Regulation proposed for crowdfunding in India

By Ganesh Prasad and Sharad Moudgal, Khaitan & Co
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Crowdfunding is a popular mode for raising funds for startups and entrepreneurs. Simply put, crowdfunding is the solicitation of funds, usually a small amount, from multiple investors through an online platform or through social networking to launch a specific venture or cause. Investors are typically individuals, often forming part of an entrepreneur’s social network.

Risks associated with crowdfunding include: (a) shifting of risk from sophisticated institutional investors to retail investors; (b) lower success rate; (c) genuineness of ventures; and (d) illiquidity, given the absence of a secondary market.

Ganesh Prasad
Ganesh Prasad

Globally, crowdfunding has evolved largely into four models based on end use: (a) donation-based, where funds are invested with no expectation of repayment; (b) reward-based, where funds are invested with the expectation of a reward; (c) peer-to-peer lending, where investors lend funds to entrepreneurs at fixed interest rates through a platform; and (d) equity-based, where investors receive shares for funds invested.

India has no legal framework regulating crowdfunding. A consultation paper on securities-based crowdfunding published by the Securities and Exchange Board of India (SEBI) in June 2014 is the sole indicator of regulatory deliberation on the subject so far. The paper envisages three models for securities-based crowdfunding: equity-based, debt-based and fund-based. The equity and debt-based models permit companies to raise up to ₹100 million (US$1.6 million) through the private placement of equity and debt securities.

Under the equity-based model, no single investor may hold more than 25% of an issuer, and promoters of the issuer are required to hold at least 5% for at least three years. Under the debt-based model, debt securities are to be issued in compliance with the Companies Act, 2013.

The fund-based model permits companies to raise monies from “crowd funds”, a new class of pooling vehicle to be registered under the under the SEBI (Alternative Investment Funds) Regulations, 2012.

In all three models, accredited investors are allowed to make investments through online crowdfunding platforms. Accredited investors comprise: (a) qualified institutional buyers (QIBs); (b) Indian companies with a minimum net worth of ₹200 million; (c) high net worth individuals (HNWIs) with a minimum net worth of ₹20 million; and (d) retail investors with a minimum annual gross income of ₹1 million, reasonable investment knowledge and experience, and access to investment advice.

Sharad Moudgal
Sharad Moudgal

Equity and debt-based models permit private placements of securities on crowdfunding platforms to a maximum of 200 HNWIs and retail investors, and any number of QIBs. The minimum offer value proposed is ₹20,000 per person, provided that retail investors cannot invest more than ₹60,000 in an issue, and a retail investor’s investments through crowdfunding should not exceed 10% of its net worth. QIBs are required to hold a minimum of 5% of any crowdfunded offer. The minimum ticket size is five times the minimum offer value per person for QIBs, four times for companies, three times for HNWIs, and the minimum offer value per person for retail investors.

Under the fund-based model, crowd funds may solicit funds from up to 1,000 accredited investors, with each investor contributing not less than ₹2.5 million. In addition, the crowd fund’s sponsor or manager is required to maintain a continuing interest of at least 2.5% of fund’s corpus in the form of an investment, and not a waiver of management fees.

The equity and debt-based models are intended to benefit early-stage startups, and unlisted small and medium enterprises. Eligible entities may raise up to ₹100 million during a 12-month period through a single crowdfunding platform only, subject to satisfaction of other requirements. There are fewer restrictions in the fund-based model. No issuer can raise funds through crowdfunding without using a recognized platform and getting approval from a screening committee constituted to assess viability of ideas.

Entities eligible to establish crowdfunding platforms have been divided into: (a) class I entities, comprising recognised stock exchanges with nationwide terminals and SEBI-registered depositories; (b) class II entities, comprising self-sufficient government-promoted technology business incubators registered as not-for-profit entities, having a minimum track record of five years and a net worth of at least ₹100 million; and (c) class III entities, comprising registered not-for-profit associations of private equity and angel investors, with at least 100 active members and having a minimum track record of three years.

The SEBI consultation paper is a positive step, and impliedly recognizes crowdfunding as a fund-raising route for Indian entrepreneurs. However, certain conditions seem restrictive and impractical. Crowdfunding aims to connect retail investors with entrepreneurs to encourage growth of ideas with minimal interference. Certain conditions proposed make crowdfunding a sub-set of venture capital, which will hinder entrepreneurs from finding legitimate sources of capital to nurture novel ideas.

Ganesh Prasad is a partner and Sharad Moudgal is a principal associate at Khaitan & Co. The views of the authors are personal, and should not be considered as those of the firm.

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