising mechanism in recent times.

Crowdfunding is “solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause.” Crowdfunding is the financing of small business enterprises in the form of small contribution from individual investors at a bulk via the internet.[1] Equity-based crowdfunding, as the name suggests, is the process by which equity in the early stage unlisted company is exchanged for the funding made.

Equity crowdfunding is advantageous to start-ups as it enables them to cast a wide net in raising funds and that too, given the power of the Internet, from investors anywhere in the world. On a macro level, such easy access also stimulates economic growth by facilitating capital flow. Crowdfunding offers a lower cost and potentially a high return investment vehicle to retail investors, helping them diversify their portfolio.

On the supply side, the heinousness of India’s crowd offers matchless crowdfunding based capital inflow prospects with a population more than 1.3 billion people and about 24.5 million households that vigorously finance in securities markets, through either secondary markets or mutual funds.[2]

IMPACT OF LEGALISING EQUITY CROWD FUNDING

1. Benefits of Equity Crowdfunding

With the use of crowdfunding, access to capital raising and investors outside their private networks has become easier for start-ups.[3] Crowdfunding has emerged as an inexpensive and striking capital-raising route to start-ups by its very nature of being an economical way of fundraising.[4]

It also permits a broader section of investors to play a part in a start-up’s accomplishments when qualified investors are given such access.[5] Apart from the exercise of due diligence by the investors, by which they are capable of piggybacking on the work of some, to establish information concerning the start-up in which they invest, such a variety of investors also permits for broader assessment.[6] It promotes innovative ideas while bringing in economic growth to the country.[7]

2. Risks of Equity Crowdfunding

Investment in an early stage company most likely goes in vain because it carries an integral risk of failure with more than half of the new start-ups failing in their first 5 years of business. In July 2013, Bubble and Balm closed its doors only after issuing 15% of its equity that rose through Crowd cube, an equity crowd-funding platform.[8] The illiquidity of the investment is another prominent risk associated with crowdfunding. These investors are incapable of getting a deal out of their securities as a recovery of their investment because these Crowd-funded securities are not traded openly.

Thirdly, there is the risk of outright fraud, which arises due to information asymmetry, lack of transparency, and the relative inexperience of investors in crowdfunding. Furthermore, while investing in a crowd-funded project, investors rely solely upon the representations of fundraisers and generally do not undertake due diligence on the business they are investing in.[9] The lack of a detailed review of the fundraising start-up’s affairs opens up the possibility of the company concealing information relevant to its future, whether actively or passively.[10] Studies have shown that detailed disclosures about risks can operate as effective signalling mechanisms that may result in the success of the fundraising,[11] although factors such as friendships and social networks cannot be discounted.[12]

3. A Regulatory Conundrum

In order to facilitate crowdfunding, it would be necessary to carve out a separate regime under securities regulation. In designing the appropriate regulatory regime for crowdfunding, regard must be had to the twin (somewhat competing) considerations of promoting economically beneficial start-up activity and at the same time, ensuring investor protection. This would result in a “win-win” situation where the benefits of crowdfunding are harnessed while mitigating the risks.

Heminway and Hoffman[13] set out the foundational principles for the appropriate regulation of crowdfunding. They are “Limit investor risk; Optimize fraud protection; Enhance informational transparency; Foster standardization of disclosures and enforcement; Constrain regulatory costs; Minimize costs to issuers and investors”. They also argue that in arriving at a regulatory balance, it is important not to impose excessive costs on issuers or regulators, because they operate as disincentives, thereby rendering crowdfunding unattractive.

EQUITY CROWDFUNDING REGULATION IN INDIA

1. Current State of Regulation

Under the pre-existing Companies Act, 2013, a company is permitted to make an offer of securities to the public only by means of a prospectus, with securities to be listed on a recognised stock exchange to provide liquidity to the investors. Private placements of securities do not have to comply with these onerous requirements so long as they are offered to specific persons, with the number of offerees not exceeding 49 persons,[14] which otherwise becomes a public offering. Hence, crowdfunding, in its usual form, is not permissible within the realm of that regime.

The “Sahara effect”[15], in which the Supreme Court found Sahara’s actions to be in breach of securities regulation and affirmed SEBI’s sanction prompted the legislature to amend the Companies Act, 2013 that makes any offer exceeding 49 persons by a private company to be a public offer.[16]

2. SEBI’s Consultation Paper

a. Eligibility for Issuers

SEBI has stipulated that the issuer must be unlisted and less than 48 months old, that it should not be part of a larger industrial group or conglomerate, and that the aggregate size of the offering should not exceed INR 100 million. Further, it proposed that the issuers or their controllers should not be in breach of corporate and securities regulations.

b. Nature of Investors

When it comes to the eligibility of the investors or the composition of the crowd, SEBI has adopted a rather stringent approach.[17] Under its proposals, crowdfunding is restricted to “accredited investors”, who are (i) Qualified Institutional Buyers (hereinafter QIBs), (ii) companies with a minimum net worth of INR 200 million, and (iii) high net worth individuals (hereinafter HNIs) with a minimum net worth of INR 20 million (excluding primary residence). A residual category of Eligible Retail Investors (hereinafter ERIs) has also been added in the category of accredited investors. ERIs are those with a minimum annual gross income of INR 1 million, and who have filed the income tax for the last three financial years. Moreover, in order to qualify as an ERI, such an individual must have received investment advice from an investment advisor, and availed services of a portfolio manager or passed an appropriate test.

Such ERIs must further ensure and certify that they do not invest more than INR 60,000 in any particular crowd-funded issue and not more than 10% of their net worth (excluding the value of primary residence) in crowdfunding activities.

c. Investment and Offer Limits

SEBI’s proposals also impose individual investment limits for crowdfunding.[18] Consistent with the Companies Rules (2014), SEBI has imposed minimum funding limits of Rs. 20,000. However, the maximum investment by an ERI is not to exceed Rs. 60,000 and the total of all investments by such person in crowdfunding cannot exceed 10% of net worth. Moreover, in order to ensure the quality of the offering, all QIBs must collectively hold a minimum 5% of the securities issued. An additional condition is that a crowdfunded offering shall not be made to more than 200 HNIs and ERIs. However, offers can be made to any number of QIBs. In other words, any crowdfunded offering ought to remain within the confines of a private placement within the meaning of company law.[19]

3. Post-Proposal Scenario

Restricting crowd-funding activities to accredited investors is simply another way of making the traditional mechanism of venture capital and private equity investors more efficient with the Internet. The higher entry barriers for retail investors only exacerbate the removal of the crowd from crowdfunding.[20]

While crowdfunding at its very core is meant to engage with investors who would otherwise be unable to participate in capital markets in the conventional sense, the high thresholds for accreditation or even for eligibility as a retail investor means that participation in crowdfunding would remain isolated from large sections of potential retail investors.

Even with the inclusion of qualified retail investors, it would be impossible for a start-up to be truly crowdfunded. SEBI’s consultation paper suggests that in order for an offer to succeed, at least 5% must be taken up by QIBs. Hence, if QIBs were not attracted to a particular start-up, a crowd-funded issue would fail. Given that QIBs would be likely to have access to greater resources, skill, expertise, and experience in investing in start-ups and therefore would be more likely to identify start-ups which would have a likelihood of success; this seems to be an effective mechanism to ensure that only those companies or projects, worthy of their attention, would succeed.

[1] E Mollick, ‘The Dynamics of Crowd Funding: An Exploratory Study’ (2014) 29 Journal of Business

Venturing 1; Loreta Valanciene and Sima Jegeleviciute, ‘Valuation of Crowd Funding: Benefits And Drawbacks’ (2013) 18(1) Economics And Management 39.

[2]NCAER, ‘How Households Save and Invest: Evidence from NCAER Household Survey’ (SEBI 2011)

< http://www.sebi.gov.in/cms/sebi_data/attachdocs/1326345117894.pdf> accessed 27 July 2017.

[3]Nav Athwal, ‘How Crowdfunding Has Changed Real Estate Investing’ (Forbes, 2 December 2015) <www.forbes.com/sites/navathwal/2015/12/02/how-crowdfunding-has-changed-real-estate-investing/#64c6f12826cc> accessed 27 July 2017.

[4] E Kirby and S Worner, ‘Crowd-funding: An Infant Industry Growing Fast’ (2014) Staff Working Paper of the IOSCO Research Department, <www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf> accessed 27 July 2017.

[5] C Catalini, C Fazio and F Murray, ‘Can Equity Crowd Funding Democratize Access To Capital And Investment Opportunities?’ (MIT Innovation Initiative Lab for Innovation Science and Policy Report, 16 May 2016)<http://innovation.mit.edu/assets/MIT_-Equity-Crowdfunding_Policy-Brief.5.16.2016.pdf> accessed 27 July 2017.

[6] Andrew A Schwartz, ‘The Digital Shareholder’ (2015) 100 Minnesota Law Review 609, 627-28.

[7] M Vitins, ‘Crowd Funding and Securities Laws: What the Americans Are Doing and the Case for an Australian Crowdfunding Exemption’ (2013) 22 Journal of Law, Information and Science 92, 116.

[8] E Kirby and S Worner (n 4).

[9] AK Agrawal, C Catalini,A Goldfarb, Ajay A, et al ‘Some Simple Economics of Crowdfunding’ (2013) National Bureau of Economic Research Working Paper 19133 < http://www.nber.org/papers/w19133.pdf> accessed 27 July 2017.

[10] A C Fink, ‘Protecting the Crowd and Raising Capital Through the CROWDFUND Act’ (2011) 90 University of Detroit Mercy Law Review 1.

[11] G K C Ahlers and others, ‘Signalling in Equity Crowdfunding’ (2015) 39 (4) Entrepreneurship Theory and Practice 955, 957.

[12] M Lin and N R Prabhala and S Viswanathan, ‘Judging Borrowers by the Company They Keep: Friendship Networks and Information Asymmetry in Online Peer-to-Peer Lending’ (2012) 59(1) Management Science 17.

[13] J M Heminway and S R Hoffman, ‘Proceed at Your Peril: Crowdfunding and the Securities Act of 1933’ (2011) 78 Tennessee Law Review 879, 937.

[14] Companies Act 2013, s 42.

[15] Sahara India Real Estate Corporation Ltd v Securities and Exchange Board of India [2013] 1 SCC 1.

[16] Companies Act 2013, s 42.

[17] SEBI, Consultation Paper on Crowdfunding in India (2014) para 9.1.4 < http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf> accessed 17 June 2017.

[18] ibid

[19] A K Iyer, ‘Pennywise: A Crowdfunding Critique’ (IndiaCorpLaw, 9 February 2016) <http://indiacorplaw.blogspot.in/2016/02/penny-wise-crowdfunding-critique.html> accessed 27 July 2017.

[20] D M Ibrahim, ‘Equity Crowdfunding: A Market for Lemons?’ (2015) 100 Minnesota Law Review 561, 571.

(Avilash is currently a student at National Law University, Odisha.)