Understanding Equity Crowd-funding

Crowd-funding can be loosely defined as the means by which an entrepreneur or a business

solicits funds of a relatively small amount from a large pool of small and unsophisticated
individual investors through the medium of the internet. In essence, equity crowd-funding
represents a retail version of private-equity investors where investors are allotted equity
shares for the money which they have invested in the start-up companies via an online
intermediary.

As such, it can play a crucial role in the economy of our country. It is well-known that there
are some uncertainties intrinsic in an investment. Financiers have to bear some risk. When the
risk involved is substantial and concentrated, it becomes difficult to find people willing to
bear it. As the financiers risk losing his money owing to uncertainty, they try to reduce
uncertainty by requiring collateral. However, with little or no collateral, most of the start-ups
struggle real hard to get access to finance. In present Indian context with the Indian economy
sitting on a pile of bad loans worth close to 150 billion dollars, the traditional methods of
debt-financing are virtually impossible for the start-ups. Besides, given the great uncertainty
surrounding the start-ups, even the venture-capitalists (VCs) and private-equity investors are
reluctant to invest in the early stage start-ups. These investors are quite selective in nature as
they tend to fund companies with proven track record and which provides clearer exit options
for them. Last but not the least, the eligibility requirements for raising money through Initial
Public Offering (IPO) is too high and most of the early-stage start-ups won’t be able to fulfil
such requirements.

In this backdrop, equity crowd-funding seeks to solve the problem by spreading risk widely
over a large number of investors. The large number of investors with little contribution
towards start-ups can prove to be really valuable for the start-ups with viable business plans
by providing them the much-needed access to finance. The collective “wisdom of the crowd”
enables start-ups to test their ideas with the market by inviting potential customers to
participate in the financial future of such ideas. From a macro-level perspective, such easier
access to finance for the start-ups stimulates economic growth and creation by facilitating
cash-flow. It would also lead to job-creation as burgeoning number of start-ups require
greater number of human resources to sustain their businesses. Thus, the equity crowd-
funding reflects a revolutionary improvement in the ability of entrepreneurs to obtain access
to finance.

Tensions with the Existing Regulatory Regime

However, there is an obvious conflict between equity crowd-funding and Indian securities
regulation. The current state of regulatory regime makes it very difficult for equity crowd-
funding in India. In fact, the trajectory of regulatory developments has driven it towards
tighter control and restrictions on the offer of shares by the companies.

Under the new Companies Act, 2013, a new provision was inserted to deal with the situations
which were created by scams like Sahara and Sharadha. Under Section 42 of the Companies
Act, 2013, any offer to 50 or more persons in each financial year (or such higher number as
may be prescribed by the Central Government) would be considered as a public offer
triggering all the requirements which you need when you issue securities to the public.( The
government increased that number to 200 persons later by virtue of the power conferred to it
under the Companies Act.1) A public offering of shares involves the appointment of one or
more merchant bankers, a registrar to the issue, filing of a draft offer document with SEBI,
eligibility requirements such as previous track record, minimum promoter’s contribution,
lock-in requirements, requirement to have a monitoring agency etc., apart from detailed
disclosure requirements.

Even though, small businesses and start-ups can offer their shares to 200 individuals but this
limitation still significantly affects the ability of such enterprises to raise money. It is
particularly so when private placement prohibits advertisement on a public platform. 2
Therefore, the small enterprises would not be able to raise small amounts of money from the
large number of investors, an aspect which is inherent to the idea of crowd-funding. What
Section 42 allows the companies to do is to seek larger amounts from few investors which are
conducive for non-crowd-funding options such as venture capital and angel investments.

In such a scenario, equity crowd-funding seems to be impermissible and cannot be done

unless the existing laws are changed to suit the functioning of equity crowd-funding
platforms. As we discussed, the regulatory regime seems to be more inclined to protect the
interests of the investors thereby putting in tighter controls over offer of securities by the
companies. However, in its zeal to protect the interests of the investors, it seems to forget the
1
See Rule 14(2)(b) of Companies Rule, 2014.
2
See Section 42(8) of Companies Act, 2013.
crucial role played by the innovative start-ups in the economy of a country and their need to
obtain access to finance.