This post has been written by Tanmayi Sharma, who joins The Boardroom Lawyer Team as an Associate Editor. Tanmayi is a fourth-year student at the Jindal Global Law School, the Convenor of their Moot Court Society and the recipient of the Shallu Jindal Outstanding Women Scholarship.
Crowdfunding is the new go-to strategy for different startups and organizations to raise money. While the idea is not novel in India, the legal grounds surrounding crowdfunding in India are still murky. This blog post seeks to examine the recent SEBI regulations regarding crowdfunding, as well as whether these regulations achieve the economic objectives that crowdfunding could produce.
What is Crowdfunding?
The SEBI Consultancy paper on crowdfunding defines Crowdfunding as the “solicitation of funds, [in small amounts], from multiple investors through a web-based platform or site for a specific project, business venture or social cause”. The type of crowdfunding varies depending on the products, or services offered and the goals of the particular project. Donation-based crowdfunding is where the investors contribute to a particular cause with no promise of returns. Rewards-based crowdfunding involves raising funds where rewards based on the particular project are awarded to investors, in exchange for donations. These rewards may or may not be substantial. Equity-based crowdfunding is vastly different from donation-based and rewards-based crowdfunding. In the foremost, contributors become part-owners of the company, receiving equity shares in exchange for their contributions. As part-owners, they become entitled to a return on the investment, as well as a share of the profits. Funds from this form of crowdfunding are generally raised on platforms that charge a commission of 7 to 12% for funds raised.
Legal Regulations regarding Crowdfunding
The avenues for crowdfunding in India are growing exponentially, which raises questions about the legality of crowdfunding in India. Under the Companies Act, companies are prohibited from issuing shares to more than two hundred potential investors, without making a public offer. A public offer necessarily requires several expensive compliance procedures and detailed disclosure requirements, which is usually impossible for a start-up. Thus, we see that the Indian company law severely limits the scope of equity crowd-funding. However, SEBI has gone one step further.
The Securities and Exchange Board of India (hereinafter ‘SEBI’) has issued certain regulations in the hopes of protecting investors, and minimizing the risks associated with crowdfunding while simultaneously lowering the cost of capital and increase the liquidity of money. To that end SEBI has made equity-based crowdfunding illegal, while donation-based and rewards-based crowdfunding remain legal. This is because SEBI wanted to balance the risks of crowdfunding with the benefits of crowdfunding. One of the main risks that SEBI has to tackle is that of money laundering. As in the Sahara case where there were a thousands of ghost investors under the guise of crowdfunding, there exists a potential for abuse of equity-based crowdfunding, as opposed to the other two methods. In an effort to counter this threat, the regulations hold that only funds of accredited investors registered with a SEBI-recognized platform could be used for crowdfunding. There are also regulations imposing a minimum amount to be solicited from each investor, and a limit to the number of investors from whom funds can be solicited. Another relevant factor, is that there exists no system of accountability or recourse for the investors. Investors would be left helpless if the platform were to shut down, temporarily or permanently, or if the project owner were to act fraudulently. In addition, SEBI was cognizant of the fact that considering that the platforms were based online, the digital market would be susceptible to security threats. The regulations were made to protect the public, including the information of the investors involved.
Economic incentives and Crowdfunding
In their effort to settle this so-called ‘unauthorized, unregulated and illegal’ threat, SEBI may be limiting the effects of crowdfunding altogether. By limiting the right to invest to accredited investors, SEBI may be protecting against the laundering of black money, but it is making it difficult for project-developers to crowdsource funds. By essentially adding another layer of bureaucracy, investors are dissuaded from registering with crowdfunding platforms. Casual investors, especially those that want to donate nominal amounts for causes or community projects that they want to support will avoid doing so because of the effort involved. It is antithetical to the ease-in-investing that crowdfunding is usually associated with. In fact, crowdfunding can act as a boost to investment, which will be explored below.
Crowdfunding can incentivize consumers to invest, as it allows them unprecedented influence. As the risk is shared between multiple different investors, there is less pressure on any one investor, making it more likely for consumers to invest. In addition, returns from investment in start-ups over a long-term period ranging from five to eight years are far higher than returns from any other kind of investment, prompting consumers to prefer crowdfunding startups over any other form of investment. It also allows investors to diversify their portfolios, providing greater security. The increase in incentive to invest would increase the velocity of money within the economy.
With crowdfunding, investment is no longer limited to stock brokers, financial managers and professional investors, but made open and easy to consumers as well. With the ever-increasing access to internet in India, as well as the easy-to-use model of crowdfunding platforms such as Kickstarter or Indiegogo, Consumers find it far easier to invest in projects than ever before. Operators of crowdfunding platforms may undergo vetting procedures to prevent fraud on the part of the project-developers, in order to protect their own reputation. Thus, such ‘reliable’ platforms may encourage investment from consumers. Crowdfunding essentially cuts out the middleman such as banks and financial capitalists making it easier for consumers to invest. Crowdfunding operates in a space, which is traditionally dominated by few investors who provide funds that are demanded by many. It makes it easier for consumers to invest, thereby making it easier for project-developers to access funds. Project-developers no longer have to rely on angel investors or venture capitalists. They are able to raise funds at lower cost of capital, without undergoing many of the difficulties associated with investment. As entrepreneurs now have a lesser overhead cost, it can lead to greater devotion of funds towards production and productivity.
Crowdfunding truly harnesses the power of the community. It allows many believers and supporters to come together around a project that they truly believe in, contributing what they can. Investors who believe in community projects can invest in them for the betterment of their neighborhood or locality. Crowdfunding in support of social causes or research projects, that usually make use of donation-based crowdfunding can work towards increasing social well-being, as well as social and natural capital. Thus, crowdfunding can work towards increasing investment, production, the velocity of money, as well as the well-being of society.
It is important not to overstate how crowdfunding can act as a boost to investment. Although the internet has now reached 34.8% of the population, a large portion of this population is still mistrustful of the internet preferring options like Cash-on-delivery to other methods of e-commerce. This would mean that Indians who do not trust online transactions through credit or debit cards would be reluctant to invest even nominal amounts, making crowdfunding entirely futile. With the high possibility of fraud, conservative investors would prefer to trust financial managers, paying them a commission to investigate projects before making an investment. As, investors would have no recourse if a business or crowdfunding website were to close abruptly. Shares or equity in crowdfunded companies are illiquid as they cannot be traded, and leave no exit option for investors. This would make any investors hesitant about investing.
Ambiguity in the Law
While examining the different benefits and risks of crowdfunding, the SEBI guidelines failed to consider some aspects. One of the major aspects was globalization and cross-border crowdfunding. Crowdfunding provides an online platform which ensures that projects receive investment not only from investors in India, but from investors across the globe. In addition, Indian investors could invest in projects in different parts of the world. This could lead to an unprecedented boost to globalization and cross-border investment. However, while the SEBI consultancy paper lists out various regulations in different jurisdictions across the world, it fails to clarify how these regulations would interact with one another.
The SEBI guidelines also fail to make any note of the Tax implications of crowdfunding. While seeking to regulate crowdfunding, the SEBI has failed to clarify whether taxes raised through crowdfunding will be subject to the current tax provisions for unlisted companies. Funds received through crowdfunding are already subject to commission from the sites, therefore, the question remains whether taxes would adversely affect the entire concept of crowdfunding. As the supply of funds for investment in crowdfunding is largely elastic, entrepreneurs will suffer the burden of high taxes, resulting in decreased overall productivity.
The internet with its rapid pace, is always forcing the law to catch-up. Just as intellectual property law grew more sophisticated to deal with platforms such as MySpace or Youtube, Corporate law must grow more sophisticated to deal with crowdfunding over the internet. Equity-based crowdfunding is still a developing concept in India. Even though certain regulations have been made, it is clear that these regulations are stringent and cautious. There are many aspects of crowdfunding that SEBI has failed to consider, and have thereby restricted the potential of investment through crowdfunding. The current law is not aligned with the economic incentives. As contributors on crowdfunding portals usually invest very small amounts, they do not warrant scrutiny. Indian law must go beyond simply characterizing equity-crowdfunding as “illegal” and set up exemptions for the existing law on equity-crowdfunding. There is a need to allow startups and small initiatives to access capital markets for additional sources of funding, while still protecting investors. India must include specific sophisticated exceptions to the current ban on equity-crowdfunding.