Introduction to Equity Crowdfunding

By Charith Reddy, for Legal Corner LLP. Akash is a fifth year student of NALSAR University of Law and will be graduating in 2021.

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) to get legal advice that is specific to your business needs. 

Equity crowdfunding refers to a method of financing often utilized by startups and other early-stage companies, wherein, the company issues shares to a broader set of unsophisticated individual investors in exchange for the required funds. Equity crowdfunding focuses on obtaining nominal amounts from a larger pool of investors, who are often referred to as “the crowd”. Although an age-old practice, the concentrated presence of crowdfunding on websites, social media platforms and other internet-based forums points towards the importance of the digitalization of world economies in facilitating and advancing crowdfunding. With its growing prominence – the global crowdfunding market is expected to reach a valuation of $28.8 billion by 2025.

Characteristics of Equity Crowdfunding.

Equity crowdfunding sets itself apart from the other forms of raising capital by laying greater emphasis on raising funds from a larger and more diverse pool of unaccredited investors. By giving the larger public an opportunity to participate in the investment processes, equity crowdfunding also democratizes the process of raising funds. Another major distinction is that equity crowdfunding does not fit into the conventional forms of raising funds through the issuance of shares. It neither resembles a public offering as it enables private companies to raise funds from the larger public nor does it resemble a private placement of shares as the companies raise funds from the larger public. Equity crowdfunding remains an exception to the conventional rule of only permitting public companies whose shares are listed on stock exchanges to raise funds from the public as it lets private companies do the same. Equity crowdfunding also gives the companies complete autonomy and control over the offering of shares – from pricing and quantity of shares to the valuation of the company. The highly digitalized process also reduces the financial and regulatory burden imposed on a company raising funds through equity crowdfunding. In this manner, equity crowdfunding remains to provide easy access to capital while also ensuring lucrative returns.

Risks with Equity Crowdfunding.

The risks and drawbacks associated with equity crowdfunding have often overshadowed the benefits derived from it in the eyes of the various stakeholders. For instance, for the market regulators, the biggest risk is that of the investors being defrauded or scammed in the absence of a defined legal framework. This has prompted various market regulators to either restrict or prohibit crowdfunding in their respective jurisdictions. This risk is further aggravated by the digitalization of the process and the subsequent relaxation in disclosure requirements. This puts the investors at a higher risk of fraud as this enables information asymmetry between the company and the investors. Apart from that, the investors also face a problem of low liquidity as there might be very limited exit options. Finally, in the eyes of the borrowers, equity crowdfunding leads to a dilution of equity without any dilution in the managerial powers in the company. However, this might be a disincentive for those companies as they might lose out on the expertise and professionalism that is derived from Venture Capitalists and Angel Investors investing in them. Due to the abovementioned reasons, equity crowdfunding has remained a contentious issue in most jurisdictions. Although the importance and value of equity crowdfunding is slowly being realized – the market regulators have remained reluctant to introduce the necessary reforms in the securities regulations or have introduced restricted reforms. In this context, the article will now look at the status of crowdfunding in India.

Equity Crowdfunding in India

In India, the securities market regulator (SEBI) has prohibited equity crowdfunding, while allowing for other methods of crowdfunding such as donation and reward-based crowdfunding. This exclusion mainly stems from the reasoning that the other models of crowdfunding do not present any element of financial returns.

The Securities and Exchange Board of India (SEBI) had released a consultation paper on the introduction of equity crowdfunding in 2014. The paper focused on established a regulatory framework for Small and Medium Enterprises (SMEs) and startups to raise funds through equity crowdfunding. The paper proposed guidelines to regulate various aspects – such as the eligibility of investors and companies, and limits on the capital that can be raised etc.

The lack of financial education and awareness in the general public in India has ensured that none of the reforms suggested in the consultation paper have come to fruition. India’s reluctance to introduce a regulatory framework to allow for equity crowdfunding has cost India the opportunity to capitalize on the emergence of the startup culture in India which has a constant need for funding.

The major roadblocks in India have been the existing legislations. The stringent clauses regarding the raising of funds in these legislations have been shaped by a history of corporate scandals that had devastated the Indian economy in the past. For instance, the Companies Act, 2013 requires companies to comply with and adhere to a cumbersome and expensive process before they can raise funds from the general public. This whole process is not only time consuming but is also expensive and intrusive as it consists of a host of disclosures and compliances. In this manner, despite SEBI’s interest in creating a restricted legislative framework for equity crowdfunding, it has never been able to gain a foothold in India. Hence, equity crowdfunding has proved to be a regulatory conundrum for the market regulators in their attempt to balance the needs of the startups and SMEs on one hand and the interests of the investors on the other. For instance, to protect the interests of the investors, it would require the market regulator to impose disclosure requirements and compliances which would then make it a costly affair for startups. Hence, it is important that the regulatory framework be introduced which not only satisfies the funding needs of these startups, but also safeguards the interests of the investors.  At the present however, equity-based crowdfunding is largely restricted to private placement of shares by companies and these crowdfunding platforms are to be registered as Alternate Investment Funds (AIFs). These improper classifications have their own share of restrictions and drawbacks which further impede the growth of equity crowdfunding in the country.

If you have any questions, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Equity Crowdfunding in the US

By Sparsh Khosla, for Legal Corner LLP. Sparsh is a second year student of NALSAR University of Law and will be graduating in 2024.

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) to get legal advice that is specific to your business needs. 

Since the beginning of the 21^st century, there has been an exponential increase in the digitisation of most activities. So much so, that purely financial activities such as transactions which need high security have shifted to the online mode. This has been used by some businesses to break the conventional methods of raising capital, particularly by small companies who might want to raise capital in exchange of securities as debt financing is not a good option for them. This method of raising capital in exchange of securities is called equity funding. When it is done on a platform where it is accessible to a large number of people, it is called Equity Crowdfunding.

Equity Crowdfunding under the JOBS Act

Title 3 of the Jumpstart Our Business Start-ups (JOBS) Act is wholly devoted to Equity Crowdfunding for Start-ups. The Equity Crowdfunding operation under the JOBS Act has two parties and an intermediary. The two parties are the investor and the start-up, which is known as the issuer. The issuer sells securities over an internet platform to an investor with the help of an intermediary, a broker or a funding portal. A securities transaction would require registration with the commission and compliance arising out of the same under the Exchange Act. But there is an exemption under the JOBS Act for registration of the securities offered through Equity Crowdfunding. This exemption will only be applicable if the investor and start-ups have followed the SEC’s monetary restrictions.

Restrictions for the Investor

The monetary restrictions are in place for both the investors and the issuer. With respect to the investors, the SEC’s significant restriction is on the amount of money invested by an individual in a one or more issuers over a year. The limitation is as low as 2000 dollars or 5 per cent of the annual income/net worth, whichever is higher, for individuals whose annual income or net worth is lower than 100,000 dollars. This stringent rule has been put in place because the shares of small businesses have higher volatility and are considered to be high-risk investments. Even if an individual has an annual income higher than 100,000 dollars, he can only invest 10 per cent of the annual income or net worth, whichever is lower.

Balance of interests

There are two interests which the US Securities and Exchange Commission (SEC) has to balance while formulating the rules for Equity Crowdfunding. The first is the start-up’s interest which is to raise money to expand its operations or in some cases, survive. The second interest is of the investors to earn profits from the money that has been invested by them. The mandate of the SEC motivates the commission to prioritise the investor’s interests. Hence, most of the rules have been formulated to protect the investor’s interest in such transactions which increases the compliance requirements for the issuer.

Compliance for the issuer

The compliance for the issuer is manifold. First, there are the requirements to disclose certain information in order to gain access to crowdfunding as stipulated by section 4 of the Securities Act. This information concerns the basic functioning of the start-up. It includes a wide array of topics from the issuer’s legal status and address to the issuer’s financials. This data is collected to give the investors an idea about the standing of the start-up. Additional compliance requirements relate to the disclosure of ongoing activities at the start-up in the form of annual reports and filling out other forms. These rules have been put in place to ensure that the investors are well-equipped with the information regarding the issuer before buying the securities. Such a requirement does increase the overall time taken and costs involved for raising capital. But the issuer is the entity seeking investment, and it is incumbent upon the SEC to ensure that the investors are not making ill-informed decisions.

Role of Funding portals and their role

The funding portals are intermediaries which are specific to equity crowdfunding. The SEC has made the registration of these funding portals mandatory in its supplementary rules. The existing brokers were also given the rights to become intermediaries in such transactions after complying with the regulations. There is one obvious stipulation to eliminate bias and chances of collusion. This stipulation is that the intermediary or its directors should not have a financial interest in the issuer. One exception is made to this rule where the issuer can compensate the intermediary for its services. This compensation has to be in the form of securities similar to those issued in the crowdfunding operation. The benefit of this exception is two-fold. First, the exception gives the smaller start-ups who could not have otherwise afforded the funding portals’ services, a chance to conduct a crowdfunding operation. Second, alignment of the interests of the investor and the intermediary reduces the scope for fraud or collusion between the intermediary and the issuer.

Provisions for tackling fraud

Several restrictions have been put in place to ensure that the incidence of fraud is minimum in equity crowdfunding operations. These regulations include the requirement of a reasonable basis for the intermediary to believe that the issuer as complied with the rules and it has established a means to create a record of all the present and future security holders. Additionally, the rules also compel the intermediary to deny access to its platform if it has a reasonable basis to believe that the compliance is inadequate or the issuer is eligible for disqualification. Such provisions do make an effort in a decent direction but put a hefty burden on the intermediary to tackle fraud. This increases the chances of collusion between the intermediary and the issuer because of the absence of other actors keeping a check on fraud-related activities.

Conclusion

Internet-based Equity crowdfunding is an innovative way tuned to the modern needs of both the investors and start-ups. The SEC making rules for keeping illegal activities in check and requiring disclosure from the issuer makes this method, safer and more reliable. This creates another way of raising capital more lucrative and empowers small businesses, especially youth innovators and entrepreneurs. But the heavy compliance makes the whole process complicated and more expensive. This has motivated several scholars and lawyers to believe that the rules do more harm than good to the entrepreneurs. The effectiveness of this operation is highly uncertain, and there should be research conducted on the same. The publication of reports on its effectivity might help the SEC develop the rules, and the balance might shift towards the issuers. On the other hand, the SEC may keep the protection of the investors’ interest as its priority, and there is a chance that the rules may remain unchanged.  In summation, the provisions and regulations have opened up a new avenue for raising capital, and comprehensive legal discussion on the same may lead to the development of the same in the future.

If you have any questions, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Why choose Alternative Dispute Resolution Mechanism for International Contracts

By Harshvardhan Tripathi, for Legal Corner LLP. Harshvardhan is a fourth year student of NALSAR University of Law and will be graduating in 2022. 

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you are planning to consider incorporate or expand your existing business in the US so as to get legal advice that is specific to your business needs. 

When entering into business agreements with entities based in other countries, parties must pay keen attention to the crucial question- what happens when a dispute arises between the parties? At first, discussing the scenario of failure of agreement even before parties have established contractual relationships might appear strange. However, having clarity over the dispute resolution mechanism saves time, money and efforts in the case of a potential conflict between the parties. In order to prevent hassle later on, the contract must include a clearly drafted and precise dispute resolution clause.

Parties based in different jurisdictions are generally unwilling to submit their disputes to the courts of the other countries due to reasons such as logistical difficulties, chances of mistrial and bias, complicated unfamiliar court procedures, language difficulties etc. Instead of pursuing litigation, parties instead prefer Alternative Dispute Resolution (‘ADR’) mechanisms such as Arbitration, Mediation and Negotiation.

The following are the benefits of ADR mechanisms over litigation that parties can consider before negotiating the dispute resolution clause:

1. Confidentiality

The biggest attraction of ADR proceedings is that, as compared to litigation in a public court, they are private and confidential. Oftentimes, the parties sign a Non-disclosure agreement to ensure that all information shared and revealed during the proceedings remains private. The benefit of privacy allows the parties to focus more on the details of the dispute rather than worrying about the loss of reputation or loss of public image or any detriment that might be caused due to sharing sensitive information. Especially when the dispute surrounds discussion of trade secrets or Intellectual Property issues, privacy becomes a key concern for the parties.

2. Easy Execution

As compared to litigation that involves many players to participate, ADR mechanisms are convenient because they only require the counsel of legal experts to execute. ADR mechanisms provide a single method of negotiating disputes and this saves the parties from the complexities and cost of multi-jurisdictional litigation.

3. Effectiveness

One of the biggest disadvantages of litigation is that if one of the  parties is disgruntled by the court ruling against them, they can appeal the decision and drag the matter for a prolonged period of time. Therefore, even if a party has a court decree in its favour, its effectiveness might become redundant because of delay and cost. ADR mechanisms provide the advantage of finality- usually ADR resolves cannot be appealed in the manner a court decree can be. Thus, an ADR resolve reached by the mutual consent of parties can be immediately given effect without worrying about another round of challenge.

4. Flexibility

In a litigation proceeding, parties are bound by the prevailing general law of the land, and there are very few opportunities of customizing proceedings according to their convenience. However, ADR mechanisms provide parties the autonomy to decide all major factors of considerations, for instance, the forum of filing dispute, the laws governing the disputes, the laws governing the procedure of the proceedings, language, time limit of completion of the proceedings, number and name of adjudicators, location etc. This gives parties greater control over the resolution of their dispute.

5. Speedy and cheaper resolution of disputes 

It is generally seen that courts of most countries are overburdened and clogged with huge pendency of cases. The situation is especially worrying in countries with dense populations where the judicial mechanism crumbles under the weight of thousands of pending suits. A commercial party might have to wait for years if not months before the matter is heard by the court, and then wait more for further rounds of litigation. This not only makes getting speedy resolution virtually impossible but also drives up the legal cost significantly. Even after investing substantial time and money into it, there is no guarantee that the court would necessarily rule in one’s favor. As compared to this, ADR mechanisms are speedy because the parties can settle the disputes amicably in fewer meetings that are conducted as per pre-decided timeline.  This saves the cost because one does not have to employ the services of Legal Counsels for all those years that matter is pending before the court, but instead their professional service is required only for a few sessions.

If you have any questions on choice of law, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

BRANCH OFFICE VS SUBSIDIARY?

By Himanshu Joshi, for Legal Corner LLP. Himanshu is a final year student of NALSAR University of Law, Hyderabad.

(The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you need assistance with incorporation of your entity in the US so as to get legal advice that is specific to your business needs).

It’s time to expand your business overseas. Before you open your doors, you must make a critical choice — one whose impact is often underappreciated: whether to open a branch office or a subsidiary?

While it may seem like a matter of semantics, a branch office, in legal terms, is wholly different from a subsidiary. And deciding on one entity over the other comes with substantial liability and compliance consequences. Opening an international office means asking complex questions about your company’s tolerance for legal risk, how the enterprise might be taxed and what compliance challenges it might face.

Herewith is an explanation of the basic entities available to companies when they organize new offices overseas, a few of the benefits (and potential pitfalls) of each and other factors to consider before making a final decision.

A direct extension — Representative and Branch Offices

First, let’s define our terms. Generally, companies have three options when they want to enter a foreign market: a representative office, a branch office or a subsidiary.

The representative office is, in essence, a beachhead. It is the simplest to establish as it only exists to allow the company’s representatives to make contacts in the local market. Promotional activities are acceptable, but companies must take care not to step over the line. In most countries, a representative office cannot handle transactions or contractual matters.

A branch office, on the other hand, is a direct extension of the parent company and can engage in core activities like sales and contracts. It is designed to help generate revenue for the company and serves a particular geographic region.

Pros and cons between branch offices and subsidiaries

Branch offices and subsidiaries both offer benefits and challenges for a growing company. Let’s tackle first a few of the pros and cons involved in choosing a branch office:

1. Branch office pros and cons
   

Speed (pro): A branch office can be set up relatively quickly — though, as we’ve noted, it is not without its bureaucratic hurdles. Some companies use a branch office as an interim step, using it to gain local knowledge and make sales before acquiring or establishing a subsidiary.

Oversight (pro): A branch is a part of the parent company and is dependent upon it. Management decisions flow directly from company headquarters, offering executives a greater measure of direct control.

Cost (pro): Branch offices tend to be smaller in size, reducing overhead costs.

Liability (con): Because they are not separate entities, branch offices provide no liability protection for a parent company. The parent is on the hook for any legal issues that may arise.

Tax worries (con): Depending on the applicable tax laws, companywide profits may be exposed to taxation in the country where the branch is located.

2. Subsidiary pros and cons

Protection (pro): Because a subsidiary has its own legal status, it provides a parent company with an additional layer of protection from liability.

Tax Limitations (pro): Subsidiary companies are taxed under local laws on their own income, thus shielding the parent company’s profits from taxes in a foreign country.

Credibility (pro): A subsidiary may open access to capital from banks and investors more comfortable with investing in a local company.

Compliance (con): Because a subsidiary is a separate entity, it may require multiple government registrations and may need to maintain a minimum level of capital to operate. It is also likely to face more stringent local regulations and annual reporting requirements.

Political Exposure (con): As the tariff disputes pitting the United States against China and others have shown, a company’s subsidiaries may be exposed to political risks beyond their control. As tariffs rose, some domestic manufacturers felt the effects because they owned a subsidiary in a country that had been penalized.

Making a choice in India and USA

As for India, a foreign company should generally prefer opening up a subsidiary company over a branch office. With respect to a subsidiary company, the compliance requirement for incorporation is simplified and easy to fulfill while a branch office cannot carry out manufacturing or processing activities in India which a subsidiary company can do. Furthermore, the Corporate Income Tax (CIT) applicable to a subsidiary company is comparatively less than a Branch office and the assets of the parent company can be attached in case the liabilities of the branch office in India exceeds the value of assets of the parent/foreign company.

In the U.S.A, there is no specific legal registration required to establish a ‘branch’. However, a branch of a foreign company may subject that foreign company to direct legal claims and liability for the acts and business of the branch. For this reason, many foreign investors prefer to do business in the U.S. by forming a corporation to help insulate the foreign company from liability. In addition to the U.S. income tax on the branch earnings, a foreign corporation may also be subject to a branch profits tax with regard to its U.S. branch earnings. The amount of tax imposed (up to a 30% rate) is calculated based on ‘dividend equivalent amounts’ to the foreign corporation, i.e., the amount of any reduction to branch equity in a given year, limited to the branch’s cumulative net earnings. The branch profits tax is a second layer tax that is imposed directly on the foreign corporation and is payable in addition to the foreign corporation’s regular U.S. income tax liability.

Without proper due diligence, if a company chooses an entity, it may stifle rather than encourage its overseas growth. Entering a new market may be exciting for a growing company, but it also means grappling with a whole host of unfamiliar rules and regulations. Choosing a trusted and experienced global corporate compliance partner can allow your company to smoothly navigate a host of compliance issues, provide insights on planning for an international location and help you create and register a legal entity when you’ve chosen the right one for your company.

If you have any questions regarding the incorporation process, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Planning to start a business or expand your operations in the US? Here’s what you should consider.

By Vivek Krisnaswamy, for Legal Corner LLP. Vivek is a final year student of NALSAR University of Law and will be graduating in 2021.

The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you are planning to consider incorporate or expand your existing business in the US so as to get legal advice that is specific to your business needs.

Whether you are looking for investors, trying to expand your operations, or gain credibility, incorporating is an important milestone while building a business. It has commercial, legal, and tax implications, and the process itself can be daunting. Consulting the right people will help you understand what you are getting yourself into and make the right decisions for your business.

If you have an existing company, you need to answer one crucial question before creating another legal entity. What kind of relationship do you want the new and old entities to have? Which one will be the parent entity, or do you wish to start a branch of your existing company? Answering this is a very technical process, considering the legal and accounting ramifications, and is best done with the help of your lawyers and CPAs.

Choosing how to structure your corporate entity is the first step in the incorporation process. Every type of entity has its own implications when it comes to matters like liability, reporting, ownership and taxation.

If you wish to keep things simple, retain shares and control of your company then it makes sense to incorporate as a Sole Proprietorship or a General Partnership. In the US, there is no need for state filing, and liability extends to the personal assets of the business owner(s).

However, there are three other options that are structured in a way to allow for exponential growth of your business and reduce personal liabilities: C Corporation – General Stock (C Corp), S Corporation (S Corp) and Limited Liability Company (LLC). Here are some differences between them.

Restricting foreigners from owning shares eliminates S Corp as an option for businesses that have or could potentially have foreign investors. LLCs are not suitable for those who desire to diversify ownership into stock options or for those who are averse to the risk of a pass-through taxation system. These are just a few considerations that make C-Corps the most popular legal structure for investment- heavy businesses and non-US companies looking to enter the US market¹.

After deciding the form of incorporation, one must decide in which State to incorporate. Every one of the United States has its own specific regimes around tax, reporting, business and legal regulations and procedures. The main things to consider here are where you intend to operate your business, and the corporate law history, on-going reporting requirements, and the levels of tax levied in a State. Often, we find that companies incorporate themselves in the state of Delaware because it has a dedicated court of chancery for resolving corporate disputes, it doesn’t tax income earned from intangible assets and offers quite a bit of flexibility and privacy an organization. However, it is important to carefully consider incorporating here as the regime may not be suitable to all.

Though we’ve just said how each state has its own procedure, you can generally formulate the incorporation process into four steps² –

1. Select or reserve a unique business name that is not already in use
2. File your articles of incorporation with the appropriate authorities and pay requisite fees
3. Establish and maintain a registered agent. A registered agent must be physically residing in the state of incorporation and must have a registered office located in the state of incorporation.
4. Register with the local tax authorities and abide by their requirements

You must apply to obtain a federal Employer Identification Number as soon as you incorporate and then open a business bank account. You have to be careful during the incorporation process, understand how much authorized share capital you should have, how much par value you should designate, if you should have only one class of shares or designate multiple classes of shares (common and preferred stock). Extra steps like this make consulting lawyers essential during the incorporation process. Any slip up while completing these tedious steps could open the doors to fines or other consequences that can have a negative impact on your business.

If you have any questions regarding the incorporation process, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.