Akshaya Kamalnath, Lecturer, Auckland University of Technology
How would you like to hold a small stake in an innovative start-up? With the space industry being opened up to the public sector for instance, once could imagine holding a stake, however small, in a company in that sector. Presumably enthusiasts would want to invest in such a company, not with the hope of profits, but rather, to be part of the story of a company that does something they find interesting. Equity crowdfunding allows the ordinary person to do this. Equity crowdfunding also allows start-ups to find an alternative funding source.
Although the Securities and Exchange Board of India (SEBI) came out with a consultation paper on crowdfunding in India proposed a framework (via a consultation paper) for equity crowdfunding in 2014, there have been no developments in this regard in India. As the consultation paper explains:
In Equity Based Crowdfunding, in consideration of funds solicited from investors, Equity Shares of the Company are issued. It refers to fund raising by a business, particularly early-stage funding, through offering equity interests in the business to investors online. Businesses seeking to raise capital through this mode typically advertise online through a crowdfunding platform website, which serves as an intermediary between investors and the start-up companies. Traditionally, Start-ups are funded through private equity, angel investor or loan arrangements with a financial institution. Any offering of public equity takes place only after the product or business becomes commercially viable. However, in Equity based Crowdfunding solicitation is done at an earlier stage.
The consultation paper then goes on to identify risks and benefits of equity crowdfunding. Amongst benefits, it notes that equity crowdfunding “provides a much needed new mode of financing for start-ups and SME sector and increases flows of credit to SMEs and other users in the real economy”. Another benefit is that “the operators of a crowdfunding platform may engage in vetting or due diligence of projects to be included on their website, to maintain the reputation of the website”. Amongst the risks, it notes that the risk taking by VCF/PE (informed investors) is substituted with retail investors, whose risk tolerance level may be very low.”
Because of the risks, the consultation paper ultimately proposed that only accredited investors would be allowed to invest in equity crowdfunding. This includes high net worth individuals, qualified institutional investors, and eligible retail investors (retail investors who have knowledge, experience or have access to investment advice and have resources to cope with the losses on their investments in a start up, are eligible to invest as ERI in crowdfunding and come within the category of accredited investors). Even an eligible retail investor could not invest more than Rs. 60,000 in an issue. Some disclosure requirements for issuers (companies proposing to issue equity to the ‘crowd’) have also been proposed. Further, some gatekeeping obligations for the crowdfunding platforms have been proposed.
The same set of benefits and risks operate in other jurisdictions and the next section will briefly comment on Australia’s equity crowdfunding regulatory framework which took a more liberal approach than the proposed model in India; but less liberal than the model in some other countries like New Zealand.
Australia (and some features of New Zealand) equity crowd funding models
Australia amended the Corporations Act 2001 2017 to ease the way for businesses to access funding from the ‘crowd’, known as crowd-sourced funding (‘CSF’). Chapter 6D.3A of the amended Corporations Act, known as the Corporations Amendment (Crowd-sourced Funding) Act 2017 (Cth) (‘CSF Act’), recognised CSF platforms as intermediaries between the investors and the business/ entrepreneur intending to raise capital.
In an article published in the Federal Law Review, I and Dr. Nuannuan Lin argue that a light regulatory approach for issuers and investors is required to ensure that crowd-sourced equity funding (CSEF) is attractive enough to both investors and issuers. Our article argues that regulation focused on preventing and detecting fraud is essential for CSF to be successful. The article therefore recommends that caps on the amount each investor can invest are not desirable and, instead, suggests other means of safeguarding against fraud, like the use of whistleblower programs, investor education and reliable dispute resolution mechanisms, in addition to what the legislation provides. The article is focused on the law in Australia and draws from New Zealand’s experience where relevant.
With respect to investor caps, we note that New Zealand is one of the only countries that allows investors the freedom to invest any amount they choose, as long as they sign a document acknowledging the risks associated with CSF. Despite this, the New Zealand regime has been successful. Andrew Schwartz, in his analysis and survey of the New Zealand regime, reported that it has been successful in generating a large amount of start-up capital and also in avoiding fraud. Detailing the successful run of the New Zealand CSF regime in its first year, he wrote that 21 out of the 27 crowdfunding campaigns were successful and that two campaigns reached the legal limit of NZ$2 000 000.88 With respect to the absence of fraud, he wrote that not a single company was revealed to be fraudulent and that only one company had been liquidated in the three years since the CSF regime was introduced. The absence of investor caps has also given rise to an important feature of CSF in New Zealand: syndicates consisting of professional investors followed by a ‘crowd’ of other investors. Professional investors add to the credibility of the offer. There is another very compelling argument against investor caps that has nothing to do with expected returns. It has been argued that CSF carries non-financial benefits like the ‘cultural promise’ of letting customers and audiences connect with content. This is what I described at the start of this post in the example about non-financial motivations for wanting to invest in a start up in the space industry.
We argue that a significant but under-utilised measure that can be considered to protect an investor is educating investors and the general public about CSF. If the logic behind the cap is to protect inexperienced and low cap individuals, as they are less able to understand investment risks as compared to professional and sophisticated investors, educating the general public in this regard is a solution and a less paternalistic one at that. We also note that requiring CSF platforms to have an internal dispute resolution process is an important ex post protection for investors. Further, whistleblower programs will help platforms detect and address fraud early.
Although there have been no developments in terms of enabling regulations to allow equity crowdfunding in India, since the 2014 consultation paper, this issue is likely to be revisited at some point. When it does, India should reconsider some of the proposals in the consultation paper in light of international developments and pertinent arguments.