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Unlocking New Horizons: Rethinking Startup Potential with Equity Crowdfunding

The authors are Pritha Lahiri and Vikas Saran, fifth and fourth year students, respectively, at Institute of Law, Nirma University.


Introduction


Crowdfunding is a method of raising capital for businesses that involve obtaining smaller amounts of cash from private investors, frequently using Internet platforms. Projections indicate a substantial growth trajectory for the global crowdfunding market, with estimates indicating a rise from $1.41 billion in 2023 to $3.62 billion by 2030. In particular, equity crowdfunding is expected to expand in the coming years. Picture this: entrepreneurs seeking capital, private investors ready to contribute, and online platforms acting as the facilitators helping startups to achieve their goals.


However, some concerns are associated with making investments through platforms that help entrepreneurs raise small amounts of money, especially when investing in Securities through these platforms. With hardly any regulations or norms defining their financial instruments and agreements, these platforms operate in a regulatory grey area.


The recent penalty imposed by the Ministry of Corporate Affairs (“MCA”) on an online crowdfunding platform for raising securities through crowdfunding has ignited discussions about the regulation of equity crowdfunding in India. While the penalty signifies the importance of regulatory oversight, it also presents an opportunity to reassess the potential benefits of equity crowdfunding and advocates for a more nuanced approach.


Through this article, the authors seek to discuss the existing regulatory challenges facing equity crowdfunding and discuss an alternative arrangement that can help startups with their security funding requirements.


The MCA Order


The Ministry of Corporate Affairs in the matter of Anbronica Technologies Private Limited passed an order against the startup Deciwood (Anbronica Technologies Private Limited), for using Tyke, an online fundraising tool, to illegitimately raise money in the form of securities. By using Tyke to market its offer to the general public, which is against Section 42(7) of the Companies Act, 2013, the startup and its promoters violated the said provision, and MCA ordered them to pay a fine of 4 lakhs. This case comes up years after a Press release from SEBI in 2016 that alerted investors to the violation of the Securities Act by electronic platforms that facilitate fundraising on digital platforms including websites and other internet platforms.


Section 42 of the Companies Act, 2013 regulates the issuance of shares through a private placement. Sub-section 7 of the provision states that “No company issuing securities under this section shall release any public advertisements or utilize any media, marketing or distribution channels or agents to inform the public at large about such an issue.”


Despite the observation that Tyke Technologies Private Ltd facilitated the company in violation of sub-section (7) of Section 42, the MCA stated that Section 42 explicitly prohibits the imposition of penalties on tech platforms.


Equity crowdfunding often involves the issuance of securities by startups, making it subject to the provisions of the Companies Act, 2013 and Securities Contract Regulation Act, 1956. However, startups engaging in equity crowdfunding commonly violate Section 42, which lays down the rules for private placements.

Given the spontaneous growth of startups across the country, it is quintessential for regulators to monitor and regulate the activities of these startups to prevent fraudulent activities, protect investors, and maintain the integrity of the financial system.


Existing Framework: Why does it need a revamp?


SEBI Consultation Paper on Crowdfunding

In its Consultation paper in 2014, SEBI highlighted the need for fresh avenues for startups to raise early-stage funding through digital platforms. It proposed exploring the potential of crowdfunding as an alternative method, highlighting its potential advantages in terms of efficiency, cost-effectiveness, transparency, and disclosure compared to conventional methods like public issues or private placements.


Crowdfunding has been defined as “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.” SEBI has ventured into Equity based Crowdfunding under the security-based model under which a firm can raise up to Rs. 10 Cr using online platforms in exchange for equity interests. However, it is limited to registered Accredited Investors and only specific platforms are eligible, i.e., unlisted companies with revenue under Rs. 25 Cr, real estate firms, and non-financing ventures.

Additional requirements include a maximum 25% ownership for a single investor and a 5% equity stake retained by promoters for three years. Companies must submit a Private Placement Offer Letter to the platform and are prohibited from public advertising or soliciting investments.


In its paper, SEBI discussed the introduction of crowdfunding as an additional funding channel for startups, balancing it with investor protection. However, the suggested proposal restricts equity crowdfunding and advises organizing it as a private placement, contradicting the essence of crowdfunding, i.e., funding from multiple investors. Ultimately, the proposal results in a limited environment making securities crowdfunding challenging without substantial changes.


Innovators Growth Platform

Introduced by SEBI in 2019 exclusively for startups, it provides relaxed listing norms for startups, including reduced trading lot size and a separate category for eligible investors. The intention behind this initiative was to foster the growth and advancement of startups. However, this platform faces significant challenges.

For a startup to be listed on the Platform, it has to operate on profit for the preceding three financial years.

According to a news report, only 17 out of 80 unicorns in India, which are highly valued startups, have managed to achieve profitability and six startups have successfully listed on this platform so far. Additionally, the majority of startups find themselves in their initial stages, where profitability may not be immediately attainable. Consequently, these startups are automatically rendered ineligible for listing purposes.


The constraints put on startups represent a restrictive mindset that impedes their growth. Despite acknowledging the advantages of crowdfunding, SEBI continues to be apprehensive due to little or no effective regulatory framework in place and risk of investor exploitation.


An Alternative Narrative


The following solutions proposed by the authors offer potential approaches to enhance the equity crowdfunding ecosystem in India:


Security Token Offering

Security token offerings (STOs) are digital representations of ownership or investment in a company or asset, which are sold to verified investors, offering benefits such as dividends and voting rights. Smart contracts (automated contracts with predefined conditions) automate the issuance, distribution and compliance processes and tokens can be traded on secondary markets for liquidity. In India, companies like Ryzer and Fandora have already introduced blockchain-based tokenized fundraising for the entertainment and real estate sectors.


At a recent summit, experts discussed the possibility of establishing legislation to support Tokenomics, which entails using digital units or tokens that can be exchanged on the secondary market in a manner akin to stocks and bonds.

The rules governing STOs in the UK can serve as an example for India. Security tokens are governed by the Financial Conduct Authority in the UK, assuring regulatory oversight and investor safety. India, which is still getting its head around this idea, may choose to develop a similar legal framework with adequate security token classification and the creation of a regulatory body.


If implemented in practice, STOs can cover the entire funding lifecycle, including issuance, maintenance, dissolution, regular reporting, voting rights, and equity transactions. This streamlined approach enhances transparency, broadens investor reach, and increases liquidity, making STOs an attractive option for efficient and inclusive fundraising.


Waiving off certain compliance requirements

A new regulatory regime can be introduced exclusively for Crowdfunding that allows startups to advertise and raise funds through equity crowdfunding without being subject to the provisions of private placement stricto sensu.


The requirement of strict adherence to non-advertisement should be done away with when a startup is seeking funding for the first time through a crowdfunding platform since advertisement plays an important role in seeking favorable investments. Cues can be taken from the US, where advertising and solicitation of the securities are allowed as long as it involves accredited investors. If there are non-accredited investors involved, the offering shall be made under Reg D Rule 506(b), where one cannot advertise or do a general solicitation.


Inclusion of both accredited and non-accredited investors

In the US, Jumpstart Our Business Startups (JOBS) Act, 2012 waives securities registration rules, enabling businesses to raise money through crowdsourcing.


Further, Rule 506(b), permits companies to offer securities to accredited investors as well as a maximum of 35 non-accredited investors. Nevertheless, there are specific restrictions on fundraising and investment amounts. For instance, businesses can use crowdsourcing to generate up to $5 million in a single year. Individual investors are also subject to investment threshold based on their income and net worth.

India, like the US, can be allowed to raise funds through both accredited and non-accredited investors which increases the inclusivity of a greater number of investors. A particular limit to the number of accredited and non-accredited investors can be prescribed which conforms with the private placement norms as provided by SEBI.


Additionally, the EU’s disclosure-based approach can be an inspiration for India to create a system where companies seeking equity crowdfunding are required to provide detailed information to potential investors, including financial statements, business plans and risk warnings and crowdfunding platforms must disclose information about fees, charges, and potential conflicts of interest.


Thus, SEBI can take into consideration these alternatives and instead of staying wary of Crowdfunding, can take a stand and frame compact regulations for equity crowdfunding to benefit the startups.


Closing thoughts


The potential for equity crowdfunding as a source of investment for companies in India is enormous. SEBI and other authorities must review and update the current crowdfunding laws in India to promote the development of startups and enable effective financing. The authorities may strike a balance between investor protection and allowing companies to access funding by adopting comprehensive and inclusive frameworks, such as STOs and more lenient crowdfunding restrictions. Such changes will promote innovation, increase investment opportunities, and support the general growth of India's entrepreneurial ecosystem.

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