[The following guest post is contributed by Arjya Majumdar, who is an Assistant Professor at the Jindal Global Law School. He can be contacted at firstname.lastname@example.org]
In the aftermath of the 2008 financial crisis, small businesses found it increasingly difficult to raise funds. As a response, crowdfunding has emerged as a viable alternative for sourcing capital to support innovative, entrepreneurial ideas and ventures. With the swift growth of the crowdfunding industry, risks associated with it have also come into sharp focus. According to a World Bank commissioned report in 2013, Kickstarter, the market leader in pledge or donation-based crowdfunding, has channeled over USD 815 million from 4.9 million backers to nearly 50,000 projects throughout the world, between 2009 and 2013. By March 2014, Kickstarter had surpassed USD 1 billion.
In India, the Securities and Exchange Board of India (SEBI) released a consultation paper in 2014 which, inter alia, proposes a framework for ushering in crowdfunding by providing start-ups and small-and-medium enterprises (SMEs) access to the capital markets and to provide an additional channel of early-stage funding. A brief background and the purport of the consultation paper may be found here.
A number of issues arise concerning crowdfunding in India - the first of which is the requirement of regulating crowdfunding, particularly when pre-existing securities laws may be interpreted to include crowdfunding activities. The nature of crowdfunding is inherently different from venture capital and public funding. This sets up the foundation for which a separate exemption may be carved out of existing securities laws. There are several primary risks arising out of equity crowdfunding which must be addressed by any securities regulator seeking to regulate this mechanism.
The first risk involves the possibility of a large number of likely non-sophisticated investors in an early-stage company, which has a high chance of failure making it an added complication. Because of the low cost of capital and the relative ease with which entrepreneurs may access and engage with crowdfunding portals, crowdfunding has been used by many startup companies to raise smaller amounts of money for their initial stage. Startup companies have an inherent risk of failure. Failure statistics universally show that over 50% of newly founded firms will fail during their first five years.
Crowdfunding portals and their operations create concerns as well – primarily due to the lack of a secondary market. Typically in a company which has issued securities to the public, such securities are freely tradable on stock markets. The Companies Act, 2013 also limits restrictions on transferability of public, listed company shares. Conversely, crowdfunded securities cannot be traded on crowdfunding portals as on date - leading to illiquidity. As a result, contributors cannot sell their securities to recoup their investments. This risk is exacerbated in cases of default or fraud, where an immediate exit option from the company does not exist.
At the same time, equity crowdfunding offers a number of advantages, the largest of which – curiously enough - is the lack of regulation. Companies that raise funds from fifty or more investors are required to undertake a public offer, regulated under the Companies Act, 2013 as well as the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. Using the Internet, an entrepreneur can sell an idea that is viable and can be monetized to literally millions of potential investors. No intermediary such as a merchant bank or an underwriter is needed. Other advantages include the spreading of risk and the boost to the economy through encouragement in the growth of SMEs.
In India, companies are prohibited from offering to issue shares to more than 200 potential investors in a financial year or from allotting shares to 50 or more shareholders, without undertaking a public offer. A public offering of shares or convertible debt securities involves the appointment of one or more merchant bankers, a registrar to the issue, filing of a draft offer document with SEBI, eligibility requirements such as previous track record, minimum promoter’s contribution, lock-in requirements, requirement to have a monitoring agency, etc., apart from detailed disclosure requirements.
Legislation exempting crowdfunding activities from traditional securities laws have been passed in a number of other jurisdictions, beginning with the United States. Other countries, including Italy, New Zealand, the United Kingdom and Australia have followed suit. Three regulatory regimes can be identified in equity crowdfunding. In the first case, regulation prohibits equity crowdfunding in its entirety while reiterating the existing law on fundraising by companies. In the second case, countries have begun to consider crowd funding as a new way of raising capital and that it falls under the regulation of public offers of securities. In the third case, several countries have adopted tailored regulations which seek to encourage this financing without apparently compromising investor protection
Similar to the Jumpstart Our Business Startups (JOBS) Act in the US and other legislations around the world, SEBI’s consultation paper also seeks to create exemptions for crowdfunding activities. This raises the second issue involving a comparison of SEBI’s proposed regulations, particularly in terms of eligibility criteria for fundraisers and contributors, mechanisms, levels of disclosure and independent accreditation, etc., with that of other jurisdictions.
Policymakers continually face the challenge of effectively balancing the benefits of encouraging small business formation against the investor protection goals of the securities laws. This challenge becomes even more pronounced in the case of crowdfunded companies which typically are small and medium enterprises. In terms of the existing law on raising capital, a proposition may be made that the present-day law in India makes it impossible for crowdfunding activities to occur. Any exemptions offered to crowdfunding activities must still address certain basic issues concerning information asymmetry, agency costs and investor protection at the very least. A review of SEBI’s consultation paper would ascertain whether the principles followed by SEBI in regulating this sector would culminate in the development of crowdfunding activity, or stifle it.
At the same time, SEBI’s consultation paper does not take into account two key aspects of crowdfunding. The first is that of peer to peer lending – when the proceeds of crowdfunds are issued to an individual and not a company. The second is that of cross-border crowdfunded companies. Given that crowdfunding is typically facilitated by web-based portals and promoted through social media and other internet-enabled networks, it is likely that crowdfunding activities will transcend national boundaries. Perhaps suitable checks and balances could be designed into Indian crowdfunding regulations.
- Arjya Majumdar