RESEARCH PAPER

CAPITAL MARKET ELECTIVE

“Regulating Equity Crowdfunding in India”

NALSAR UNIVERSITY OF LAW, HYDERABAD

Submitted to:

Mr. Sudhanshu Kumar

Submitted by:

Mayank Labh

IVth Year, VIIth Semester,

B.A. LL.B. (Hons.)

2014- 5LLB-26
 TABLE OF CONTENTS
Introduction................................................................................................................................3

Understanding Crowd-funding...................................................................................................3

Virtues of Equity Crowd-funding..........................................................................................4

Dark-side of Equity Crowd-funding......................................................................................5

Tensions with the Existing Regulatory Regime.........................................................................8

Analysis of SEBI Consultancy Paper and Policy Recommendations......................................10

Eligibility Norms for Investors............................................................................................10

Problems in having minimum offer limit.............................................................................12

Maximum number of retail investors...................................................................................12

Private Companies not allowed to seek funding..................................................................13

Stringent disclosure requirements........................................................................................13

Conclusion................................................................................................................................15
Introduction
Recently in 2016, an investor-interest warning was issued by Securities and Exchange Board
of India (SEBI) which1 questioned the very legality of equity crowd-funding in India. In one
sweep, it has termed more than half-a-dozen digital equity crowd-funding platforms like
GREX, Equity Cres, Tracxn and LetsVenture illegal, unauthorised and unregulated.2

The said notification assumes great relevance for the economy of India as it directly questions
the ability of the burgeoning number of start-ups and small and medium enterprises (SMEs)
to raise money from the public via digital platform. It is pertinent to note that start-up
companies face a great degree of financial constraint as they rarely have access to finance
from private equity investors, venture capitalist investors or other conventional forms of
financing.3 It is particularly the situation in such sectors where there is a great risk of failure.4

In this context, it is pertinent to analyse the role of equity crowd-funding as an early-stage

financing alternative in India and whether it is actually as harmful as SEBI notification seems
to make it to be. The first part of the article after introducing the concept of crowd-funding
will analyse the benefits and risks of the equity crowd-funding in the country. It then analyse
the tensions with the present regulatory regime to see how enabling the present regulatory
regime is for small start-ups and SMEs to obtain access to finance. Finally, the article
proposes some changes in the regulatory regime to enable the functioning of equity crowd-
funding which balances the interests of all the stakeholders in the country.

Understanding Crowd-funding
Crowd-funding can be loosely defined as the means by which an entrepreneur or a business
solicits funds of a relatively small amount from a large pool of small and unsophisticated
individual investors through the medium of the internet. 5 Unlike other forms of online fund-
raising, it is a many-to-one relationship which entails exchanges between various lenders and

1
Shailesh Menon, Crowd Control: SEBI warning turns off crowdfundingtap for start-ups, (Sept. 11, 2017),
http://economictimes.indiatimes.com/small-biz/money/crowd-control-sebi-warning-turns-off crowdfunding-
tap-for-startups/articleshow/54202702.cms.
2
Id.
3
Arjya B. Majumdar and Umakanth Varottil, Regulating Equity Platform In India, (Sept.11, 2017),
http://ssrn.com/abstract=2804427.
4
Id.
5
Jitendra Soni and Kanad Bagchi, Crowdfunding in India: A Tale of Misplaced Regulations, (Sept. 2, 2017),
http://www.epw.in/journal/2014/48/commentary/crowdfundingindia.html?0=ip_login_no_cache
%3Dcbd8404e360ec9d34bfd6ced8cb7f93c.
a recipient.6 It leverages the huge connecting power of the Internet by enabling entrepreneurs
of all sorts to raise money by pitching ideas to a vast online horde of potential funders.7

There are different types of crowd-funding but it can be broadly divided into two categories:
i) Patronage Crowd-funding and ii) Investment Crowd-funding.8 First, under the patronage
crowd-funding, business ideas are funded by the financial contributors without an expectation
of monetary returns. At best, the lenders get some small thank-you gifts from the promoters
of the start-up companies who are receiving the funds. 9 Second, under the investment crowd-
funding, business ideas are funded either in the form of loan against interest or for an equity
stake in the business (equity crowd-funding).10 It is the equity crowd-funding which the
article would be focussing upon for it generally involves investment in a company triggering
the securities regulation which is a primary focus of the course Capital Markets.

Virtues of Equity Crowd-funding

In essence, equity crowd-funding represents a retail version of private-equity investors where

investors are allotted equity shares for the money which they have invested in the start-up
companies via an online intermediary. 11 As such, it can play a crucial role in the economy of
our country. It is well-known that there are some uncertainties intrinsic in an investment.
Financiers have to bear some risk. When the risk involved is substantial and concentrated, it
becomes difficult to find people willing to bear it.12 As the financiers risk losing his money
owing to uncertainty, they try to reduce uncertainty by requiring collateral. However, with
little or no collateral, most of the start-ups struggle real hard to get access to finance. 13 In
present Indian context with the Indian economy sitting on a pile of bad loans worth close to
150 billion dollars, the traditional methods of debt-financing are virtually impossible for the
start-ups.14 Besides, given the great uncertainty surrounding the start-ups, even the venture-
capitalists (VCs) and private-equity investors are reluctant to invest in the early stage start-

6
Id.
7
Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and US Securities Regulation,
13 THE TENNESSEE JOURNAL OF BUSINESS LAW 66 (2014).
8
Supra, note 3.
9
Fulfill Your Dreams Through Crowdfunding, MY INTERNET BUSINESS REVIEW (Sept. 24,
2017),http://myinternetbusinessreview.org/55/fulfill-your-dreams-through-crowdfunding.
10
Supra, note 3.
11
Supra, note 5.
12
RAGHURAM RAJAN, Introduction in SAVING CAPITALISM FROM THE CAPITALIST, 27 (Collins Business, 2003).
13
Id.
14
Promit Mukherjee and Devdutta Tripathy, The debt threat lurking behind India’s zombie power plant, (Sept. 8,
2017),http://www.livemint.com/Industry/8RRbnHNYLHiD5RrytxBVxM/The-debt-threat-lurking-behind-
Indias-zombie-power-plants.html.
ups. These investors are quite selective in nature as they tend to fund companies with proven
track record and which provides clearer exit options for them. 15 Last but not the least, the
eligibility requirements for raising money through Initial Public Offering (IPO) is too high
and most of the early-stage start-ups won’t be able to fulfil such requirements.16

In this backdrop, equity crowd-funding seeks to solve the problem by spreading risk widely
over a large number of investors. The large number of investors with little contribution
towards start-ups can prove to be really valuable for the start-ups with viable business plans
by providing them the much-needed access to finance.17 The collective “wisdom of the
crowd” enables start-ups to test their ideas with the market by inviting potential customers to
participate in the financial future of such ideas.18 From a macro-level perspective, such easier
access to finance for the start-ups stimulates economic growth and creation by facilitating
cash-flow. It would also lead to job-creation as burgeoning number of start-ups require
greater number of human resources to sustain their businesses.19

It also democratizes the process of investment in as much as it allows the crowd to invest in
the valuable economic activities being undertaken in an economy. 20 Earlier, such a privilege
was limited to the wealthy and sophisticated investors (accredited investors). But equity
crowd-funding as a financial innovation has expanded the community of investors to a
greater number of people who can contribute and participate in the growth and creation of
new innovative ideas.

Thus, the equity crowd-funding reflects a revolutionary improvement in the ability of

entrepreneurs to obtain access to finance. It hints at a world where a person’s ability to create
wealth is determined by the quality and viability of his/her ideas rather than the size of bank-
balance!

Dark-side of Equity Crowd-funding

15
Steven C. Bradford, Crowdfunding and the Federal Securities Laws”, 1 Colum. Bus. L. Rev. 5 (2012).
16
Swetha Chandrashekhar, Equity-based Crowdfunding as an Early-Stage Financing Alternative: Critique of
the Regulatory Proposals in India (8th Sept., 2017), http://indiacorplaw.blogspot.sg/2016/03/equity-based-
crowdfunding-as-early.html.
17
Darian Ibrahim, Equity Crowdfunding: A Market for Lemons?, 100 Minnesota Law Review 571 (2015).
18
P.M. Vasudev and Susan Watson, Regulating Equity Crowdfunding in India in GLOBAL CAPITAL MARKETS:
A SURVEY OF LEGAL AND REGULATORY TRENDS 177 (EDWARD ELGAR PUBLISHING, 2017).
19
Swetha Chandrashekhar, Equity-based Crowdfunding as an Early-Stage Financing Alternative: Critique of
the Regulatory Proposals in India (8th Sept., 2017), http://indiacorplaw.blogspot.sg/2016/03/equity-based-
crowdfunding-as-early.html.
20
Arjya B. Majumdar and Umakanth Varottil, Regulating Equity Platform In India, (Sept.11, 2017),
http://ssrn.com/abstract=2804427.
So far, virtues of equity crowd-funding have been chanted. Is there no downside to the
development of equity crowd-funding platform? What about scams like Saradha wherein
billions of dollars were raised from more than one million which eventually turned out to be a
ponzy scheme?21 What’s the guarantee that such scams will not happen in the case of equity
crowd-funding? For, just like Saradha, the people from whom the funds are raised are
gullible, unsophisticated investors.22 Information asymmetry and lack of transparency further
increases the likelihood of outright fraud on the part of start-up companies. To substantiate,
start-ups companies and their promoters will be privy to substantial information with respect
to the situations and conditions of their business that is not accessible to the investors.
Investors do not have the independent means to get the information but to rely on the
representations which is made by the start-up companies. In such a situation, it is possible
that the start-ups would conceal some information which they believe would be disfavoured
by the investors.23

Also, with such information asymmetry, it is hard for an investor to tell the honest from the
dishonest. Even if there is a default, it is not easy to separate bad luck from crookery. Since
the dishonest are hard to identify and punish, investors with limited information has to resort
to demanding higher returns from their investment. Honest companies who intend to provide
returns and dividends to the investors are very sensitive to the demand of higher returns
considering their financial constraints themselves. They expect to bear the full burden of
providing the investors with the highest returns as it was agreed. The higher the demands of
the investors are, the more honest fund-raisers will drop out of the pool of applicants,
realizing that the credit is not worth the high repayments which are to be done in terms of
dividends. By contrast, start-ups who have no intention of paying the dividends will apply for
fund-raising and remain in the pool of applicants, no matter how high unreasonable the
demands for dividends are. In short, the higher the demands of dividends, the more the pool
of applicants will be “adversely selected” to be primarily bad fund-raisers.24 But the higher
the concentration of bad borrowers, the higher the demands of dividends an investor would

21
Mukul Aggarwal, Deepak Jodhani and Simone Reis, Supreme Court to Sahara: It’s not Private, (6th Sept.
2017),http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-
view/article/supreme-court-to-sahara-its-not-private.html.
22
Romita Dutta, Saradha raised deposits from 1.7 million, probe finds (Sept.15, 2017),
http://www.livemint.com/Specials/TQWJ1auPZMCYnZqC4tK7VN/Saradha-raised-deposits-from-17-million-
people-probe-finds.html.
23
Ajay Agrawal, Some Simple Economics of Crowdfunding. National Bureau of Economic Research Working
Paper 19133, (Sept. 22, 2017), http://www.nber.org/papers/w19133.pdf.
24
Darian Ibrahim, Equity Crowdfunding: A Market for Lemons?, 100 Minnesota Law Review 571 (2015).
ask to break even, in light of the higher expected rate of default. This is vicious cycle.
Clearly, such information asymmetries make investors choose lemons over peaches. 25

Even though when the start-ups do not have improper motives, the money of investors can
still be at risk. First of all, there is an inherent risk of failure when it comes to start-up
companies.26 It has been observed by one of the research studies that more than 50 percent of
the start-ups fail during their first five years of operation only. 27 When the businesses fail, it
leaves all the investors in the lurch. Furthermore, the illiquid nature of the investment adds to
the woes of the investors. Investors would not have the option to sell their shares to other
investors if they want to exit from the business. It is because there is no secondary market
like stock-market which exists wherein you can trade your stocks with other investors. The
investors will be largely stuck with their investments in the start-ups and would not be able to
recoup their investments. 28

Finally, as the people who are investing in the market are quite dispersed and diverse in
nature it would be difficult for them to co-ordinate amongst themselves. Such inability would
affect them in monitoring the functioning of the start-up companies in which they are
investing. So, there is a problem of agency between the promoters and shareholders which is
instrumental for better corporate governance.29

Clearly, there are risks. But fortunately, none of these looming problems is without
resolution. There is a way out of these problems and that’s where the role of the government
comes in. What is needed is sufficient regulatory safeguard, a sophisticated web of checks
and balances, which balances the interests of the investor with the economic interests of the
start-ups and small and medium enterprises to obtain access to finance. However, before we
delve into what ideally the regulatory regime should be, it is important to analyse how crowd-
funding could function under existing regulatory regime.

25
The Lemon Dilemma, (Sept. 23, 2017), http://www.economist.com/node/813705.
26
Arjya B. Majumdar and Umakanth Varottil, Regulating Equity Platform In India, (Sept.11, 2017),
http://ssrn.com/abstract=2804427.
27
Kirby, Eleanor and Shane Worner, Crowd-funding: An Infant Industry Growing Fast, (Sept. 8, 2017).
http://www.iosco.org/research/pdf/swp/Crowd-funding-An-Infant-Industry-Growing-Fast.pdf.
28
Hu Ying. Regulation of Equity Crowdfunding in Singapore. SINGAPORE JOURNAL OF LEGAL STUDIES, 46
(2015).
29
Andrew Schwartz, The Digital Shareholder, 100 Minnesota Law Review, 609 (2015).
Tensions with the Existing Regulatory Regime
There is an obvious conflict between equity crowd-funding and Indian securities regulation.
The current state of regulatory regime makes it very difficult for equity crowd-funding in
India. In fact, the trajectory of regulatory developments has driven it towards tighter control
and restrictions on the offer of shares by the companies. It is clear that the emphasis and
focus is on protecting the interests of the investors as opposed to providing a conducive
environment for businesses to grow particularly in the context of crowd-funding platforms. 30
To substantiate my point, I would explain the major legal development with respect to the
Indian Securities Regulation.

First of all, an offer of securities is governed by the Companies Act as well as regulations
issued by SEBI under SEBI Act, 1992. Under the old Companies Act, 1956, a company could
make an offer of securities to the public only when it is doing it by way of prospectus and
when it intends to list its securities on the stock-exchange. There are complex set of
requirements attendant to the offer of securities to the public such as extensive public offering
process. It was lengthy, cumbersome and prohibitively expensive process which many of the
small companies could not afford to do so. However, if the companies issue securities by way
of private placements under the old law then it did not have to comply with the burdensome
requirements as it is required under the public offer of securities. But under private
placement, you could issue the securities to the specific persons and the number should not
exceed by 49. If it does then it would be deemed to be public offer. So, under the old
Companies Act, the equity crowd-funding in its usual form is impermissible if they are not
complying with the public offer requirements.

It was hoped that the new Companies Act, 2013 could bring some respite for the growth of
alternative investment funds by making the regime more liberal keeping in mind the interests
of the small businesses. However, while the new Companies Act, 2013 was in the process of
being drafted, India was hit by several financial scandals which involve issue of illegal
securities to the public. The broader impact of these scams has been on the regulatory regime
of our country in as much as such scams intrinsically shaped the reform process with respect
to the securities regulation.31

30
Arjya B. Majumdar and Umakanth Varottil, Regulating Equity Platform In India, (Sept.11, 2017),
http://ssrn.com/abstract=2804427.
31
Id.
One of the noteworthy scam was that of Sahara scam. It so happened was that the two
unlisted public companies, SIRECL and SHCL, raised more than 24,000 crores from more
than three crore investors by way of distributing information memoranda. 32 Such a huge
raising of fund was possible thanks to the intricate network of Sahara group of its associated
companies, employees and other related individuals. However, it did not comply with the
disclosure requirements which are required under the Companies Act when securities are
issued to the public. In a long drawn battle with SEBI which culminated into a decision by
the Supreme Court, it was categorically held that an offer to more than 50 persons would
constitute a public issue triggering disclosure and other attendant requirements.33

While the Sahara scam was taking up the minds of the regulators and the judiciary, India was
hit by another scam called Saradha scam in which the group received deposits from more
than 1.7 million people and flee away with all the monies. Besides, there were other scams of
similar nature which captured the attention of our regulators and judiciary. 34 The response of
public institutions has been reactionary in nature, responding to imminent threats and
concerns. Such reactionary behaviour often tends to ignore the bigger picture and same
happened in the case when the regulators had to respond to the concerns raised by illegal
fundraising by various companies. The unfortunate effect of the response towards scams like
Sahara and Sharada is that even the equity crowd-funding by honest and genuine small
entrepreneurs have been meted the same treatment as the unscrupulous companies who raise
money through illegal means.

To be more specific, these scams played a crucial role in the enactment of new Companies
Act, 2013. Under the new Companies Act, 2013, a new provision was inserted to deal with
the situations which were created by scams like Sahara and Sharadha. Under Section 42 of
the Companies Act, 2013, any offer to 50 or more persons in each financial year (or such
higher number as may be prescribed by the Central Government) would be considered as a
public offer triggering all the requirements which you need when you issue securities to the
public.( The government increased that number to 200 persons later by virtue of the power
conferred to it under the Companies Act.35) A public offering of shares involves the
appointment of one or more merchant bankers, a registrar to the issue, filing of a draft offer
32
Ramesh Sinha, SEBI-Sahara Case:How it all Began?, HINDUSTAN TIMES, Mar. 4, 2014.
33
Mukul Aggarwal, Deepak Jodhani and Simone Reis, Supreme Court to Sahara: It’s not Private!, (Sept. 22,
2017),http://www.nishithdesai.com/information/research-and-articles/nda-hotline/nda-hotline-single-
view/article/supreme-court-to-sahara-its-not-private.html.
34
Supra, note 30.
35
See Rule 14(2)(b) of Companies Rule, 2014.
document with SEBI, eligibility requirements such as previous track record, minimum
promoter’s contribution, lock-in requirements, requirement to have a monitoring agency etc.,
apart from detailed disclosure requirements. This rule was made to avoid the situation which
was created by scams like Sahara and Sharadha.

Even though, small businesses and start-ups can offer their shares to 200 individuals but this
limitation still significantly affects the ability of such enterprises to raise money. It is
particularly so when private placement prohibits advertisement on a public platform. 36
Therefore, the small enterprises would not be able to raise small amounts of money from the
large number of investors, an aspect which is inherent to the idea of crowd-funding. What
Section 42 allows the companies to do is to seek larger amounts from few investors which are
conducive for non-crowd-funding options such as venture capital and angel investments.37

In such a scenario, equity crowd-funding seems to be impermissible and cannot be done

unless the existing laws are changed to suit the functioning of equity crowd-funding
platforms. As we discussed, the regulatory regime seems to be more inclined to protect the
interests of the investors thereby putting in tighter controls over offer of securities by the
companies. However, in its zeal to protect the interests of the investors, it seems to forget the
crucial role played by the innovative start-ups in the economy of a country and their need to
obtain access to finance.

It is not to say that SEBI is totally blind to the cause of the small businesses. In fact, SEBI has
recognised the importance of the start-ups for their role in the growth of the economy and
their need for finance to contribute to the economy of the country. In 2014, it had come up
with the consultation paper seeking to explore the possibility of regulating equity crowd-
funding in India. The next part of the article will critically analyse the various aspects of the
crowd-funding with an aim to provide a concrete suggestions as to how the equity crowd-
funding should be regulated in the country. Though, it was an extensive consultation paper I
would be dealing with issues which affect equity crowd-funding in a fundamental manner.

Analysis of SEBI Consultancy Paper and Policy Recommendations

Eligibility Norms for Investors

36
See Section 42(8) of Companies Act, 2013.
37
Supra, note 30.
First of all, the SEBI Consultation paper proposes that only the accredited investors can
invest in the start-up companies. 38 Accredited investors, according to the paper are: i)
Qualified Institutional Buyers (QIBs) ii) Companies with a minimum net worth of INR 200
million iii) High net worth individuals with a minimum net worth of INR 20 million or more
or iv) eligible retail investors. Furthermore, Eligible Retail Investors (ERIs) have been
defined as a retail investor who has received professional investment on advice or has availed
the services of a portfolio manager and he/she must have also the minimum annual income of
10 lakh rupees and who has filed an income tax statement for at least three financial years.39

The definition of SEBI of accredited investor is contrary to the fundamental tenets of the
crowd-funding as an alternative mechanise to raise funds. The primary aim of the crowd-
funding aim is to take little amount of money from the large number of investors (the Crowd)
and not from a set of sophisticated investors. 40 In as much as the consultancy paper has set
such a tighter eligibility norms for the investors, it takes away the “crowd” out of the crowd-
funding. It is appreciable that the intention was to protect investors by only allowing
sophisticated investors but it takes away the opportunity of other class of retail investors to
invest in start-ups and small enterprises. It is also true that there is an inherent risk when it
comes to investing in start-ups but the whole crowd-funding process can be designed in a
manner which can reduce the loss of the investors to a minimum and bearable level. As far as
protecting the investors are concerned, there must be maximum limit of the amount which
they can invest and that should be in proportion to their net income. Furthermore, Risk
Acknowledgement statements, disclosure necessities on the part of the start-ups, investor
education program and the checks conducted by the online intermediary would further reduce
the risk of investors getting duped by the unscrupulous business-men.41

Moreover, such tighter norms, are not going to help the case of start-ups as well for most of
the accredited investors and particularly Qualified Institutional Buyers(QIBs) are reluctant to
invest in early stage start-ups given their exhaustive screening and due-diligence
requirements. QIBs which include venture-capitalists, mutual-funds, foreign institutional
investors (FIIs), Public Financial Institutions, Commercial Banks etc., generally invest in
38
SEBI, Consultancy Paper on Crowdfunding in India, (Oct. 4, 2017),
www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf.
39
Id.
40
Andrew Fink,, Protecting the Crowd and Raising Capital through the CROWDFUND Act, 90 U. Det. Mercy
L. Rev. 1 (2012-13).
41
Debanshu Mukherjee, Shubhangi Bhadada, Aditi Singh, Ketan Paul, Response to the SEBI Consultation
Paper on Crowdfunding, (Oct. 8, 2017), https://vidhilegalpolicy.squarespace.com/s/Vidhi-Crowdfunding-
Paper.pdf.
such start-ups which have been there for more than two years.42 However, the consultancy
paper is meant for the start-ups which are there for less than two years. 43 Furthermore, the
requirement that QIBs must, in any case, at least have 5 percent of shareholding in the start-
up only further restrict the ability of the start-ups to raise funds from the potential investors.
It is the same old thing in a new package which just makes it more efficient for the VCs and
Private Equity Investors by providing them an additional avenue of internet platform.

Problems in having minimum offer limit

Secondly, there is a minimum offer limit which has also been prescribed in the consultancy
paper. It is submitted that there is no justification for imposing a minimum limit on the
amount of money which the investors want to invest. It is understandable that such rule is
coming from Chapter III of the Companies (Prospectus and Allotment of Securities), 2014
which requires that the minimum offer must be of at least 20, 000 INR. However, this rule
affects the ability of the small retail investors to contribute smaller amounts with a low down-
side risk of loss. Therefore, the language of the rules must be changed to allow the retail
investors to invest smaller amounts or a specific exemption should be granted with respect to
equity crowd-funding.

Maximum number of retail investors

Thirdly, the consultancy paper requires that the maximum number of retail investors which
can participate in an equity investment is 200. Again, it is coming from the Chapter III of
Companies( Prospectus and Allotment of Securities), 2014 which limit the total number of
investors up to 200. However, at the expense of repeating myself, crowd-funding is aimed at
involving the participation of individual investors in the fund-raising of early-stage start-ups.
It also violates the bedrock concept of crowdfunding which is “safety in numbers”.44
Restricting the number to 200 would severely affect the potential of the crowd-funding
method to raise capital for the business enterprises. It will be very difficult to reach the
maximum amount of 20 crores as prescribed in the prospectus if one limits the number of
investors to 200 only. A specific exemption must be granted in favour of crowd-funding to
increase the number to the maximum of 1000 investors.45

42
Swetha Chandrasekhar, Equity Crowd-funding as an Early-Stage Financing Alternative: Critique of the
Regulatory Proposals in India, (Sept. 28, 2017), https://indiacorplaw.in/2016/03/equity-based-crowdfunding-
as-early.html.
43
Supra, note 38.
44
Supra, note 42.
45
Supra, note 41.
It is understandable that such a huge number can affect the administration and management
of the start-ups by the promoters and managers of the company. However, this concern can
be addressed by issuing differential voting rights to the investors which restricts the right of
the investors to interfere in the crucial affairs and management of the company.46 But, there
are certain conditions which need to be fulfilled for the issuance of differential voting rights:
i) it has to be no more than 26 percent of the total issued paid-up share capital, ii) the
company should have a consistent track record of distributable profit for three years and iii)
there must not be default in any filing of financial statements. 47 Again, it is submitted that
these conditions are too onerous for early stage start-up companies. Particularly, the one
which requires three year track record of distributable profits as most of the early-stage
companies have not even finished three years and in fact under the consultancy paper only
such start-up companies are eligible to receive investments who have not finished more than
two years. In fact, the Central government has come up with a draft notification which
exempts private companies from fulfilling such onerous requirements when they issue
differential voting rights to the shareholders. Such an exemption should be all the more
provided to the start-up companies for VCs would be reluctant to invest in such companies
owing to the unbridled power of the unsophisticated investors if the differential voting rights
is not given. Last but not the least; such voting rights will not act as a disincentive for
majority of the shareholders for their primary concern is to get profits without getting
involved in day-to-day affairs of the company.

Private Companies not allowed to seek funding

Fourthly, SEBI proposal restrict crowd-funding to only unlisted public companies and not
private limited companies. However, it has been found that most of start-ups register
themselves as private limited companies and not public companies. The simple for the same
is that it is easier to set up a private limited company than a public company. The
requirements to form a public company are: i) public company requires at least 7 members to
form a company as opposed to 1 in case of private companies ii) There is no restriction in the
transferability of shares in the public company. It would have an implication that it will create
an unregulated secondary market for the shares of the start-up companies. iii) Additional
number of administrative and disclosure requirements than a private company. So, all of this

46
Id.
47
Id.
suggests that it is better and convenient for a start-up to form a private limited company than
a public company and any such restriction to form a private limited is not justified.

Stringent disclosure requirements

Finally, we come to the disclosure requirements which have been specified by the SEBI
consultancy paper. It is submitted that the disclosure requirements are quite stringent in
nature and follows the same standard what companies have to follow when they undertake
private placement of securities.48It is understandable that one needs to have adequate
disclosure requirement to protect the interests of the investors but it should not be at the
expense of making it impossible for the start-up companies to raise the funds itself owing to
administrative and operational costs of fulfilling such requirements. There is a need to carve-
out a balance to protect the interests of the investors with the interest of the start-ups that such
requirements do not become prohibitively expensive and cumbersome for the early-stage
start-up companies.

According to the consultancy paper, the costs of disclosure are to be borne by the issuer
companies. However, as discussed, these companies are at the early-stage of their operation
and might not have the capacity to satisfy the disclosure requirement like providing audited
balance-sheet, profit and loss account, cash-flow statement etc. In this scenario, the role of
online platform comes in. Being sophisticated enough as it is catering to lots of businesses, it
can provide the disclosures of start-up companies comfortably and for the same services it
might charge some commission from the start-up companies. It should also put risk
investment form which must categorically state that there is a clear risk of potential loss of
money and illiquid nature of investment. However, it must also state that such nature of risk
does not take away the legal liability of the issuing of financial companies if they disclose
false or misrepresented information.49

Furthermore, it also requires the companies to provide on-going future projections of the
company. It is important that the investors should have access to the information which
discloses the future projections of the start-up companies but providing the disclosure at a
continuous level is expensive and difficult for the early stage start-up companies. Instead,
what should be provided is that portal provides periodic reviews of the companies and keeps
the investors abreast of the financial status of the companies. While we are discussing, this it

48
Supra, note 42.
49
Supra, note 41.
must be kept in mind that the investors are unsophisticated in nature and they might not be
able to appreciate the full import of the future projections of the companies. It is highly
possible that they might be blinded by the light, the over dose of information which will be
provided to the investors related to the business prospect of the issuer companies. In such a
scenario, it would be appropriate to allow independent financial analyst to rate the financial
viability of the issuer companies.50 The regulations may prescribe the methodology on the
basis of which financial rating is to be given.

Even if that is not sufficient, there can be an online social networking platform for all the
investors registered with the portal and the issuer companies wherein the investors can
monitor the returns made by other investors( in the same start-ups or different) and keep each
other aware of the development made by the issuer companies. 51 However, it must be ensured
that the participants do not provide any false information in order to create an artificial
demand for the securities. For that, it must be ensured that the investors register themselves
under the investor category and with their real names. It will help other investors (the
“wisdom” of the crowd) to construe the advice given by the investors in such manner only.

Conclusion
Thomas Friedman, in his book “The World is Flat” called India as the future of innovation
and technology. The reason was the emerging number of tech companies and start-ups
fuelling the process of creative destruction whereby old ideas and organizations are
constantly challenged and replaced by new, better ones. However, for start-ups to flourish
they need access to finance and equity crowd-funding can prove to be one of the instrumental
and alternative ways to fund the innovative ideas of the start-ups.

However, the present regulatory regime, in light of the recent financial scams like Sahara
scam and Sharadha scam, has made equity crowd-funding impermissible in the country.
There is more emphasis in protecting the interests of the investors at the expense of creating
conducive environments for genuine enterprises to grow and prosper. It is submitted that it is
not necessary that these two competing considerations cannot be reconciled. . What is needed
is sufficient regulatory safeguards, a sophisticated web of checks and balances, which balance

50
Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and US Securities Regulation,
13 THE TENNESSEE JOURNAL OF BUSINESS LAW 66 (2014).
51
Id.
the interests of the investor with the economic interests of the start-ups and small and
medium enterprises to obtain access to finance.

To achieve this purpose, SEBI had come up with the consultancy paper. In as much as it
recognized the importance of equity crowd-funding it was a step in the right direction.
However, what began as a relatively straightforward approach to assist start-ups and small
and medium enterprises to raise capital ended with a regulatory scheme weighed down with
limitations, restrictions, obligations, transaction costs and countless liability traps.52

52
Stuart R. Cohen, The New Crowd-funding Registration Exemption, 64 FLORIDA LAW REVIEW 1445 (2012).