Crowdfunding to Finance Your Start Up: Moving Beyond Traditional Venture Capital and Private Equity

Editor’s comment: Oculus VR launched a crowdfunding campaign back in 2012 to develop ‘Oculus Rift’, a state-of-the-art virtual reality headset. Both the campaign and the product were a hit! The company crossed its initial funding goal of $250,000 within 24 hours, raising over $2.4 million by the end of the drive thanks to Kickstarter – a well-known crowdfunding platform. Two years later, Oculus VR was acquired by Facebook for a staggering $2 billion, bringing much joy to its founders, but leaving its initial backers miffed for not realising any tangible financial gain.

 

Crowdfunding is a powerful tool at the hand of entrepreneurs, who are always looking-out for a more ‘democratised’ form of venture funding. Regulators however stand wary and press for higher controls, especially in a nascent start-up ecosystem like India. Their hesitation is visible in an ambiguous set of rules, which in turn suppresses financial innovation and makes business look at it as a non-actionable option.

 

Equity Crowdfunding

 

Crowdfunding is an alternative for entrepreneurs, artists, filmmakers etc. to fund their ventures directly from the public. An online platform like Kickstarter acts as an intermediary and sources small financial contributions from a sizeable number of people. This “crowdsourcing” ensures a significant funding requirement can be fulfilled by bypassing traditional financing routes e.g. venture capital funds etc.

 

The “crowd” becomes the real asset.
Crowdfunding to Finance Your Start Up: Moving Beyond Traditional Venture Capital and Private Equity

While Oculus VR is often cited as the posterchild for this model, the company used Reward Crowdfunding i.e. where participants (or investors) are compensated in kind, through goodies like T-shirts, mugs, posters, pre-order rights etc, in exchange for the amount they raise. When Facebook acquired Oculus, early investors, not acknowledging this obvious condition, felt cheated that the transaction could not benefit them financially. They perhaps mistook their investment as Equity Crowdfunding, where participants can gain share ownership in lieu of their participation.

 

Incidentally it is Equity Crowdfunding, which in spite bringing a real expectation of returns, is where the Indian regulator is the most conservative.

 

Equity Crowdfunding does come with its own set of risks. It allows the public to participate unsupervised in a high risk low liquidity asset class – traditionally the turf of venture capital and private equity funds. There is not much recourse in cases of fraud or default. Moreover, with funding platforms being vulnerable to cyberattacks, and an absence of sophisticated market makers like investment banks, there is always a chance of mis-selling and information asymmetry.

 

There are major plusses as well. Equity Crowdfunding acts as a new investment avenue for start-ups/SMEs and retail investors hungry for yield. It unlocks pools of household capital, usually tied to fixed deposits and savings accounts. It unburdens start-ups from tedious due diligence requirements they generally face while dealing with VCs. Lower diligence translates to a lower cost of capital.

 

Current Regulations 

 

Fund raising via equity issuances is regulated by Companies Act, 2013 and SEBI guidelines in India. While Reward and Donor Crowdfunding (with its philanthropic roots) have some legal basis, a regulatory framework around Equity Crowdfunding is missing.

 

Platforms instead rely on present Private Placement rules to execute a quasi-model. These rules force companies to approach not more than 200 investors in a financial year, with a single offer not allowed to exceed beyond 50 people. Also, no issuer executing a Private Placement can release a public advertisement. It is obvious the Private Placement rules suppresses the basic philosophy driving Equity Crowdfunding i.e. the more investors, the merrier.

 

Though SEBI is cognisant of these challenges, its 2014 consultation paper was no less restrictive. Permitting only ‘accredited investors’ or ‘qualified institutional buyers’ (i.e. excluding retail) to participate, along with strict contribution and investor number caps, the regulator has made it clear that Equity Crowdfunding is nowhere close to becoming a mainstream funding option in India. A 2016 notice explicitly declaring 20 crowdfunding platforms as ‘illegal’ has not helped.
Crowdfunding to Finance Your Start Up: Moving Beyond Traditional Venture Capital and Private Equity

International precedents should be examined e.g. the United States created an exemption to US securities law for crowdfunding in 2012. It permitted the sale of securities through crowdfunding via the Jumpstart Our Business Start-ups Act, abbreviated as the JOBS Act. It has significantly reduced disclosure, registration and procedural requirements and has set an upper limit of $1 million within a period of 12 months. Australia and Singapore have also carved out similar exemptions.

 

A regulatory sandbox may be considered to create a ‘safe space’ for Equity Crowdfunding. Without seeing this model in action, it will be imprudent to implement straight-jacket rules.

 

Indian start-ups are dependent on foreign capital. Almost 90% of funds flowing in Indian VC and PE are of a foreign origin. Equity Crowdfunding can be a way to unlock domestic capital and ensure Entrepreneurs have access to more diverse funding options.

 

The regulator should move beyond repetitive consultations and blanket bans, and instead see the model in action under controlled conditions. Investors should be protected by gaining experience and including safeguards, instead of point blank paternalism.

 

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