Updated: Oct 4, 2020
Crowdfunding is a method used in order to accumulate funds from numerous investors for a specific and definitive objective. It provides those who lack access to such funds, the ability to cumulatively accrue small contributions, primarily by way of a web-based platform or through a social networking site. While the concept in itself is not one that is uncommon in India, the existing regulatory framework fails to reflect the same.
Types of Crowdfunding
According to the SEBI Consultation Paper crowdfunding is defined as the “solicitation of funds [in small amounts], from multiple investors through a web-based platform or site for a specific project, business venture or social cause”
The definition itself does not allude to the various types of crowdfunding the distinction of which arises from the products or services offered, or the motive for which the specific project is set up.
The following are the major forms of crowdfunding prevalent in today’s market structure:
(a) Donation-based Crowdfunding: The funds raised are utilized for social causes or similar philanthropic purposes and are made as donations with no expected return on the investment.
(b) Rewards-based Crowdfunding: The contributions are made by investors in exchange for existing or future tangible rewards.
(c) Debt Crowdfunding: This is an instance of peer-to-peer lending wherein the borrowers are matched with lenders/investors on an online platform for the provision of unsecured loans at an interest rate fixed by the platform.
(d) Equity-based Crowdfunding: Refers to a method of funding whereby the investors are offered equity shares in the company as consideration for their contributions. The investors would thereby be entitled to a return on their investment as well as a share of the company’s profits.
Of the above-mentioned types of Crowdfunding, Equity-based Crowdfunding faces regulatory restriction particularly with respect to the issues arising out of the provision of equity shares and part ownership arising therefrom. As under the Companies Act 2013, Section 2(68) a private company is defined as one which by way of its articles:
(a) Restricts the right to transfer its shares;
(b) Limits the number of its member to 200 (except in the case of a One Person Company);
(c) Prohibits any invitation to the public to subscribe for any securities of the company.
Thus without making a public offer, a company is prohibited from issuing shares to more than 200 potential investors who would thereby be part owners in the company.
The SEBI further classifies Equity-based Crowdfunding as illegal, and has issued multiple regulations in order to minimize risk, and ensure the protection of investors. The rationale for the same arises out of the high risk associated with unregulated investment for those who lack the skill or experience in ascertaining risk prior to investing. In 2014 the SEBI proposed guidelines in the form of a ‘Consultation Paper on Crowdfunding in India’ with the objective of improving access to funds for small-to-medium enterprises as well as start-ups.
The following are the principal SEBI guidelines on Crowdfunding:
(i) Only ‘Accredited Investors’ may invest;
(ii) ‘Qualified Institutional Buyers’, as defined under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, are to hold at least 5% of the issued securities.
(iii) Contributions made by a retail investor; Minimum - INR 20,000, Maximum - INR 60,000.
(iv) Maximum number of retail investors should not exceed 200;
(v) Start-ups which are only less than two years old are eligible;
(vi) Disclosure of details to be made with regard to the proposed business plan. Audited financial statements, intended fund usage, management details, and so on;
(vii) The Registered Crowdfunding platform is to conduct regulatory checks and basic due diligence of both start-ups as well as of investors.
When discerning the benefits and risks associated with Crowdfunding, the SEBI guidelines fail to address a few key aspects. The first issue is that it pertains to cross-border Crowdfunding. Since this method of investment is conducted entirely online it ensures that projects are able to receive investments from both Indian investors as well as those from foreign jurisdictions. While the Consultancy paper outlines various regulatory measures and compliance checks required for different jurisdictions across the world, it fails to elaborate on how these regulations would interact between the two jurisdictions.
Furthermore, the guidelines fail to clarify the tax implications of the funds raised via Crowdfunding, and whether the same would be subject to the current tax provisions pertaining to unlisted companies. More often than not the funds raised are subject to commission from the platform itself and further taxation would hinder the objectives of the startup or enterprise.
Economic Benefits& Inherent Risk
Crowdfunding does incentivize consumers to invest, a primary reason for the same being the shared risk between multiple investors. Crowdfunding thereby does away with detailed and expensive compliance procedures as well as disclosure requirements that are associated with an IPO. The reduction of overhead costs in such a manner would assist the entrepreneur to divert the funds entirely toward the objective for which the project was established. Return on investment from equity Crowdfunding in startups can be tremendous and while most startups may not achieve the expected return, long-term investment in a promising start-up could produce higher returns than any other form of investment. Crowdfunding further allows an investor the opportunity to diversify their portfolio and mitigate market risk. It is herein that the need for effective regulation lies.
Crowdfunding involves the risk of a large number of inexperienced investors partaking in an early-stage company, resulting in mismanagement and possible failure. The risk of fraud on part of the borrower also exists, as no recourse is provided for, should they default with the investment. However a major aspect of Crowdfunding that demands regulatory attention is the issue of money laundering as was seen in the Sahara Case, wherein numerous investors were revealed to be non-existent, created solely to facilitate fraudulent activity.
The need for relevant regulation is imminent. While the SEBI has attempted to regulate Crowdfunding the same proves to be both stringent and cautionary in nature. Neglecting multiple pertinent issues the existing regulations further restrict potential investment and fail to align with the ‘ease of investment’ that Crowdfunding boasts. Rather than branding Equity-based crowdfunding as ‘illegal’, provisions should be made for exemptions so as to provide small enterprises and startups, access to capital markets, as an additional source of funding, while also protecting the interests of the investor. The existing regulations need to keep pace with the contemporary financial market and require the inclusion of sophisticated legislation to facilitate overall economic growth.