Unlocking the Potential: Equity Crowdfunding and its Legal implications in India

By Aditya Sharan (Batch of 2027 – Symbiosis Law School, Noida)

[This Blogpost is a 7th Entry of the 1st Edition of the National Blog Writing Competition 2023 organized by Centre For Innovation, Incubation & Legal Entrepreneurship (CIILE) in Association with PANDA LAW (TEAM CODE-06)]

Image Source: https://www.istockphoto.com/photo/funding-financing-business-project-gm1369579737-439312870

Introduction

At the Nascent stage, startup enterprises encounter obstacles in securing venture capital and resorting to public fundraising avenues, largely attributable to their ventures’ inherent uncertainty and risk. This challenge has been exacerbated since the 2008 financial crisis[1]. Consequently, crowdfunding has emerged as an appealing alternative for sourcing funds to bolster innovative business concepts and endeavours.

Crowdfunding gathers small financial contributions from numerous investors through online platforms or social networks to support a particular project, business endeavour, or social cause. It involves the collective financing of small businesses through individual investments made in bulk via the Internet^[2]. Equity-based crowdfunding, as its name implies, exchanges equity in an early-stage, unlisted company in return for the funds provided. Equity crowdfunding offers distinct advantages to startup companies by allowing them to reach a broad audience when seeking funding. Leveraging the Internet’s global reach, startups can attract investors worldwide. At a more general level, this accessibility promotes economic expansion by facilitating the movement of capital. Crowdfunding provides an economical and potentially high-yield investment opportunity for retail investors, assisting them in diversifying their investment portfolios.

On the supply side, India’s vast population, exceeding 1.3 billion people, and approximately 24.5 million households actively participating in the securities markets, whether through secondary markets or mutual funds, present unparalleled opportunities for capital inflow through crowdfunding.^[3]

INFLUENCE OF LEGALIZATION OF EQUITY CROWDFUNDING

1. Benefits of Equity Crowdfunding:

Startup companies can now easily access capital from a broader range of investors beyond their immediate networks. Crowdfunding provides an accessible and cost-effective method of raising funds, which is particularly beneficial for early-stage businesses.

Equity crowdfunding allows a more varied group of investors to participate in a startup’s success. This diversity brings fresh capital and enables a broader range of assessments and perspectives, fostering innovation and economic growth.

By engaging in crowdfunding, investors can perform due diligence and gain insights into the startup they are investing in. This allows for more informed investment decisions and promotes transparency. Through crowdfunding, startups^[4] have found securing capital and attracting investors beyond their established networks increasingly convenient. Crowdfunding^[5] is an economical and compelling avenue for raising money due to its cost-effectiveness.

Furthermore, it allows more investors to actively contribute to a startup’s achievements when eligible investors are granted such opportunities^[6]. In addition to investors’ due diligence efforts, which enable them to leverage the collective insights of others when assessing^[7] the startup in question, this diverse investor base also fosters a broader evaluation of potential investments. This, in turn, encourages innovative ideas and contributes to the nation’s economic growth^[8].

• Risks of Equity Crowdfunding:

Investing in early-stage companies carries a substantial risk of failure, as more than half of new startups typically do not survive their first five years. As an illustration, in July 2013, Bubble and Balm ceased operations after allocating 15% of its equity through the CrowdCube equity crowdfunding platform^[9]. Furthermore, a prominent risk associated with crowdfunding is the lack of investment liquidity. Investors often find converting their securities into cash to recover their initial investments challenging, primarily because these crowdfunded securities are not openly traded.

In addition, there exists a significant risk of fraud, which is exacerbated by factors such as information asymmetry, limited transparency, and the relative inexperience of investors in the crowdfunding domain. Typically, when participating in crowdfunding projects, investors rely heavily on the representations made by fundraisers and frequently do not conduct comprehensive due diligence on the businesses they support^[10]. This lack of detailed scrutiny regarding the affairs of the fundraising startup creates the potential for the company to withhold information that could be pertinent^[11] to its future, intentionally or inadvertently. Research indicates that thorough disclosures about risks can serve as effective signalling mechanisms that may contribute to the success of a fundraising effort^[12]. However, the influence of factors like personal connections and social networks should not be underestimated^[13].

• Regulatory Considerations:

To enable crowdfunding effectively, it is imperative to establish a distinct regulatory framework within the securities regulation domain. When crafting this regulatory structure for crowdfunding, it is essential to carefully consider the dual and somewhat conflicting objectives of promoting economically beneficial startup endeavours while safeguarding investors’ interests. Striking a balance between these objectives can result in a “win-win” scenario where the advantages of crowdfunding are harnessed while the associated risks are managed.

Heminway and Hoffman^[14] have articulated foundational principles for the appropriate regulation of crowdfunding. These principles include limiting investor risk, optimizing measures to prevent fraud, enhancing transparency in information sharing, promoting standardization in disclosures and enforcement, constraining regulatory costs, and minimizing the burdens placed on both issuers and investors. They argue that maintaining this regulatory equilibrium is critical, as excessive charges imposed on issuers or regulators could act as disincentives, making crowdfunding less appealing.

STATUS OF EQUITY CROWDFUNDING REGULATION IN INDIA

1. Current Regulatory Landscape:

Under the existing Companies Act of 2013, a company is only allowed to issue securities to the public through the formal process of a prospectus, and these securities need to be listed on a recognized stock exchange to provide liquidity to investors. Private placements of securities are exempt from these rigorous requirements as long as they are exclusively offered to specific individuals, with the number of potential investors not exceeding 49 individuals^[15]. If the number surpasses this threshold, it transforms the offering into a public one. Consequently, traditional crowdfunding, as typically practised, does not fall within the scope of this regulatory framework.

However, an event known as the “Sahara effect^[16]” pertains to a Supreme Court ruling that found Sahara’s actions to violate securities regulations and upheld SEBI’s penalties, prompting the legislative body to amend the Companies Act of 2013. This amendment stipulates that any offering by a private company to more than 49 individuals is to be classified as a public offering^[17].

• The Consultation Paper by SEBI:

SEBI has set forth specific criteria for issuers. They must be unlisted companies with a track record of less than 48 months. Additionally, these companies should not be part of larger industrial groups or conglomerates, and the total offering size should not exceed INR 100 million. Furthermore, the issuers and their controllers should not have violated corporate and securities regulations.

Regarding the qualifications of investors or the numerical composition, SEBI has adopted a stringent approach^[18]. According to their proposals, crowdfunding is limited to “accredited investors,” including Qualified Institutional Buyers (QIBs), companies with a minimum net worth of INR 200 million, and high net worth individuals (HNIs) with a minimum net price of INR 20 million (excluding their primary residence). A residual category of Eligible Retail Investors (ERIs) is also included in the category of accredited investors. ERIs have a minimum annual gross income of INR 1 million and have filed income tax returns for the last three financial years. To qualify as an ERI, such individuals must have received investment advice from an investment advisor, used the services of a portfolio manager, or passed a relevant test. ERIs must also certify that they do not invest more than INR 60,000 in any specific crowdfunded issue and that their crowdfunding investments do not exceed 10% of their net worth (excluding the value of their primary residence).

SEBI’s proposals also include individual investment limits for crowdfunding^[19]. They have set a minimum funding limit of Rs. 20,000 per the Companies Rules (2014). However, the maximum investment for an ERI should not exceed Rs. 60,000, and the total assets by such individuals in crowdfunding cannot surpass 10% of their net worth. To ensure the quality of the offering, all QIBs must collectively hold a minimum of 5% of the issued securities. Additionally, a crowdfunded offering should not be made to more than 200 HNIs and ERIs, although it can be offered to any number of QIBs. In essence, a crowdfunded offering must stay within the confines of a private placement as defined by company law^[20].

POST-PROPOSAL SCENARIO

After implementing the proposed changes, limiting crowdfunding activities to accredited investors essentially transforms the traditional venture capital and private equity investor model into a more streamlined process, leveraging the Internet’s efficiency. The higher entry requirements for retail investors further disconnect the broader public from crowdfunding[21].

Although crowdfunding, at its core, aims to engage with individuals who would otherwise be excluded from traditional capital markets, the substantial accreditation thresholds or even the criteria for retail investor eligibility continue to restrict the participation of a significant portion of potential retail investors.

A startup cannot be considered genuinely crowdfunded even if qualified retail investors are included. According to SEBI’s consultation paper, at least 5% of the offering must be subscribed to by Qualified Institutional Buyers (QIBs) to succeed. Consequently, if QIBs are not attracted to a specific startup, a crowdfunded campaign would not meet its funding goal. Given that QIBs likely possess more significant resources, skills, expertise, and experience in investing in startups, they are more likely to identify startups with a more significant potential for success. Therefore, this mechanism effectively ensures that only companies or projects deserving of their attention have a chance to succeed.

[1] Erkens, David H., Mingyi Hung, and Pedro Matos. “Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide.” Journal of corporate finance 18, 389-411 (2012).

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

[3] NCAER, ‘How Households Save and Invest: Evidence from NCAER Household Survey’, SEBI 2011, (Sept. 27, 2023), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1326345117894.pdf&gt.

[4] Nav Athwal, ‘How Crowdfunding Has Changed Real Estate Investing’, Forbes; Dec. 2, 2015, (Aug 27, 2023) www.forbes.com/sites/navathwal/2015/12/02/how-crowdfunding-has-changed-real-estate-investing/#64c6f12826cc.

[5] E Kirby and S Worner, ‘Crowd-funding: An Infant Industry Growing Fast’, Staff Working Paper of the IOSCO Research Department; 2014, (Sept. 15, 2027), www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf.

[6] 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, (Sept. 29, 2023), http://innovation.mit.edu/assets/MIT_-Equity-Crowdfunding_Policy-Brief.5.16.2016.pdf&gt.

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

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

[9] E Kirby and S Worner, supra note 5.

[10] AK Agrawal, C Catalini,A Goldfarb, Ajay A, et al ‘Some Simple Economics of Crowdfunding’ (2013) National Bureau of Economic Research Working Paper 19133, (Oct. 7, 2023), http://www.nber.org/papers/w19133.pdf&gt.

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

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

[13] 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’, Management Science 17 (2012).

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

[15] Companies Act, 2013, § 42, No.18, Acts of Parliament, 2013 (India).

[16] Sahara India Real Estate Corporation Ltd v Securities and Exchange Board of India, (2013) 1 SCC 1.

[17] Companies Act, 2013, § 42, No.18, Acts of Parliament, 2013 (India).

[18] SEBI, Consultation Paper on Crowdfunding in India, para 9.1.4; 2014, (Oct. 11, 2023), http://www.sebi.gov.in/cms/sebi_data/attachdocs/1403005615257.pdf&gt.

[19] Id.

[20] A K Iyer, ‘Pennywise: A Crowdfunding Critique’, IndiaCorpLaw; 2016 (Oct. 2, 2023), http://indiacorplaw.blogspot.in/2016/02/penny-wise-crowdfunding-critique.html&gt.

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