CROWDFUNDING

Introduction

In investment circles, Crowdfunding internet platforms have created a new asset class with shared risks that promises start-ups not just funding but also mentoring and advisory services.

Crowdfunding may be innovative and cool, but it may not be an answer to every start-up’s visions. In today’s scenario partnering with hundreds of unsophisticated small shareholders (micro funding) may be a pretty inefficient way to fund a company. It could be an administrative nightmare (for Company Secretary and his department) to qualify all those strangers and keep in touch with them as equity investors they do have rights. Their disorderly effect on governance and control might scare off the serious VCs you may need to attract for future funding rounds.

Could the Crowdfunding create more jobs and help succeed start-ups?

May be, but to reach there is likely to be shoddy, too. As Eric Reis and Steve Blank of the Lean Start-up movement have pointed out, and as Cindy Padnos of Illuminate Ventures echoes in her column and Bo Burlingham in his, easy access to capital can sometimes be a start-up’s worst enemy. It can skew incentives and weaken the discipline required to get a company to experiment, fail quickly and flop a winning idea.

In total, it is not going to generate great ideas, or great entrepreneurs. VCs like Mark Suster have long argued that the market’s worst problem right now is not too little cash but too much cash chasing too few good ideas. Adding more dumb money to the market won’t fix that.

On the other hand it is also true that many companies in India have been started by micro funding efforts of general public. e.g. TISCO was started way back in 1907 by micro-funding efforts of general public. Reliance was funded by micro funding efforts of general public, although not by crowdfunding.

Need for Regulations

There are many crowdfunding agencies operating in India at present without any regulatory mechanism. While the democratization of capital formation sounds good as a theory, it will likely be messy in practice. Start-ups won’t be less risky because more money is available on the contrary a lot of senior citizen investors are going to lose their investment in crowdfunded start-ups. And let’s face it, not all entrepreneurs raising money from unsophisticated investors are going to use it to elevate humanity. More percentage is going to use it to elevate their lifestyle before absconding to somewhere.

And if enough small crowdfunders have a bad experience, it won’t be good for anyone—especially entrepreneurs.  There is a fear among investing public that any cunning operator can put himself as a genuine crowd funding agency. After some time he can tell gullible public that a there is a genuine effort in floating a company and his help was sought.  After collecting money from public he can simply disappear. There is no dearth of fly by night operators in financial sector. The investing public will be at a loss.

The idea’s time has arrived; a sort of crowdfunding bill has to be passed by Parliament also and which calls for removing regulatory barriers to capital access for small businesses.

A good crowdfunding enactment is needed to be passed by Indian parliament also and it calls for removing regulatory barriers to capital access for small businesses. Indian Government and Parliament should intervene and enact law like US and Italy. And also, it should be brought under SEBI. It is very serious matter for investing public

Crowd funding and Internet

Crowd funding or crowdfunding (alternately crowd financing, equity crowdfunding, or hyper funding) describes the collective initiatives of individuals who network and pool their money, usually via the Internet, to support good initiatives (NGO initiatives or business initiatives) started by a nodal platform agency or organization.  Crowdfunding is used in support of a wide variety of activities, including disaster relief, citizen journalism, support of artists by fans, political campaigns, startup company funding, motion picture promotion, free software development, inventions development, scientific research, and civic projects.

Crowdfunding replaces the need for specialized grant applications or other more formal and traditional fundraising techniques with that of a more casual, yet powerful, approach based on crowd participation. Examples of the basis of Crowdfunding has its origins in the concept of crowdsourcing, which is the broader concept of an individual reaching a goal by receiving and leveraging small contributions from many parties. Crowdfunding is the application of this concept to the collection of funds through small contributions from many parties in order to finance a particular project or venture.

Crowdfunding models involve a variety of participants. They include the people or organizations that propose the ideas and/or projects to be funded, and the crowd of people who support the proposals. Crowdfunding is then supported by an organization (the "platform") which brings together the project initiator and the crowd.

Role of the crowd

The inputs of the individuals in the crowd trigger to crowdfunding process and influence the ultimate value of the offerings or outcomes of the process. Each individual acts as an agent of the offering, selecting and promoting the projects in which they believe. They will sometimes play a donor role oriented towards providing help on social projects. In some cases they will become shareholders and contribute to the development and growth of the offering. Each individual disseminates information about projects they support in their online communities, generating further support (promoters).

Motivation for investor participation stems from the feeling of being at least partly responsible for the success of others’ initiatives (desire for patronage), striving to be a part of a communal social initiative (desire for social participation), and seeking a payoff from monetary contributions (desire for investment).

An individual who takes part in crowdfunding initiatives tends to reveal several distinct traits: innovative orientation, which stimulates the desire to try new modes of interacting with firms and other consumers; social identification with the content, cause or project selected for funding, which sparks the desire to be a part of the initiative; (monetary) exploitation, which motivates the individual to participate by expecting a payoff.

Equity

Crowdfunding can be seen in Cooperatives (co-ops) around the world. However, the Internet can provide new streamlined approaches to quickly imitating the co-op model for low-level and/or sudden needs (ie. disaster relief, travel expenses, legal fees and so on.). It is this reason that a term be used to encompass the act of informally generating and distributing funds, usually online, by groups of people for specific social, personal, entertainment or other purposes.

An early precursor form of the crowdfunding model was the Subscription business model which was used in the 17th century to finance book prints. Similar to crowdfunding an additional benefit to donors was offered like the mentioning on the title page. Even now, the same model is adopted to sell niche publications i.e. by pre-publication  subscription.

Crowdfunding is an innovative way and out of box way of funding a startup and get up with the times to open up capital markets to new businesses and existing small businesses. It has the potential to be a powerful venture capital model.

Crowdfunding, a practice that takes advantage of the collective effort of individuals who pool money mostly through the Internet to support start-ups, appears to be gathering momentum in India with at least four such initiatives being introduced in the past one year.

Crowdfunding can also refer to the funding of a company by selling small amounts (micro funding) of equity to many investors. This form of crowdfunding has recently received attention from policymakers in the United States with direct mention in the JOBS Act; legislation that allows for a wider pool of small investors with fewer restrictions. While the JOBS Act awaits implementation, hybrid models, such as Mosaic Inc., are using existing securities laws to enable the public in approved states to invest directly in clean energy projects as part of a crowd.

Equity Based Crowdfunding is a mechanism that enables broad groups of investors to fund startup companies and small businesses in return for equity. Investors give money to a business and receive ownership of a small piece of that business (equity and / or debt). If the business succeeds, then its value goes up – and so does the value of that share of that business. The converse is also true. Coverage of Equity Based Crowdfunding indicates that its potential is greatest with Startup businesses, who are seeking smaller investments to launch and that additional follow-on funding required for rapid growth may come from other sources.

The Jumpstart our Business Start-ups (or JOBS) Act Of US

The JOBS Act bill went through a number of amendments and on April 5, 2012 President Barack Obama signed the JOBS Act into law. The U S House of Representatives in 2012 has passed the Jumpstart our Business Start-ups (or  JOBS) Act.  The legislation mandates that funding portals must register with the SEC as well as an applicable self-regulatory organization to operate.

The U.S. Securities and Exchange Commission has been given approximately 270 days to set forth specific rules and guidelines that enact this legislation, while also ensuring the protection of investors. Some rules have already been proposed by the SEC.

Italy has become the first country in Europe introducing equity crowdfunding. This innovation shows a new approach of Italy towards innovation and indeed we have seen more and more start-ups recently set up in the country.

Previously, it was illegal for startup companies and small business to solicit investment from the general American public. Only accredited investors could invest in small or early stage companies due to the financial risk and possibility of fraud. Accredited investors are defined as individuals who either have a net worth that is more than $1 million dollars (excluding their home), who have had $200,000 in income for the last two years and are forecasted to have a similar income for the current year, or an individual who has had $300,000 in household income for the last two years and is expecting the same income for the current year.

The current version of JOBS Act will allow unaccredited investors to invest upwards of $2,000 per year via crowdfunding portals in startups and small business. Traditionally, only family/friends of the founders, angel investors, and venture capital firms could invest in startup companies. Angel investors are typically wealthy individuals who will invest anywhere from $25,000 up to $500,000. Venture capital firms are financial organizations that will invest $1 million and up in startup companies at varying  stages of development.

Among other securities law changes, the JOBS Act allows issuers to raise up to $1 million from a large number of accredited and unaccredited investors by selling securities through a broker or SEC-approved funding portal.  When sold through these qualified intermediaries, crowdfunded securities are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), and state securities laws.

JOBS Act Requirements

Annual Investment Cap 

For an investor with an annual income or net worth below $100,000, the investor’s annual investment in crowdfunded securities is capped at the greater of $2,000 or 5% of such investor’s annual income or net worth.  For an investor with an annual income or net worth above $100,000, the aggregate annual crowdfunded investment is capped at 10% of such investor’s annual income or net worth.  Securities sold to investors under the crowdfunding exemption are restricted securities with a one-year holding period, except under certain limited circumstances. 

Information Requirements 

Issuers offering crowdfunding securities are required to file a minimum threshold of information with the SEC regarding their businesses and provide that information to  investors and potential investors through the crowdfunding intermediary they use to sell the securities. 

o The initial filing includes:

a)     the name, legal status and addresses of the business,

b)    the names of directors, officers and significant shareholders,

c)     a business plan and description of the business,

d)    financial information including, depending on the size of the business, income tax returns and officer-certified financial statements, unaudited financial statements or audited financial statements,

e)     a description of the purpose and intended use of the funds, (vi) the target offering amount,

f)      the price of the securities,

g)     the ownership and capital structure of the business, including the terms of each class of the issuer’s securities, risks of minority ownership andmethods of valuation for the securities, and

h)    any other information required by the SEC. 

o Following the issue of crowdfunding securities, issuers are obligated to submit annual filings to the SEC and investors with reports on operations and financial statements for the prior year. 

·        Restrictions on Issuers 

Issuers are prohibited from advertising a crowdfunding offering except for notices directing potential investors to the applicable crowdfunding portal.  Issuers cannot compensate any promoter without disclosing the compensation to investors. 

Though not required to register the crowdfunded securities, an issuer, including the issuer’s officers, directors or partners, may still be held liable for any material misstatements or omissions under the Securities Act or any state securities laws prohibiting fraud, deceit or unlawful conduct in connection with a securities transaction. 

·        Regulation of Intermediaries

The JOBS Act requires brokers and funding portals to register with the SEC and an applicable SRO as intermediaries between issuers and investors in crowdfunding offerings.  Generally, intermediaries are prohibited from compensating promoters or finders and from allowing their officers or directors to take a financial interest in any issuer engaging their services.  Funding portals, which are not subject to the extensive registration requirements applicable to a broker, are subject to additional restrictions including prohibitions from offering investment advice, soliciting transactions in securities offered on their portal, compensating any employees or agents for soliciting transactions, holding investor funds or securities, and engaging in any other activities prohibited by the SEC. 

·        Duties of the Intermediaries

·        Crowdfunding intermediaries, which can be either brokers or SEC-approved funding portals, have substantial duties under the JOBS Act to provide information, reduce the risk of fraud and be responsible for investors’ and issuers’ compliance with the law. 

·        Intermediaries must collect the information an issuer files with the SEC and make that information available to investors and potential investors.  In addition to this reporting requirement, the intermediaries are required to obtain background checks on each of an issuer’s officers and directors, and anyone holding more than 20% of an issuer’s equity. 

·        Under the JOBS Act, funding portals and brokers offering crowdfunded securities must:

a)     provide and require investors to review risk-related disclosures and other education materials;

b)    require investors to positively affirm they understand the risks of crowdfunding securities by answering questions pertaining to the risks generally applicable investments in start-ups, emerging businesses and small issuers and the risk of illiquidity in crowdfunded securities; 

c)     ensure that investors are limited to the caps on annual investments; and

d)    protect investor privacy.

Issues to Consider

Crowdfunding In Practice  

For years, founders of small businesses have sought to raise the capital they need to start and grow their businesses from their own networks of family, friends and business associates.  The JOBS Act changes the landscape these enterprises must navigate by creating an alternative pathway for small companies to raise a limited amount of capital from a much wider and deeper pool of potential investors.  Following the rule-making period, small businesses will be able to plan for their financial future by choosing crowdfunding from among more traditional options such as angel investors, bank loans, government grants and venture capital. 

Choosing Crowdfunding  

The business decision to crowdfund, however, comes with a new set of legal risks and factors potential issuers must consider.

o  Businesses must weigh the benefits of crowdfunding against traditional financing options that may bring more intangible resources and access to future financing. 

o  The expenses of crowdfunding are still uncertain.  Businesses will need to plan for the expense of compliance with the JOBS Act, including the cost of

(i)                producing the initial filing information and providing annual reports,

(ii)             creating equity documents and

(iii)           engaging an intermediary. 

The magnitude of many of these expenses will remain uncertain until the SEC produces the reporting rules and intermediaries can calculate the costs of compliance, which will be passed on to issuers. 

o  The disclosures required of issuers in a crowdfunding offering may create risk for competition at a very early stage of product development because of the amount of information that will be publicly available, such as the business plan and financial statements of the business. 

o  Issuing crowdfunded securities could potentially provide a good way to market a company’s product or service and increase exposure to a wide range of investors and end-users.  Conversely, products for which a market does not exist may be weeded out at an earlier stage by public disinterest in funding the business.

o  Proper planning of the equity issue will include considering the voting, participation, anti-dilution and repurchase rights of the securities.  Issuers will also need to consider restrictions on the use of proceeds from the offering.

Intermediary Concerns  

Business bodies seeking to become a market participant as a crowdfunding intermediary will have a related set of legal considerations.  The major concerns for intermediaries will be

(1) the expense of developing the funding portal platform in compliance with the requirements of the JOBS Act,

(2) the expense of conducting the required background checks on issuers and their officers, directors and significant shareholders, and

 (3) the liability of the intermediary for ensuring compliance with applicable rules and regulations for the crowdfunding.

In Short, it will make it a lot easier for start-ups to raise money and will lower the cost of going public. To get into the specifics:

o  It allows entrepreneurs to advertise for equity investors on a crowdfunding site, something they can’t do contemporarily without running afoul of a bunch of securities laws.

o  Entrepreneur can raise up to $1 million this way from investors putting in no more than $10,000 each, or no more than 10% of their income, whichever is less.

o  Entrepreneurs can raise up to $2 million if they supply your  “crowd”  investors with audited financial statements.

o  Entrepreneur don’t have to disclose their company’s financial statements until they have more than 1,000 shareholders. Currently, SEC disclosure rules kick in once they hit 500 shareholders.

o  It allows entrepreneurs to raise up to $50 million in an IPO without having to comply with the SEC’s full regulatory structure and related fees.

Crowdfunding platforms

There are over 500 crowdfunding platforms. Project creators need to do their own due diligence in order to understand which platform is the best to use depending on the type of project that they want to launch. There are fundamental differences in the services provided by many crowdfunding platforms.

Crowdfunding platforms serve as a “network orchestrators”. They create the necessary organizational systems and conditions for resource integration among other players to take place.

Relational mediators act as an intermediary between supply and demand (i.e. SellaBand, Kickstarter, Uinvest). They substitute a traditional intermediary  (traditional record companies, venture capitalist). These platforms link new artists, designers, project initiators with committed supporters who believe in the persons behind the projects strongly enough to provide monetary support.

Social gatekeepers assist people to raise fund by exploiting their social network connections (i.e. Kapipal). They add an intermediary role that was previously absent. These platforms intermediate consumer-to-consumer funding.

Growth engines focus on the strong inclusion of investors (i.e. Trampoline Systems). They dis-intermediate by eliminating the activity of a service provider previously involved in the network. These platforms that use crowdfunding to seek stakes form a community of high net worth private investors and match them directly with project initiators.

There are questions about the legality of taking money from “investors” without offering any of the security demanded by conventional investment schemes. Sites such as SellaBand have a failsafe. They hold funds in an escrow account. If the nominated target isn't reached, all funds are returned to contributors. While sites such as ArtistShare allow projects to keep all the funds raised.

Investors are given something for their money - so in a legal sense, they have paid for and received something. Rewards range from having your name in the credits, an initial shot at the product itself and in some cases even revenue returns.

Micropatronage is a system in which the public directly supports the work of others by making donations through the Internet. In use as early as 2001, the term was popularized in 2005  by blogger Jason Kottke when he quit his day job as a web designer and spent a year blogging full-time, living off the voluntary donations of his readership. Micropatronage differs from traditional patronage systems by allowing many “patrons” to donate small amounts, rather than a small number of patrons making larger contributions.

The write up has been written with the inputs from information gathered from various sources and all those sources of information are gratefully acknowledged.

Disclaimer: In this note, we have attempted to summarise some of the significant aspects to be kept in mind by readers to ensure compliance of tax laws and regulations. Readers should ensure to verify specific provisions as applicable to each case before taking any business decisions. It would be pertinent to note that some changes are being made to the tax laws and rules and regulations on a continuous basis by way of notifications, clarifications etc issued by the department based on their practical experience in implementing the legislation.

It may be noted that nothing contained in this note should be regarded as our opinion.  Professional advice should be sought for applicability of legal provisions based on specific facts. Though reasonable efforts have been taken to avoid errors or omissions in this note we are not responsible for any liability arising to readers directly or indirectly due to any mis-statements or error contained in this note. It must be noted that the views expressed in the note are based on our understanding of the law and regulations as published by the Government authorities and we may or may not agree or subscribe to such views. This blog, between contributor and readers, shall not create any attorney-client relationship.