WHAT IS CROWD FUNDING AND HOW DOES IT WORK?
Doing business heavily relies on the availability of funds, raising capital is one of the toughest challenges which every business faces during its initial phase. Crowdfunding is when a “crowd” funds a project or a business, rather than one or two major investors. Journal of business venturing, 2004 defines crowd funding as an open call. Essentially through the internet for the provision of financial resources either in the form of donations or in exchange for some reward and/or voting rights in order to support initiatives for specific purposes.
It funds ventures, majorly through online mediums, without the need for traditional financial intermediaries. It is highly advantageous for those entrepreneurs that have appealing ideas but no track record. There are three parties involved in this-
A. The project initiator who proposes the idea
B. Individuals who support the idea
C. A platform that brings both the parties together to launch the idea
It provides proof for validity of an idea, is more efficient and less time consuming. The sole purpose however, is not always funding. It can vary from one investor to another. Sometimes, it is also used by founders to showcase the demand for their proposed products, which further leads to funding from traditional sources. The landmark case of Sahara V. SEBI demonstrates that fundraising environment is inadequate and is not aligned to crowd funding objectives. This also clearly reflects that balanced crowdfunding regulation usually lowers the cost of capital and ensures adequate investor protection and minimizes investment risks.
TYPES OF CROWD FUNDING
1. Donation Based Crowd Funding- It involves giving out funds as a philanthropic purpose wherein, the individual giving capital to the startup companies do not expect repayment in any firm. It is also called patronage funding.
2. Reward Based Crowd Funding- The investors make the investments but they always get something in return for their investment. This can be either in the form of existing product or exclusive services.
3. Debt Based Crowd Funding- This type of crowd funding must be repaid to the investor. The investors, or crowd loan capital to a business in exchange for repayment plus interest over time. It is different from the traditional method of applying to a bank for a loan as in this case the funds are contributed by multiple investors.
4. Equity Based Crowd Funding- It simply involves providing the investors equity shares in a company in exchange for their contributions. An equity share is a part ownership in the company. The biggest advantage of possessing equity shares is voting rights since the operations of the company will have a direct impact on the returns the equity share holders gain from the company. SEBI has declared equity-based crowd funding in India as “unauthorized, unregulated and illegal”.
EVOLVING COMPANIES THAT USE CROWD FUNDING
A. GoFundMe- This platform is welcoming towards individuals and supports personal causes. Campaigns are held to fund life events like medicine treatment, sports and education. Unlike other platforms, this platform doesn’t have the independent community but the campaigns held on it can be easily shared, which makes up for the lack of community. Anyone seeking to raise money through this site can start a campaign advertise it, and collect the donations. You can keep any and all of the donations that you received, subject to the website’s 5% fees. Unlike other websites, you do not have to reach a certain goal before getting funded.
B. Kick Starter- It is heavily focused on catering to creative projects like art, music, film, technology etc. If you don’t reach your funding goal within the timeline, no funds are given that were promised to your project. This approach is called an all or nothing funding. Kick Starter justifies this by arguing that a minimum requirement creates less risk for both entrepreneurs as well as investors and motivates all parties to achieve their goals.
C. Indigogo- On this site, all kinds of projects are accepted for fund raising. This diverse consumer base is a huge advantage for this site. This website offers both fixed and flexible funding options. This gives fund raisers more flexibility in choosing the way they want to raise money.
CROWDFUNDING UNDER INDIAN LAW
On a policy level, crowdfunding is allowed in India. The provisions for raising funds by companies are regulated under the Companies Act, 2013 and Securities Act i.e., SEBI Act, 1992, Securities Contract Act, Depositories Act. The major task is to allow crowdfunding within the existing company law framework. The easy way out is allowing crowdfunding only for public companies. However, it is not a sustainable solution as young start-ups will be discouraged from registering themselves due to the higher compliance requirements imposed on public companies. To evade the higher compliance requirements, private companies come into the picture. However, the Companies Act does not permit invitation to the public to subscribe for any shares or adventures of the company. As per Section 67(3) of the Act, a public offer is any offer to fifty persons or more.
Either a new proviso needs to be incorporated for startups in the Companies Act, or they need to be exempted from any sanctions when they indulge in crowdfunding. Only then can the Companies Act be truly equipped to deal with crowdfunding.
SEBI has introduced reforms with the aim to recognize startups’ potential in boosting the economy. Its reforms are aimed at improving access to funds for small to medium enterprises (SMEs). In order to regulate “angel funds”, SEBI also amended the SEBI (Alternative Investment Funds) Regulations 2012.
PROPOSAL FOR CROWDFUNDING IN INDIA
Being in the era of a knowledge economy with rapid advancement in technology, accessing information via social networking sites is much easier now. Entrepreneurs must make use of this information at their disposal while being conscious of the risks involved. In order to seek funding, there should be a viable model instead of future estimates of profit or loss margins. This decreases the risk of failure and thus, the loss to the investors. There should not be many entry barriers for the investors or regulatory burdens on them. Crowdfunding will have to build an offline base to spread mass awareness and encourage more participation.
The present SEBI regulation is narrower in the sense that it puts a cap on the category and number of investors, taking away the essence of “crowd” in crowdfunding. It has imposed strict requirements that a public company has to follow. Finally, for entrepreneurs who seek crowdfunding, there are some clear lessons. First, project quality is important, and
entrepreneurs should look for ways to address how prepared they are in the market. Social network ties have also been found to be important in crowdfunding. Most importantly, careful planning is required both to set these goals and to prepare for a crowdfunding success, which will ensure that the promised venture is implemented.
Ms. Kashish Shah and Navya Bassi
M/s Aura & Co.