How about crowdfunding for start-ups?

The Indian start-up story received a lot of attention last year when global investors, flush with funds, bet big on fledgling Indian companies. Number of deals as well as deal value was the highest ever in the third quarter of 2021 and a string of consumer-facing start-ups made bombastic debuts on Indian stock market.

But if you thought that this was the best of times for all Indian start-ups. you would be mistaken. For, out of 61,400 start-ups launched till January 2022, only around 7 per cent have been able to raise funds from PE or VC investors. The remaining 56,000 start-ups are still out there looking for ways to raise funds.

The saga of the companies which have managed too raise money from PE and VC investors is not too upbeat either. With these investment funds suffering large losses in the tech-stock meltdown on Nasdaq and other stock exchanges over the last six months, and money becoming scarcer due to monetary tightening by global central banks, they have become far more tight-fisted with their existing investments; requiring the funded start-ups to reduce expenses and improve margins. Deal value as well as number of deals have been declining in 2022.

In other words, not only do the non-funded start-ups require channels for raising funds, but funded start-ups may also be looking for means to reduce their reliance on the venture capital and private equity investors.

The aam janata can help here and the way to tap this segment is through crowdfunding. Start-ups in countries such as UK, US, Japan and France are already using crowdfunding to raise resources. The Indian regulator is going slow as of now due to the multiple challenges in this route. But it would be good to address these issues to open this channel soon.

Why crowdfunding?

Numbers reveal that wealth and savings of Indian households increased during the pandemic. Over the last two years, poured copious amount of money into stocks, mutual funds, cryptocurrencies et al. It may be a good idea to allow retail investors with the wherewithal to take high risk, a foothold in the start-up ecosystem as well; through the crowdfunding channel. Not only will this allow small investors to benefit from the vibrant start-up ecosystem, it will also provide a more sustainable source of funds for the upcoming companies.

Crowdfunding, as the name suggests, asks the crowd to give funds for specific projects, businesses, social ventures etc. Small amounts of funds can be raised from a large number of investors by launching fund-raising campaigns, which are accompanied by strong advertising, and run for specified periods. These fund-raising projects are executed through crowdfunding platforms, social media etc.

In community crowdfunding, funds are raised for a social or charitable causes and money given here is akin to donations with no expectation of return. Some community crowdfunding platforms give rewards or gifts to donors.

But participants in financial returns crowdfunding platforms expect to earn returns for the funds given. These platforms could be either peer to peer lending platforms or equity crowdfunding platforms.

In India, community crowdfunding platforms are legal and allowed to function. Of the two types of financial returns crowdfunding, the RBI regulates peer to peer lending activities. But SEBI is yet to frame regulations for equity crowdfunding which can be used by early-stage start-ups to source funds.

The regulatory quandary

SEBI had floated a consultation paper on equity crowdfunding in 2014, but not much progress has been made after that. This could be due to the myraid challenges in opening this route.

The biggest regulatory challenge is investor protection. The risk taken by angel, PE and VC investors will be transferred to retail investors, who may not be sophisticated enough to evaluate the business or the risk involved. There will also be no recourse to investors if the company defaults or does a vanishing act.

Two, there is a risk of the platforms being misused by fraudsters to dupe investors in to putting money in to dubious projects. With the fund-raising campaign being run on social media and internet, money can be raised from overseas as well. This can lead to violation of FEMA and money laundering.

The shares issued may be illiquid with no secondary market available for trading in them.

The Companies Act, 2013 which lays down rules for public and private placements of equity shares and the Securities Contracts (Regulation) Act need to be modified to permit businesses to issue equity through these platforms.

Crowdfunding platform in SEs

While the challenges seem to be many, they may not be unsurmountable. Investors face equally high risk in understanding and evaluating main-board and SME IPOs; yet there are many takers for those. Similarly, risk of companies defrauding investors exist in regular as well as SME segment of the stock market too. Retail investors wanting to participate in early stage start-ups should therefore be allowed to do so.

The JOBS Act (Jumpstart Our Business Startups Act, 2012) of US and regulations for equity crowdfunding framed by other regulators can give some guidance on the manner in which the rules for this segment can be framed.

In the Indian context, QIBs, companies, high networth individuals and eligible retail investors (ERI) can be allowed to invest in crowdfunding issuances.

Minimum annual income of ERIs could be ₹25 lakh and they should have filed tax returns for at least two years. There should be limit of ₹1 lakh for investment in each crowdfunding campaign. The retail investors should not be allowed to invest more than 5 per cent of their networth in such issues. It will be the job of the platforms to screen the investors and ensure that the investors meet this criteria.

The size of each crowdfunding campaign should be limited to ₹10 crore and the issuing company should file all related information regarding the management, business and financials along with past legal record with SEBI. This will go a long way towards increasing the credibility of these issuances.

Financial statements of the issuer should be disclosed on the company website every six months and SEBI should also lay down the networth and other criteria for entities eligible to launch equity crowdfunding platforms.

The BSE and NSE do have a dedicated platform for start-ups — the Institutional Trading Platform. But they only help investors of already funded start-ups sell their stake. Activity is pretty somnolent here.

One way to kickstart start-up funding through retail investors is by allowing stock exchanges to have a platform dedicated to equity crowdfunding where the campaigns can be run. The exchange can oversee these campaigns and also whet the eligible investors.

The stocks issued through these campaigns can be listed and traded on the ITP platform. Not only will this provide liquidity to investors in crowdfunding campaigns, the ITP platform can also become an active hub for start-up investing.

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