A Guide to Simple Agreements for Future Equity (SAFEs)

By Shreya Kalidindi, for Legal Corner LLP. Shreya 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 seeking advice on structuring SAFEs or other investment agreements tailored to your business needs. 

What are SAFEs?

A Simple Agreement for Future Equity (SAFE) agreement is one made between a company (generally in its seed financing round) and an investor wherein the company agrees to provide an investor with potential future equity in return for immediate cash. They have been introduced by American startup accelerator Y Combinator in 2013 and have since gained popularity among both founders and investors, mostly owing to their simplicity.

How do SAFEs convert?

The future equity – or the SAFE – eventually converts to equity during a subsequent round of financing, provided that a particular trigger event (previously agreed upon and outlined in the SAFE Agreement) takes place. Trigger events can include subsequent rounds of equity financing, the sale of a majority of the company’s shares, or the acquisition of the company. The size of equity investment is not material.

Following the trigger event, the investor has a choice between receiving the investment amount back or converting it into shares in the company. The number of shares receivable upon such conversion depends on where the share price stands during either the priced equity round or the trigger event (as applicable). Prior to the SAFE maturing in this manner, it is treated like any other convertible security (for instance, options or warrants).

How do SAFEs differ from Convertible Notes?

The primary difference between the two is that Convertible Notes have a maturity date, upon which the amount given by the investor is either converted into equity at a predetermined rate or is returned. Furthermore, investments under Convertible Notes are considered to be loans, and involve more negotiation than SAFEs, seeing as the notes convert after a specific period, and can accrue interest during this period.

What makes SAFEs a distinctive form of raising funds?

Maturity – SAFEs do not have an expiry date. They remain valid and continue to exist in the issued state until a trigger/ liquidation event occurs, upon which they convert into shares.

Interest – A SAFE is not a debt instrument, and thus a SAFE investment does not accrue interest, regardless of how long it takes for it to convert into shares.

Deferred Valuation – Similar to other forms of convertible debt, there is no requirement for the company and its investors to agree upon a valuation price at the time of entering into the SAFE Agreement. This can be ascertained at a later date and is usually done when the company has more revenue.

Why are startups opting for SAFEs?

In the previous year, the number of SAFEs and other similar notes (such as the Keep It Simple Securities, also known as KISS) that have been used by pre-funding companies was 58%, thus making them equally prevalent as convertible notes. This is largely owing to the fact that they are seen as a simple and risk-free method of raising money.

SAFEs terms are not standardized to a large extent, and thus can be negotiated – often to the benefit of the startup. These include terms relating to conversion, dissolution and repurchase rights. Furthermore, seeing as SAFEs only conditionally convert into shares on a later date, voting rights are not immediately given to the investors. This enables many startups to retain a larger degree of control during their initial stages and inculcate practices that help materialize their vision.

Apart from the benefits of flexibility and control, SAFEs are also preferred because their implementation involves a lesser degree of paperwork and legal costs.

Important terms to be established in a SAFE agreement  

Valuation Cap – this is the maximum valuation at which a SAFE can convert to equity upon maturing. For instance, if the valuation cap is $6 Million and the company raises money at a valuation of $10 Million, then the investor is entitled to convert their SAFE at a share price equivalent to the former amount.

Discount – this is the valuation discount given to a SAFE investor and is relative to the investors in the subsequent financing round. These discounts range between 10% to 30%, and are usually implemented to entice early investors. For instance, a SAFE is issued with a 20% discount, and the investor puts in $60,000. If the future investment is $15, the price per share after discount will be $12. Thus owing to the discount, the investor ends up with 5,000 shares instead of 4,000 shares.

A SAFE can come with either of these provisions, both of them, or a Most Favored Nation (MFN) clause instead of the discount or valuation cap.

Risks associated with issuing SAFEs

While SAFEs offer benefits such as expediency and simplicity, using them as financing options can also be one of the reasons for the failure of an issuing company. One of the largest issues that SAFEs can create for a company is unintended dilution of ownership. Seeing as SAFE dilution is not reflected in the capitalization table till the point of maturity, many issuers may lose sight of how much dilution they are taking on. If due consideration is not taken, issuing SAFEs in such a manner may even lead to a loss of control in the company.

Even before future equity rounds, another risk posed by SAFEs is improper valuation. Often, the valuation cap is seen as the actual valuation of the company, which in turn makes any price below this cap an undesirable ‘down round’ in subsequent priced financing rounds.

Additionally, while one of the advantages of issuing SAFEs is their flexibility, this also allows for the insertion of one-sided and onerous clauses (such as guaranteed board seats) being put in favor of the investor. Such terms make it difficult for investors in future equity rounds to provide funds for the company, seeing as more than the expected degree of company control has been relinquished.

However, these inherent risks can be combatted through measures such as creation of dynamic capitalization tables to track SAFE dilution, putting a hold on company valuation during the SAFE stage, and ensuring that the non-standard terms of a SAFE Agreement are well balanced and negotiated.

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

Equalisation Levy: Extra Territoriality an obstacle

By Akash Kumar Prasad, 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. 

The Finance Act 2020 was passed on March 27, 2020 and created a lot of confusion as it amended the position of Equalisation Levy (EL), a type of digital service tax (DST). The Equalisation Levy was first introduced pursuant to the Finance Act, 2016 wherein a non-resident service provider, providing service to the resident are required to withhold at the rate of 6% of the gross amount of fee payable by the resident in lieu of such service. After the amendment of Equalisation Levy, the legal position related to it has changed drastically. Post amendment, the non-residential e-commerce operators are required to withhold at the rate of 2% of the gross amount received/receivable in lieu of the e-commerce supply and service. The Act has extra-territorial application as it attempts to tax the income earned from the advertisements (directed at Indian customers), or even accessed through Indian IP addresses and income earned from the sales of goods and services to anyone using any Indian IP address. Furthermore, EL has now been made applicable on both supplies of goods and services and on both B2B and B2C transactions. This article engages with the extra-territorial aspect of EL and aims to highlight both the practical and technical issues that arise/are being faced due to its implementation in its present state in India.

Technical difficulties that arise with the imposition of EL in its current state 

The first technical issue is the absence of a global tax collection system. In the context of a fragile global economy, the requirement of the same becomes necessary because any unilateral actions by different nations have the potential to impair the investments and economic growth on a global level. The Organisation for Economic Co-operation and Development (OECD) an intergovernmental economic organisation which deliberates the policies on digital taxation is still in the process of developing a common system and arriving at a consensus on taxable nexus and allocation of taxing rights.

Another issue is that the OECD has recommended the idea of ‘Significant Economic Presence’ (SEP) to be the basis of taxable nexus. Hence, it is highly possible that, a company’s permanent establishment, which is a taxable presence of the company outside its state of residence, may be in one country and the SEP in another country. Now, this is problematic because this gives rise to the issue of double taxation and hence defeats the purpose of Double Tax Avoidance Agreements (DTAAs) which aims to avoid international double taxation. The Akhilesh Ranjan Committee had also observed this as an inherent limitation of EL.

Furthermore, another technical concern is the lack of explanation to the technical terms such as ‘systematic, continuous soliciting’, and ‘users’ as mentioned in the explanation 2A (b) to S.9 of the amended Act. For instance, there is not much statutory guidance as to who would qualify as an Indian IP address user. It is not clear whether the threshold is merely visiting a website via an Indian IP address or that of browsing through links therein. Such lack of interpretation could be highly chaotic and lead to confusion among the litigators and the taxpayers alike.

 Practical difficulties that arise with the imposition of EL in its current state

The first practical concern is that the States normally charge taxes from non-resident entities that have no physical presence in their own territory, by taxing the domestic source of their revenue. The same had been followed until the scope was widened. The concern now is that the present EL regime aims to charge under S. 165A of Finance Act, 2016 directly and it is still not clear how the Indian government aims to achieve the same. There are high costs involved in tracking and storing the location of all the users and it is unlikely that the foreign businesses would want to incur such costs. Thus, it becomes difficult for such businesses to assess and pay the taxes owed.

Another issue is the absence of compliance and penalising mechanism in the event of non-payment of EL, by a non-resident entity. Although the Act provides for the attraction on unpaid taxes, penalisation and prosecution for non-compliance, such provisions aren’t enough to deter foreign businesses which have no tangible assets in India. Furthermore, there is an issue relating to the ‘revenue rule’ (general principle of international taxation) which states that the courts of a country can refuse enforcement of foreign revenue or tax laws. Thus, if any foreign country is unsatisfied with EL’s applicability on their domestic businesses, it may refuse EL’s enforcement on their resident businesses. It is highly possible that the foreign countries might raise an issue due to the above-mentioned concerns. For instance, the United States Trade Representatives raised an issue recently saying India’s DST (Digital Service Tax, referred as Equalisation Levy in India) is discriminatory, unreasonable, and burdens or restricts US commerce, and thus, is actionable under Section 301 (of Trade Act, 1974). The investigation, initiated by the USTR on June 2 last year, said that this tax explicitly exempts Indian companies and only ‘non-residents’ must pay the tax.

Conclusion

The objective and intention behind the expansion of the scope of EL is appreciative and it might have appeared to be effective to address the challenges of permanent establishment principle, but has surely caused confusion and significant predicaments as explained above. It seems that there was no proper deliberation and discussion before amending the position and hence the inevitable result is an adverse effect on free flow cross border transaction and India’s reputation as business-friendly jurisdiction. It is clear that the Indian government is aiming to further its revenue from all ways possible as it too has faced a heavy blow due to pandemic, but at the same time, there is an urgent requirement of issuing clarifications and supplementary rules to remove the surrounding ambiguity on the implementation of EL.

Equalisation Levy in India: The issues and the silence continues

By Akash Kumar Prasad, 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. 

Equalisation Levy was introduced in India in 2016, with the goal of taxing the digital transactions i.e. the income accruing to foreign e-commerce companies from India. Digitalization is one of the most important developments since the Industrial Revolution, which has virtually changed the way in which businesses are carried out, across the globe. Some studies have assessed that the worldwide digital economy was worth $11.5 trillion in 2016 (Digital economy report–Value creation and capture: implications for developing countries) and for India, it was assessed to be $200 billion annually (Report of ministry of electronics and information technology-India’s Trillion Dollar Digital Opportunity, February 2019). However, it has been observed that taxation laws which are based on the conventional business models have been battling to keep pace with these changes. This has brought about many transactions completely getting away from the tax net. Hence, the need was felt to address the challenges presented by the digital economy.

A joint effort to address the requirement for tax reform is being taken by OECD/ G-20 since 2015-2016 under the “Inclusive Framework on BEPS”. Base Erosion and Profit Shifting (“BEPS”), as defined by the OECD, refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity or to erode tax bases through deductible payments such as interest or royalties.

While the OECD is working towards creating consensus on an inclusive framework to address tax challenges from digitalization of the economy, several countries have introduced unilateral measures to tax the digital economy. In 2016, India introduced an Equalization Levy on revenue earned by non-residents from online advertising and related services. In 2019, the Indian Income tax law was amended to introduce the idea of ‘significant economic presence’. However, while passing the Finance Act 2020, the Indian government deferred its implementation, citing the absence of effective measures in the tax treaties. What came as astonishment to everyone was the introduction of an Equalisation Levy on sales of goods and services in India by overseas e-commerce operators, which was originally not part of the original Union Budget proposals of 2020-21. This levy has been effective from April 1, 2020 and in its current form, has wide-ranging coverage.

The Issues Involved

This levy was added as a last-minute amendment to the Finance Act day before the entire nation went into the first phase of lockdown in March. However, due to the rush in this decision-making, the provision enabling the levy was ambiguously worded and could cover several transactions which may be unintended. Moreover, it also covers transactions between two non-resident companies in case of sale of advertisement concerning Indian citizens or sale of data collected from Indian residents or if the IP address is located in India. The process transactions tracking on the basis of IP addresses may not be a viable option. With the use of bypass tools such as VPN, proxy sites etc, accurately tracking the transactions might prove to be a difficult task for the entities.

A study conducted by The Dialogue, a Delhi based think-tank proposes to rather look at the billing address or sales location to determine the residents. Moreover, the provision additionally doesn’t clear the tax base for the levy. It is unclear whether the tax has to be paid on the gross amount of the product or the commission received by the e-commerce entities.

There are also other issues such as the impact of this levy on inter-group or inter-company transactions and its interplay with the Digital Services Tax (DST) levied in other countries, which might lead to double taxation. However, due to the lack of clarifications, these issues still remain unaddressed.

Further, (Online Information Database Access and Retrieval Services) OIDAR tax and equalisation levy will create extra burden for the companies who may pass on these tax to the end consumers. Despite the fact that the levy targets non-resident companies, transferring of such cost to the Indian companies who utilize international platforms for their operations may come as an added burden to the Indian startups.

Conclusion

It is important that India maintains an investment friendly climate and such unilateral actions might impact it. Taxation of the digital economy is a sensitive and complicated matter. With multiple jurisdictions involved including India, there is a need for a multilateral consensus rather than a unilateral action and definitely not a rushed through levy such as the present one. There is an urgent requirement for issuing clarifications on the present levy in order to avoid taxing unintended business and narrow its scope.If you have any questions, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.

Union Budget 2021-22 – Impact on the Corporate Law

By Akash Kumar Prasad, 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. 

On 1 February 2021, the Hon’ble Finance Minister presented the Union Budget 2021-22. While the Union Budget for the FY 2021-2022 was focused on infrastructure development, it also brought in several significant changes in the area of corporate laws. Changes have been proposed to decriminalize the LLP Act, 2008, increase in the threshold of the definition for small companies, introduction of an updated version of the MCA, changes in the OPC framework, increase in the FDI limits in an insurance company, etc.

Change in definition of ‘small company’

Section 2(85) of the CA, 2013 defines the term ‘small company’ as any company other than public company having paid up share capital not exceeding fifty lakh rupees and turnover not exceeding two crore rupees. It has been proposed in the Budget, to revise the definition of Small Companies by increasing the thresholds for paid up share capital from “not exceeding fifty lakhs rupees” to “not exceeding two crore rupees” and turnover from “not exceeding two crore” to “not exceeding twenty crore rupees”. The increase in thresholds will bring more than 2 lakh additional companies under the definition of ‘small company’ which can have a lower compliance burden including lower penalties for violations and lower filing requirements. Therefore, this proposal can surely be seen as an important drive for ease of doing business.

Changes to One Person (OPC) Company Network

Rule 6(1) of the Companies (Incorporation) Rules, 2014 provides for mandatory conversion of OPC into a Public Company or a Private Company as where the paid up share capital of an One Person Company exceeds fifty lakh rupees or its average annual turnover during the relevant period exceeds two crore rupees, it shall cease to be entitled to continue as a One Person Company. Now, by the Union Budget, Government has removed the limit of paid up share capital and turnover for conversion of OPC which is mostly done by the start-ups. Another important change for OPC has been proposed by relaxing the eligibility of person for such company. The criterion of 182 days has been reduced to 120 days to allow Non-Resident Indians to operate OPCs in India. These amendments with respect to OPC will give relief to these companies as the threshold limit of paid up share capital and turnover burdened the companies with the burden of conversion. Furthermore, it has also been proposed to allow Non-Resident Indians to operate OPCs in India and also some tax Incentives for start-up and Innovators like claiming tax holiday till March 31, 2022 has been proposed.

Decriminalization of offences under Limited Liability Act, 2008 (LLP Act)

Considering the fact that the Government has completed taking its steps for decriminalization of offences by amending the Companies Act, 2013, Finance Minister in her speech mentioned that it is now the time for decriminalization of the offences under the LLP Act. Having said that, it is important to note that the Government has already started taking tangible steps for giving effect to this proposal. The Company Law Committee (CLC) has presented/issued its Report of the Company Law Committee on Decriminalization of the Limited Liability Partnership Act, 2008 to the Ministry of Corporate Affairs on 4th January, 2021 for decriminalization of certain compoundable offences and shifting them to the In-house Adjudication Mechanism. The said Report proposes to decriminalize 12 offences and 1 penal provision has been proposed to be omitted. The motive behind the same is to de-clog the courts or the NCLTs thereby reducing their burden from non-serious matters. Further, the Report not only contains changes in the LLP Act for decriminalization of offences but also travels much beyond. Some of the other major changes in this regard consists of introduction of explicit provisions for issuance of secured NCDs by LLPs, restricting the merger of LLPs with companies, introduction of accounting standards for certain classes of LLPs, etc. Besides this, the Report also introduces changes in the definition of business of LLPS, alignment of the reference with that of the Companies Act, 2013 (CA, 2013) and much more.

Increased FDI in insurance companies

The main proposal for insurance companies in the Budget is to increase the permissible FDI limits such companies from the current 49% to 74%. Further, the said increased limit has been proposed with several safeguards with respect to ownership and control which includes: majority of Directors on the Board and Key Managerial Persons (KMP) to be resident of India; independent directors- at least 50% of the directors to be independent directors; and specified percentage of profits being retained as general reserve. Further, it is also imperative to mention about the IRDA (Indian Owned and Controlled Guidelines) which currently provides a limit of 49% of foreign shareholding in an Indian insurance company. Considering the aforesaid proposal, the said limit will be changed to reflect the increased limit.

Strengthening of NCLT framework

It has been proposed to strengthen the NCLT framework to ensure faster resolution of cases. In light of the new normal and increased emphasis on Digital India, e-Courts have been proposed to be implemented. Further, with a similar intent and to further provide an alternate mode of debt resolution, a separate framework is also proposed for the cases involving the MSMEs.

Securities Market Code

The Budget has proposed to consolidate the provisions of following laws relating to securities market into a rationalized single Code to be termed as “Securities Market Code”: SEBI Act 1992, Depositories Act 1996, Securities Contracts (Regulation) Act 1956, and Government Securities Act 2007.

Conclusion

Small company status offers relaxation from various provisions of CA 2013 and eases compliance burden on them. As mentioned in the budget speech, the increase in the threshold limit for a small company is likely to benefit 200,000 companies. Changes to the OPC regulatory framework offers motivation to grow without any restriction of paid-up capital and turnover, augmenting foreign capital and technology. Recognition of Start-up Company as a class of company for the purpose of fast track merger allows start-up option to explore restructuring without necessarily going to the National Company Law Tribunal (NCLT) for sanction. Overall, the thrust of budget on company matters aims at facilitating ease of doing business.

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

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.

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