Equity Crowdfunding in India
Crowdfunding is an age-old method of raising funds for any particular project or necessity. It can be traced back to the Dutch East India Trading Company in the 15th and 16th centuries.
They started exploring the world beyond the known map to find treasures and trade with other kingdoms and states. These endeavors involved a lot of risks as a significant number of ships never returned. So, if one invested all the resources in one ship, the chances of getting returns were very low.
The Dutch East India company resolved this by inviting the general public to invest in a group of ships. Since there were a lot of people investing in a few ships, the risk was divided. This provided an opportunity for the general public to invest in a business and gain some profits. It also relieved the individual ship owners of bearing all the risk by themselves. Thus, by crowdfunding their marine trade business, the Dutch East India Company was able to profit from an otherwise high-risk endeavor, while also helping the investors get a share in the profits.
This article will look into the current status of crowdfunding for businesses in India, especially with respect to equity crowdfunding.
What is Crowdfunding?
Crowdfunding is the practice of raising money from a large number of people for any personal, medical or business necessity. It is a form of alternative finance where individuals and businesses can raise funds for their needs from interested people.
Crowdfunding uses the internet as a medium of operation The process involves three parties, the project initiator, the supporters, and the moderator. The project initiator is the person or business that needs funds and has decided to start a crowdfunding campaign. The supporters are the people on the internet who have chosen to support the campaign by making some contribution. Finally, the moderator is the crowdfunding platform or website where the other two parties are operating and interacting.
There are primarily four different types of crowdfunding: reward-based, donation-based, debt-based, and equity-based.
Reward-based crowdfunding can be used by businesses to raise funds from the public in return for specific rewards to the supporters. Donation-based crowdfunding is usually used for personal and medical necessities, or for a community project. And, the campaign initiators have no liability of returning the funds collected. Debt-based crowdfunding works like regular lending in that anyone can raise money on a crowdfunding website, payable back at a specified interest rate.
What is Equity-based Crowdfunding?
Equity-based Crowdfunding is a form of crowdfunding where the supporters become the stakeholders of the firm. Under this, a business can invite the general public to invest in their business which would get them a share in the equity.
The individuals who are interested in investing in the business can head over to their crowdfunding campaign and support their idea. Once a person invests in such a campaign, they have bought a share in the equity of the company proportionate to their investment. Now, they will get a share in the profits of the company and they will also be liable to bear the losses if any.
This type of crowdfunding is particularly helpful to businesses in early-stage funding. They can offer equity interests in their business to investors online by advertising it on a crowdfunding platform. The platform serves as an intermediary between investors and businesses.
To understand the challenges faced by equity crowdfunding in India, we need to see how it works in a supportive and well-regulated environment.
1. Equity Crowdfunding in the USA
The “Jumpstart Our Business Startups” (JOBS) Act 2012 is a US law intended to help support startups and new businesses. Its purpose is to encourage funding of small businesses that are based in the USA and to ease various securities regulations by the U.S. Securities and Exchange Commission (SEC).
New exemptions were introduced under the JOBS Act to allow a company to receive smaller public investments. The previous requirement of having to register for an initial public offering (IPO) was also removed.
Moreover, the Act also encourages equity crowdfunding. It also increased the number of shareholders a company can have without registering with the Securities and Exchange Commission. A company has to be publicly reported once it exceeds $10 million in assets and has more than 500 shareholders.
2. Equity Crowdfunding in the UK
Financial Conduct Authority or the FCA is the regulatory authority for crowdfunding in England. Crowdfunding, in England, is divided into four categories: Investment-based, Loan-based, Donation-based and Pre-payment/Reward-based.
Financial Services and Market Act, 2000 regulates investment-based and loan-based crowdfunding. And, the Payment Services Regulation Act, 2017 regulates donation-based and pre-payment/reward-based crowdfunding activities.
Current Status of Equity Crowdfunding in India
In India, equity-based crowdfunding per se is only limited to the private placement of shares under the Companies Act. But, the Securities and Exchange Board of India (SEBI) issued regulations in 2012 which created a new form of crowdfunding called fund-based crowdfunding.
Now, all crowdfunding platforms involved in equity-based crowdfunding are required to register as Alternative Investment Funds (AIFs). There are a lot of disadvantages to these platforms in registering themselves as AIFs.
Under this model, only an accredited investor can invest. And, the funds of the accredited investors registered with a recognized platform will be collected online through the platform. These funds will be pooled under the Alternative Investment Fund (AIF) to invest in shares or debt securities in crowdfunded ventures which are displayed on a recognized crowdfunding platform.
Extremely high qualifications are required for someone to be recognized as an accredited investor. The qualifications prescribed in the regulation are as follows:
- Companies incorporated under the Companies Act, with a minimum net worth of Rs.20 crore,
- High Net-worth Individuals (HNIs) with a minimum net worth of Rs.2 crore.
- Eligible Retail Investors (ERIs) who fulfill the prescribed criteria.
The SEBI 2012 regulations also place certain restrictions on the kind of companies that can raise funds through Security based crowdfunding. Some of those restrictions are as follows:
- A company which is not listed on any exchange
- A company which is not more than four years old
- A company which is not promoted, sponsored or related to an industrial group which has a turnover in excess of Rs. 25 Crores
- A company intending to raise capital not exceeding Rs. 10 Crore in a period of 12 months
- A company that is not engaged in real estate and activities that are not permitted under the Industrial Policy of Government of India.
Impact of SEBI Regulations
The SEBI 2012 regulations imposed certain restrictions on crowdfunding platforms engaged in equity-based crowdfunding. These regulations have largely affected the freedom of the crowdfunding platforms.
Firstly, they put restrictions on who can be the potential and legitimate investors. The number of people who can be approached for funds was drastically cut down since only accredited investors are now permitted. For example, these platforms are now permitted to pool money only from investors having minimum liquid net-worth of Rs2 crores. This seriously curtails the number of people these platforms can approach for investment.
Secondly, they imposed restrictions on the kinds of companies that can raise funds through security-based crowdfunding. So, they not only reduced the number of people who can invest through these platforms but also reduced the number of businesses that can approach crowdfunding platforms to raise funds. This poses a serious threat to the entire industry engaged in security and equity-based crowdfunding.
Moreover, SEBI only ‘proposed’ a legal, structural, and regulatory framework governing crowdfunding for Startups in 2014. Then, in 2015, they had a consultation with the government to evolve guidelines on crowdfunding. And yet today in 2019, there is no clear framework to regulate platforms engaged in security-based crowdfunding. Ambiguity in law and lack of appropriate law pose a serious threat to the functioning of new businesses.
What does the future look like?
Equity Crowdfunding is an unexplored territory in Indian markets with explosive potential. The results in other countries have shown that with appropriate regulations and frameworks, everyone can benefit from this.
In the USA, funds raised through crowdfunding grew 33.7% in 2018. In the UK, the amount raised through equity-based crowdfunding between 2012 and 2014 increased by 410%. This sudden increase happened due to the introduction of the Seed Enterprise Investment Scheme (SEIS) in 2012. SEIS provided 50% tax relief on equity investment in early-stage companies, including those made through crowdfunding platforms.
There is enough evidence to point to the fact that crowdfunding, as a business activity, is beneficial to all the parties involved. Businesses use it to ease their burden of raising funds and gauge the response of people to their products. Consumers can use it to find out about new business ideas and products that they like. Investors can benefit from new opportunities to invest in upcoming businesses. And, lastly, for the Government, it can imply a stronger economy with flourishing businesses and increased revenue from taxes.
There is no reason why any Government should not allow web-based platforms to engage in equity and security-based crowdfunding. On the contrary, it is highly profitable for the government to put proper regulations in force in support of equity crowdfunding as has been seen in the USA and UK. Not only can it help improve the country’s economic growth by providing new investment opportunities but also result in the democratization of businesses. Crowdfunded businesses are obligated to pay attention to their online supporters and their demands as they are their primary investors and potential customers.