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The regulatory vaccum in equity crowdfunding

A file photo of the Sebi headquarters in Mumbai. The time is probably ripe for a re-look at equity crowdsourcing and how it must be regulated.  (Photo: Mint)Premium
A file photo of the Sebi headquarters in Mumbai. The time is probably ripe for a re-look at equity crowdsourcing and how it must be regulated.  (Photo: Mint)

  • Equity crowdsourcing is in a regulatory vacuum. Legislation could ease fund-raising and aid investor protection
  • Sebi’s concerns aren’t trivial. Industry estimates suggest that 90% of all startups fail. How can the crowdsourcing platforms ensure that the small investor makes an informed decision?

NEW DELHI : A little over a year ago, Nameet Potnis, an entrepreneur, tweeted: “Is someone working on creating a secondary market for startup stocks in India? I looked at building this back in 2011. Thought the time was right back then, think the time is right even now :)"

He ended the tweet with a sort of call to action. “We need a Zerodha for private companies! Same simplicity and ease as public markets." Zerodha is one of India’s biggest stock brokers.

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Spectacular rise

The responses from the Twitterati make for interesting reading. At least six accepted they had already tried building such a product in different forms. Some had questions around regulation. Will this be construed as ‘dabba trading’ (an illegal, parallel stock market with its own rules)?

One user, Nishadh Amonkar, commented: “The real challenge here would be regulation. The tech won’t be very different from say crowdfunding."

The Twitter chat underlines a growing buzz within the startup community. The idea of democratising investment, or having a digital platform where startups can directly raise money from investors at a mass scale and one where investors can explore easy exits, has been doing the rounds.

Angel networks such as Let’s Venture, AngelList, Inflection Point Ventures and JITO Angel Network, among others, are already doing it but they are mostly restricted to high-net worth individuals. What we are talking about here is the idea of equity crowdsourcing platforms where anyone—even the middle class—can invest in an early-stage startup.

The problem, like Amonkar points out, is regulatory. Equity crowdsourcing is unregulated in India. Market regulator Securities and Exchange Board of India’s (Sebi) position towards such crowdfunding has remained ambiguous, lawyers Mint spoke to said.

However, this hasn’t prevented companies from cropping up in this space. The Twitter conversation also underlines that many don’t know of platforms such as GREX Alternative Investments Market (GREX), Tyke Technologies and POD. The three companies already operate a private fundraising marketplace. They do so by abiding by the laws under the Securities Contracts (Regulation) Act, 1956, and the Companies Act, 2013. Section 42 of The Companies Act, 2013, provides for provisions around private placement of equity shares, which online platforms and angel networks follow in issuing shares.

“There is a regulatory lacuna in the equity crowdfunding space in India unlike the US and Australia where they have clear legislation regulating equity crowdfunding," says Anupam Shukla, a partner at law firm Pioneer Legal.

“In India, Sebi came out with a consultation paper in 2014 but thereafter, not a lot of progress has been made. When there is a regulatory ambiguity around something, people generally tend to act as if it is permitted. Therefore, existing platforms are using various ‘jugaad’ solutions to work within the contours of law," he added.

Sebi’s concerns, however, are not trivial. What if the small investor is led into a territory he doesn’t know enough about? Industry estimates suggest that 90% of the startups fail. How can the regulator ensure investors make an informed decision?

“Sebi’s concerns around investor protection are not unfounded. In the past, Sebi has come down strongly on the misuse of collective investment schemes or co-operative societies to collect funds from small investors with promised returns," says Shukla. “Sebi found out that such schemes were often not kosher. Either investors were getting defrauded or money-laundering was sometimes involved. The lack of laws around small ticket investments has often been misused," he adds.

A legislation and clarity from the market regulator could therefore help in balancing investor protection with the ease of equity crowdfunding. It may even boost early-stage investments in India. There’s certainly a need gap.

The need gap

Data available from Tracxn shows there are over 1,000 early-stage startups in India. The average funding increased to nearly $15 million in 2022 from $9.7 million the previous year. Since PE/VC investors prefer investing large chunks of money in exchange of high equity stakes, the funding tap for many early-stage startups largely remain dry.

Even as angel networks such as Let’s Venture and JITO Angel Network have reduced the ticket size for individual investors to a couple of lakhs, such networks operate in a closed environment. And the same set of investors can be registered on multiple platforms.

“The startup space is quite competitive. There have been instances where two investors investing at the same time could be quoted different valuations. This is purely because the startup investment space is not organised. There is no platform in India where you can go and check out the prices of unlisted companies unlike foreign countries where startup shares can be bought and sold through a platform whether secondary or primary," says Pooja Mehta, chief investment officer at JITO Angel Network.

In the US, a crowdfunding intermediary must register with the Securities and Exchange Commission (SEC) as a broker-dealer or as a funding portal. A company can only raise up to $5 million through crowdfunding offerings in a 12-month period. The SEC limits the dollar amount an individual investor can invest across all crowdfunding offerings within 12 months. Besides, securities purchased in a crowdfunding transaction generally cannot be resold for one year.

WeFunder, StartEngine, Republic, Netcapital and MicroVentures are some of the popular US-based equity crowdfunding platforms. Europe too allows crowdfunding where platforms such as Seedrs and Crowdcube are active.

So, how are the current set of Indian platforms navigating the regulatory vacuum? And what do they offer?

No and yes

Manish Kumar, CEO and co-founder, GREX, could visualise an exchange-like private platform for early-stage startups and investors many years ago. He founded GREX in 2014—those were still formative years for the Indian startup ecosystem. Remember, the e-commerce wars were just about starting with Amazon’s entry in 2013.

Kumar’s idea, back then, was to get companies listed on the platform, disclose their financials, get them graded by a rating agency, and facilitate transactions. The company tied up with regulated key intermediaries such as the Central Depository Securities, CARE Ratings and Orbis Financials.

“As we worked towards it, we voluntarily approached the market regulator Sebi for the license. The action backfired as they prohibited us from executing any fundraise on our platform," says Kumar.

GREX, by then, had already onboarded over 500 companies and 800 investors on its platform. It helped three startups raise a total of 45 million in just three months, between November 2015 and January 2016. Document management startup Next Gen Paper Solutions Pvt. Ltd. (Kleeto), its first client, raised 1.5 crore from 14 investors.

Two years later, Sebi rolled back the prohibition.

Little angels

POD and Tyke are relatively new in the business.

Bengaluru-based POD was founded in 2021. It claims to have “democratised" startup investments by reducing the ticket size to as low as 20,000. The maximum limit for non-accredited investors is 2,50,000. And for the accredited investors, the maximum limit is 10% of their net value.

The fund-raise on the platform happens in two ways–direct equity dilution or issuing compulsorily convertible debentures (CCDs). These are bonds that are to be compulsorily converted into equity after a certain time period. It allows investors to earn interest and later take ownership in the company when the bond matures.

Startups can decide as to how many investors they are willing to on-board.

“We are preparing a proof of concept that we are willing to take to Sebi. We will explain as to how we made it happen without breaching any law. A proper regulation for platforms like us will help us move forward and add value to the entire ecosystem," says Kanishk Pratap Singh who works on investor relations at POD.

Tyke, meanwhile, has gone a step ahead and reduced the startup investment size to 5,000 through community stock options (CSOPs). These are similar to employee stock option plans (ESOPs) under which employees can buy shares of the company they work for at a discounted rate. However, unlike ESOPs, CSOPS are not governed by Sebi. They are covered under the Contracts Act and have the same financial rights as equity shares but no voting rights.

“We introduced this concept taking precedence from global markets. CSOPs are a contract which have the same upside and risks that an equity security might have but they are not equity per se. This has helped us reduce the compliance burden because it doesn’t have the restrictions that private placements have," says Karan Mehra, founder, Tyke.

Launched in October 2021, Tyke has helped fund more than 65 companies in a year, crossing gross transaction value of $20 million last month. The average fund-raise through CSOPs stood at 3.75 crore.

TagZ Foods, a Bengaluru-based snacks brand, is one company that issued CSOPs for its consumers in February. The issue got oversubscribed by 756% from 5,000-odd consumers. The funding ranged between 5,000 and 5 lakh.

Protecting investors

Let’s revisit Sebi’s concerns. How can one ensure investors make informed decisions?

As of now, the online platforms are doing their own due diligence. For example, Grex has made a provision for listed startups to mandatorily disclose four metrics on a quarterly basis–revenue, burn rate, earnings before interest, taxes, and amortization (EBITA), and customer traction (number of active/paying customers). Apart from these, companies seeking to raise funds must also share details of the management, board, shareholding, business offerings, key competitors, etc.

POD prefers speaking to the founders in detail to understand if they really have a solid business idea.

Virendra Verma, a portfolio manager with a family office, says he has invested through crowdsourcing platforms. “I have been an investor in early-stage startups for last six years now. I can say that these startups are as serious about disclosures as any other listed company. I have been receiving quarterly updates from the startups since I invested," he says. “The only challenge is lack of a liquid secondary market platform through which I can exit," he adds.

The intermediaries do facilitate secondary market exits but in an offline manner. Currently, there is no regulatory framework to create an online platform where unlisted shares can trade.

Unfinished Work

From an operations and business development perspective, there are other headwinds the sector faces. Lack of awareness and restrictions on advertising make it hard for these platforms to reach out to a larger audience. “One needs to register on our platform as an investor to see all the startups that are listed to raise funds. We cannot talk about it on social media or advertising forums," says Kanishk Pratap Singh of POD.

Another challenge is doing the paperwork—from offer letters to term-sheets—for every single investor. A clear-cut law around the same to ease the onboarding process can help platforms scale up.

A third challenge is scale. The Company Law limits investors in private companies to 200. “Economy of scale doesn’t work. You cannot have 5,000 investors investing 1,000- 2,000 if you stick to limits under the Company Law. The Companies Act also restricts deposits from the public," says Anupam Shukla of Pioneer Legal.

“It is recommended that the Companies (Prospectus and Allotment of Securities) Rules, 2014, be amended to allow private placements offers to 1,000 investors or more for the purpose of crowdfunding. While such a large number of shareholders may increase the transaction costs and cause administrative difficulties for the promoters and the management, such issues can be dealt with by restricting the rights given to shareholders through issuance of shares with differential voting rights," the Vidhi Centre for Legal Policy stated in its responses to the Sebi consultation paper of 2014 mentioned earlier.

The time is probably ripe for a re-look at equity crowdsourcing and how it must be regulated. Opening up the startup ecosystem to the masses will not only give small businesses the much-needed capital to grow but may also boost the economy.

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