How to Fund Your Startup With Equity Crowdfunding In India
By: Fatema Diwan
Published On: May 30, 2018
While crowdfunding in India is slowly picking up speed (The industry is currently estimated at 300 crores with a compound annual growth rate of 100% per annum.) the limits on what can be funded with the help of individuals is slowly expanding to encompass education, medical emergencies, art projects, films, student conferences and of course, the infamous potato salad on kickstarter.
But apart from its rampant use for funding social causes and personal shortcomings, the crowdfunding model is being viewed more and more as a democratic shark tank. Young founders with innovative startup ideas are turning to the “crowd” for funding and support.
The Startup Ecosystem in India
If you’ve been living in a metro city (or even close to one), you couldn’t have missed the mushrooming of startups all around you. Chances are, you might already have a techie cousin, who quit his full time job to start something of his own. Indians are brimming with Ideas and with the growth in VC Groups and Incubators, more and more ideas are getting funded to fruition.
Picture Credit: "The Intern"
According to this Nasscom report, India ranks 3rd globally with around 4200 startups in total. In 2016, over 600 startups were funded and the number of active investors grew to 490. The report also showed a 40% increase in the number of incubators across the country.
With the burgeoning of startups, the relevance and probably, the necessity of equity crowdfunding in India is growing. However, under current regulations enforced by SEBI and the MCA (Ministry of Corporate Affairs), equity crowdfunding remains defunct.
Is Equity Crowdfunding Legal in India?
Crowdfunding in India is regulated by SEBI (Securities and Exchange Board of India) which hasn’t yet drafted norms or regulations. It released a consultation paper in 2014 and is still in the process of coming up with regulations to govern the crowdfunding market, which is slowly growing out of its nascent stages to become a major financing alternative.
For the time being, equity crowdfunding through independent platforms in prohibited under various acts that regulate public offers and private investments for companies.
Read the complete analysis of SEBI rules regarding equity based crowdfunding here.
Public offer or Private placement? - The Dilemma with Equity Crowdfunding in India
According to some experts, equity crowdfunding is neither a public offer nor a private placement. Section 42 of the Companies Act, 2013 allows any company to make a private placement offer only up to 50 people at once and only up to 200 people in a financial year. SEBI’s crowdfunding notice rests on the fact that websites allow companies to make private placement offers to more than the approved number of people therefore are in breach of the act. The possible solution would be to restrict the number of investors to 200 in a year on the platform for a company, however, in that case crowdfunding platforms would be restricted from making public offers (since they can’t make an offer to more than 200 people).
In case these platforms are allowed public offer, it will create another conflict with the existing guidelines. SEBI allows equity securities to be listed only on recognised stock exchanges as per section 19 of the Securities Contracts (Regulation) Act, 1956 (SCRA). If equity crowdfunding is to be made legal, SEBI will have to recognise platforms as stock exchanges and come up with separate guidelines for private placements.
This is quite a problem for SEBI and MCA to fix and adds a layer of ambiguity on the functioning of certain quasi-equity crowdfunding platforms in India like Let’s Venture and Catapoolt.
In the light of the above, equity crowdfunding platforms in India have thus turned themselves into a marketplace where investors and startups are brought together but the funding happens offline. This is temporarily making equity crowdfunding possible for startups in India till SEBI reaches a conclusion on specific laws.
How Does Equity Crowdfunding In India Currently Work?
Equity crowdfunding allows anyone to invest a small amount in your venture. You pitch your startup online just like you would pitch it to a VC group and accept investments in smaller denominations (starting from as low as $100) from anyone who is interested. While some platforms verify investors and provide investor profiles, many also allow direct investments from anyone.
In India, equity crowdfunding is done offline. Platforms like Let’s Venture, one of the largest in the space works in the following way:
You create a profile for your startup
Your idea is promoted and investors are “matched” by the platform
You connect and chat with interested investors
The platform helps you close the round with all the paperwork done offline
Equity crowdfunding in India is thus longer and a more tedious process, urging startups to turn to other crowdfunding models instead.
If Not Equity Crowdfunding, Then What? Exploring Other Models
While equity crowdfunding is a coveted method for most startup founders, other types of crowdfunding models - rewards and debt-based specially - have also proven to be successful in funding many ventures. The best way to choose the model that fits you is to understand your strengths and weaknesses and your aim with the fundraising.
Here are some quick pros and cons of each method, that can help you pick the right one for your startup:
Donation based crowdfunding: Enterprises with a social or community impact
This model is the least preferred for startup crowdfunding. Before you opt for it, ask yourself, why would someone donate to my idea? Most contributors invest in startups for some kind of a reward or return. The charity model has only helped those ventures that are inclined towards creating a social or community impact. In this case, the donor knows that his “investment” in your startup with lead to the welfare of individuals or society.
Even then, startups find it difficult to fund themselves through this. Many don’t reach their goal amount and have to keep whatever they get, which might eventually lead to failing of the venture due to the lack in funds. DROR, an app that aims at increasing the safety of women in cities was able to raise some, if not the whole amount, with this model.
No return of investment
Can make use of CSR funds
Great for social or community ventures
Not many takers
Can’t raise large amounts needed for initial stages
Not suitable for all kinds of ventures
Rewards based crowdfunding: Get the ball rolling with presales
Western platforms like Kickstarter and Indiegogo have funded thousands of ventures with this model. (Remember the Pebble Smart Watch?). Rewards based crowdfunding is a more popular method to launch you idea to the market with the help of your direct consumer/ customer. The model works best for product or service based ventures that can raise capital as well as test the market through offering presales.
Products and services are offered as rewards for contributions made to the idea. Basically, your product is first sold and then manufactured instead of the other way round. However, one of the biggest setbacks to this can be the all-or-nothing model most sites follow. You either reach the goal amount or the whole campaign fails and contributions are returned back. This works on the idea that your goal amount is the minimum capital you need to kickstart the idea, thus if you aren’t able to reach it, the venture automatically will face a loss.
Test your product for the market
Get loyal supporters/ customers for your venture
No payback or profit-sharing or any kind
Costs are incurred to market and promote the campaign
All-or-nothing may lead to failure of the venture
Great for initial investment but not sustained growth
Read First Round’s further analysis of rewards and equity crowdfunding for startups here.
Equity Crowdfunding in India for Startups: Advantages and Problems
Equity crowdfunding entails a large number of interested investors on the internet funding your project/company in small amounts in return for some stake/equity in the company. The investors receive returns based on how well the company is doing. The model offers tremendous opportunity to new startups and companies to stand and grow on their own with the help of niche supporters, instead of hunting for angel investments or acquiring loans from financial institutions.
It also involves a lot of risk and while the SEBI crowdfunding guidelines can be debated, here’s a look how equity crowdfunding in India can be both rewarding and problematic.
Easy way to reach a large number of investors: New startup founders usually have a tough time reaching out to investors. Crowdfunding platforms bring in select investors to the right projects to make raising investments easier than it is otherwise.
Minimization of risk: Since a large number of investors invest in small amounts of equity, it minimizes the risk of one single entity owning a large part of the company. (the new SEBI crowdfunding guidelines that are still under contemplation will ensure that no one company or person own more than 25% stake across platforms.)
Testing the idea: Equity crowdfunding platforms let startups compete amongst one another for investor’s attention and money. This is a great way to test the market strength of your idea - and if it is lucrative.
Streamlining the fundraising process: Raising money for your startup can be quite tedious with email strings, keeping track of investors and explaining your growth and idea to each individually, equity crowdfunding brings everything to one platform - where you can simply put everything on one link and track interested investors and investments at one place.
Risks of Equity Crowdfunding in India
All or nothing: The first and perhaps the most obvious risk is the investors, especially those who aren’t seasoned, might end up losing all of the money if the venture fails. Most startups (almost 50% if studies point correctly) fail in the first 5 years.
Susceptible to fraud: Compared to other models of crowdfunding, it is far more vulnerable to fraudulent claims and activities. Even USA and UK haven’t been able to set proper guidelines to minimize fraud. In fact, very recently UK’s top equity crowdfunding platform Crowdcube was under fire for lapses in due diligence that posed a risk to investors.
Limited Capital: Even with the strength of a huge crowd, most equity crowdfunding platforms in the west have a limit to the amount one can raise on the platform. This means, only smaller companies can benefit from this, while the bigger ones that need more capital have to go back to traditional fundraising methods.
Missing out on key expertise: As a new startup founder, interacting with investors one-on-one that have expertise in markets and businesses might be of more value than just raising funds from small inexperienced investors online. As Christian Catalini, assistant professor at MIT Sloan states, “The value you get from interacting with angel investors and VCs is more than anything you could get from a crowd of individuals online.” Additionally, investors that have higher stakes in your company may take more interest in its ongoing and perhaps, even push it in times of need.
What Must be Done with Equity Crowdfunding in India?
Expert opinion online sways both ways regarding allowing the model to function in India. While some believe that crowdfunding will open doors to non-expert investors which will do more harm than good to the startup, others conclude that the model create a “community”to help drive the idea forward.
As Ethan Mollick, professor at Wharton tells Livemint “the unique value of crowdfunding is not money, it is community. Equity crowdfunding is simply harnessing the power of the crowd through a tech (online) platform and soliciting small amounts of funds from multiple investors.”
Many also argue that there are enough incubators and investors to not evoke a need for crowdfunding. However, allowing equity crowdfunding under proper regulations can only benefit by adding more investors into the market and getting more ideas funded with the help of the crowd.
What’s the Verdict on Equity Crowdfunding in India?
Looking at the opportunities in economic growth that such an idea can bring about, SEBI is trying to negotiate with the above problems to come up with guidelines. Experts fear though, that in the absence of proper understanding of the market (crowdfunding itself is in its nascent stage in India) and the high risks involved in the model, SEBI crowdfunding guidelines will be extremely harsh. It is already leaning towards certain regulatory ideas like:
Restricting it to Accredited investors only. Which essentially means companies with a net worth of Rs. 20 crores and high net worth individuals with a net worth of Rs. 2 crores along with some eligible retail investors and qualified institutional buyers.
Capping the crowdfunding amount to Rs. 10 crore. Companies can raise only up to Rs. 10 crore in 12 months including oversubscription which will be restricted to 25% of the intended amount to be fundraised.
Only 200 private investors. Startups can raise funds from a maximum of only 200 individuals (excluding institutional investors)
Screening committee to be set up. SEBI proposed that apart from the general due diligence, platforms should also set up a proper screening committee to assess risks and identify fraud.
Platforms can charge a nominal fee. The proposal has allowed platforms to charge a nominal fee to companies and investors.
It also requires all equity crowdfunding platforms in India to be registered with SEBI along with making sure that no one single entity get more than 25% of a company’s equity (even across platforms).
However, these are only guidelines and proposals, until final regulations are set down and decided upon, startups will have to make do with rewards based crowdfunding in India.