Introducing Crowdfunding
It is an internet enabled way of raising money for a business idea. It started off as receiving finances from friends and families and later on to receiving donation. Now, it has taken a form of debt and equity attracting potential investors.
Crowdfuding is a way of collecting small amount of money for funding any project and the likes from interested investors typically through a portal online acting as an intermediary. It creates a platform for innovators and creators to raise capital in order to execute their ideas into reality.
SEBI, in a consultation paper has defined Crowdfuding as “solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause”.
Crowdfunding Models
The two main categories of Crowdfunding are:
Community Crowdfuding helps in raising non-equity capital, sometimes in exchange for early access to products etc. This allows individual to attract funds from donors for a specific project.
Financial Return Crowdfunding is a means of raising capital by way of debt or equity. It refers to selling a part of ownership or selling claims to business’s Intellectual Property Rights or availing loans etc.
Crowdfunding ModelCategorisationCharacteristicBenefitsChallengesCommunity CrowdfundingDonation basedGenerous donors donate capital without any expectation of return.No risk.Difficult to raise money since this involves no return.Reward basedFinances are raised by giving early access to products, or pre selling of products.Risk is minimal. (Only fraud risk).Return is small and there is no accountability taken by the investors. Entrepreneurs need to have a mass appeal.Financial CrowdfundingPeer to Peer LendingOnline platform is used to match a lender with the borrower to provide loans.Pre- determined rate of interest. Also, in case of bankruptcy, they are ranked higher than the equity holders.This mostly involves unsecured loan which exposes investors to greater risk. Start-ups do not have already existing cash flow.Equity basedInvestors hold equity stakes and assume all the risk associated with it.Share in profits of the venture.Absence of credible secondary market makes shares illiquid. Also, equity holders are secondary to creditors.Royalty basedThe funders receive regular return out of revenue of the start-up.Risk is lower compared to equity and higher regular gains out of revenues of the company.Returns are small and a start-up may not always generate profits.
Suitability of Crowdfunding
Suitability of Crowdfunding depends on the type of project/ business, their geographical presence, and the amount of funding required. The type of Crowdfunding suitable for a project shall further depend on the type of the project and the capital required. For example an art based project is more suitable for donation based Crowdfunding, a newly launched product or a service is more suited for reward based Crowdfunding. Following table gives a clear idea on suitability.Crowdfunding typeProject TypeCapital sought (Appx.)Donation-Based
CrowdfundingArt or Community basedLess than 6,00,000Reward based
CrowdfundingLaunching a new product or serviceLess than 60,00,000Peer to Peer LendingCompanies that already have cash flowLess than 60,000Equity Based CrowdfundingHighly innovative projectsLess than 1,50,00,000
Note: Source for the capital sought above is the World Bank report on Crowdfunding Potential for Developing World.
Legality of Crowdfunding
The question whether or not crowd funding is legal depends on Crowdfunding Model. Community Crowdfunding is out of scope of Security exchange as it does not involve interest of any investors who are expecting a return. It is a grant / donation with no expectation of return or yield on it which makes it outside of the purview of security exchange regulator and hence there are no legal issues involved. However financial return Crowdfunding as the name clearly suggests involves security market implications.
The legal issue revolving around finance Crowdfunding is that any entity which facilitates any transactions involving any kind of investment, as per Security Contracts Act, must be recognised by Security Exchange Board of India (“SEBI”) as an exchange mandatorily. But if they are recognised as an exchange, they have to mandatorily deal in listed securities.
In the backdrop of an increase in Crowdfunding activities, SEBI has directed that the entities engaging in such activities must provide a disclaimer that it is neither a stock exchange nor has it been authorised by capital market regulators to operate. Disclaimer should also include the fact that the investment made on such platforms are not traded on any regulated exchange.
SEBI has also formed a Committee on Financial and Regulatory Technologies (CFRT) to look into technology driven financial market.
While laws are not in place in India, United States passed Jumpstart Our Business Start-ups Act (JOBS) in the year 2012. However, it comes with certain checks and restrictions including:
The amount that can be raised by Crowdfunding
An audit to be conducted by a public accountant in certain cases and disclosures to be made
The plan of utilisation of the money raised.
Increase in these activities can act as a catalyst for SEBI to formulate requisite laws. As of now, community Crowdfunding is the most pragmatic approach.
Advantages of Crowdfunding
Low cost alternative
Crowdfunding is a low cost alternative for both raising the capital and for channelling savings into real economy. Further, the aerodynamic algorithms online calls for low infrastructure costs to determine the creditworthiness of the person raising capital. This also leads to increase in return in a way since there would be lower administration costs. Furthermore, Crowdfunding will lead to increase in the competition which would benefit both the lender and the borrower. Traditional entities are likely to compete with the online portal which will lead to fall in their heavy cost carrying exercises and hence would benefit the investors in general.
Easily accessible
Online activity has made it convenient for people to reach out to potential investors not just in the local area but internationally. Social media is the easiest way to reach people in large number. It is relatively easier for them to expand and to manage his portfolio. Online platform can also be accessed at any time of the day as opposed to traditional market which may be accessible only at a certain time of the day.
Market Validation
This benefit is from the perspective of the person with an idea of raising capital. Through Crowdfunding, the person can actually know if the idea is reaching the prospective buyers. It is a way of receiving feedback from them so that necessary modifications can be made. It is a relatively cheaper way of conducting market research.
Opportunity for Mediocre Investors
Traditionally, the minimum amount of investing in early stage speculative ventures is quite high. This would enable only the accredited investors who have a certain level of income and assets. However, Crowdfunding makes it possible for mediocre investors to invest and improve their portfolio by investing a small amount as the minimum amount in Crowdfunding is quite low. This creates a level playing field for both accredited and non-accredited investors.
Risks/ Due Diligence under Crowdfunding
Lack of Professional Guidance
Success of start-ups not only depends on the capital it raises but also on the management, and plan of its structure. Raising capital through traditional methods like venture capital and angel investors helps a start-up with not just raising money but also with its professional expertise and guidance. There definitely exists a greater risk in Crowdfunding due to lack of guidance on usage of capital in right pace.
Risk of Fraud
While investing money in Crowdfunding, the investors must exercise proper due diligence and should not hurry into investing money. Since the method of money raising is through internet, the likelihood of a fraud venture cannot be eliminated. Hence, it is to be ensured the platform is genuine.
Vulnerability of attacks from Hackers
Hackers have shaken the faith of people in digitalisation by stealing valuable information of credit cards and other banking information. This puts Crowdfunding in a dubious position. It is to be ensured that the platform through which the capital is raised, is secure and free from any kind of uncertainty.
Crowdfunding not a primary choice
Business ventures, in the past, have turned to Crowdfunding only because they could not attract investment through angel investors or venture capitalists. If this is the case, then it makes Crowdfunding a mediocre investment opportunity. In turn, it would not be considered a lucrative platform for investors to invest.
Lack of Laws and Regulations
Even though there have been efforts, there is no laws governing Crowdfunding as of now. In fact, as mentioned above, SEBI has clarified that it does not regulate Crowdfunding. The only thread Crowdfunding is hanging on in India is on the fact that it has not been specifically prohibited. In the absence of laws, it makes the investment riskier than it already is. However, it is to be noted that internationally it has been recognised by a few countries with a twofold objective of saving the interest of unqualified investors and providing an opportunity to young entrepreneurs. But this is not out of place of mention that these young entrepreneurs turn to Crowdfunding only when they cannot procure funds through conventional financial market.
Way Forward/ the Future Scope
While currently Crowdfunding is predominantly a phenomenon in the developed nations, but the potential does exist for the developing nations like India. Factors that play an important role in making it a phenomenon are understanding how Crowdfunding works, the role of government in making requisite regulations, and the technological infrastructures.
Considering the social media penetration in India (as opposed to internet penetration) Crowdfunding seems to have a good scope and people are more likely to understand how Crowdfunding works.
Even though right now Crowdfunding has not been regulated by the government in India, the recent notification of SEBI making the disclaimer compulsory in itself is a huge step towards recognising Crowdfunding and can be seen as a positive step in at least recognising this method of raising funds.
Technologically, the era of digitalisation in India is definitely likely to have a positive impact on understanding and usage of Crowdfunding. With more number of people being on social media and starting to use smart mobile phones, it can be said that there exists a great potential for Crowdfunding in India.
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