Crowdfunding in India: A Beginner’s Guide for Startups
After the global financial crisis of 2008, which was largely a result of bursting of housing bubble in the US, banks globally started transitioning to implementation of Basel III capital adequacy norms (For Indian banks the deadline to meet Basel-III norms has been extended till March 31, 2019).
Basel III norms mandate a bank to maintain certain capital reserves in order to reduce the risk of the bank failing in the event of a widespread defaults by the borrowers of the bank. It aims to make individual banks resilient to system-wide shocks and reduce the risk of the bank going bankrupt.
- Also Read : Do’s And Don’ts of Crowdfunding Your Startup
- Also Read : 19 Ways To Fund Your Startup In India
With the implementation of Basel III, it became mandatory for banks to maintain a certain minimum credit profile for its borrowers. It thus became difficult for the banks to lend funds to startups or small ventures due to the high risk of default associated with them.
Crowdfunding platforms offered themselves to fill up the vacuum created by the banks in the funding space. Small businesses, looking for funds, could now pitch their business idea to everyone connected with the internet, around the globe. Moreover, it could be done with practically no paperwork and much less effort (as compared to a bank loan or listing on a stock exchange).
Crowdfunding is the concept of funding a venture, project or a startup by way of raising money from a large number of people generally through an online platform. Crowdfunding platforms can be used to raise equity, debt, donations or for providing rewards in return for funding.
These platforms can broadly be divided into four categories. Let’s briefly understand each one of them.
Types of Crowdfunding
Reward Based Crowdfunding –
Here the backers or investors of a project receive tangible items or service in return of their investment into the venture. This could either be a T-shirt, a product manufactured by the company in which you have invested (say a phone). 5 free car washes (if it’s a car washing company that you are backing or the first edition of the book (if you are backing a writer to get her book published). It is not necessary that the reward you receive is something that the company, in which you are investing in, manufactures, creates or deals in.
Equity Based Crowdfunding –
In this type of crowdfunding, you receive a share of the company in proportion to the money that you have invested. Every country has separate regulations specifying whether a company can raise money from general public through a crowdfunding platform. It is like investing in an unlisted entity and hence very important that the investor understands the risk while committing investment in equity based crowdfunding. If the company performs well, the investor makes money on investment. But if it fail, the entire money is lost. According to industry experts, 9 out of 10 startups fail to earn revenue. Such crowdfunding in India needs to comply with private placement guidelines in accordance with the Companies Act, 2013. This is explained later in the article.
Debt based Crowdfunding –
As the name suggests the contribution made by the investors is treated as a loan or debt. The money invested earns a fixed interest and the company is liable to repay the amount invested after a fixed period.
Donation based Crowdfunding –
This type of crowdfunding is generally, but not always, raised for charitable projects and humanitarian causes. It provides an opportunity to an individual to share money for causes and projects that they feel strongly about, thus giving them a chance to create an impact. A large number of contributors are asked to donate a small amount. In return, the contributors may receive a token gift.
Crowdfunding Scenario in India
While donation-based and rewards-based crowdfunding do not pose any risk of loss of investment (as there is no financial incentive involved), the equity and debt based crowdfunding pose risk of loss of capital as they promise financial incentive once the startup’s P&L turns green.
Governments around the world need to make sure that crowdfunding should not result in substitution of institutional risk (risk taken by financial institutions in the form of loans etc.) by retail risk (investments done by retail investors).
Securities and Exchange Board of India (SEBI) had come up with a consultation paper in 2014. It has been proposed in the paper, that for equity-based and debt-based crowdfunding, only Accredited Investors be allowed to participate in crowdfunding.
While the definition of Accredited Investors has been quite broad (it includes QIBs, HNI and even retail investors who have been filing tax return for last 3 years), SEBI has purposely kept the lower income groups out of the purview of crowdfunding. Since these type of investors may not have sound financial advice available and may not fully understand the risk of investing in a startup, SEBI has excluded them from crowdfunding.
SEBI has outlined certain guidelines for startups willing to raise funds in India through crowdfunding via the equity crowdfunding and debt crowdfunding mode.
(1) The company should be an unlisted entity incorporated in India and should not raise more than Rs. 10 crores through crowd funding. Companies looking to raise than Rs. 10 crores, should raise funds through stock exchanges.
(2) Further, the company raising funds through a crowdfunding platform shall not approach more than 200 investors in a financial year. This is line with the Companies Act, 2013 which stipulates that a private unlisted entity (a private limited company) cannot have more than 200 shareholders at any given point in time. This limit excludes Qualified Institutional Buyers (QIBs) such as banks, mutual funds and other financial institutions and the employees of the company which receive shares under the Employee Stock Option scheme (ESOPs).
(3) The company also cannot publicly advertise that it is raising money through any channel, including social media.
(4) Investors participating in equity crowdfunding shall have rights of an equity shareholder as specified in the Companies Act. Similarly, participants of debt based crowdfunding shall have rights of a debenture holder.
Crowdfunding has definitely offered itself as a credible and exciting alternative to traditional means of financing. Every technological advancement poses challenges for the policymakers. From internet to mobile telephony, policies have been drafted and re-drafted to accommodate the breakthroughs of technology. It remains to be seen how the stakeholders work together to create an win-win situation for startups, investors and the economy.