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 (email@example.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.
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