This article is written by Sukeshi Singh who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (including PE and VC transactions) from LawSikho.

Introduction

Crowdfunding is a method of raising funds from the public for specific purposes like for a creative project like music, film or book publishing, to fund a new business venture, for benevolent causes like community-based initiative, social cause or donations for medical emergencies. The funds are collected by organizations, groups or individuals by raising small amounts from a large number of people. 

Securities and Exchange Board of India (SEBI), a regulatory body has defined crowdfunding as solicitation of funds in small amounts from multiple investors through web-based platform or social media site for a specific project, business venture or social cause . Funds can be collected manually or digitally. 

There are various websites available online to raise money for different purposes, for example, Indiegogo site is usually used by start-ups and entrepreneurs having innovative ideas, non-profit organisations usually campaign through the site Ketto, similarly, individuals who wish to raise money for their personal purposes can use social media accounts or GoFundMe platform for the same. 

History and Growth

Crowdfunding is one of the oldest methods of raising funds. For centuries, books are being crowdfunded. One of the earliest forms of crowdfunding is subscription schemes, which required a minimum number of subscribers for the books to be published. A renowned philosopher, Auguste Comte published his work after issuing notes for public support.  It is not exactly crowdfunding as we have today but it helped in building confidence in the investors to risk publications. 

Another form of early crowdfunding was the war bonds issued by the British Government in the 1730s, during the time of military conflicts. As the people lost faith in the currency and demanded conversion of their currency into gold, the London mercantile community stepped in to support the bank and restore faith in the currency by crowdfunding their own money. 

Another example of early crowdfunding is when the publisher Joseph Pulitzer decided to launch a campaign in a newspaper to raise funds for the pedestal of Statue of Liberty after the government failed to do so. The campaign was very successful in attracting small donations from nearly 1,60,000 donors and raising enough money to pay for the pedestal. 

Online Crowdfunding

Usage of the internet for the purpose of crowdfunding is increasingly gaining popularity. With 4.57 Billion people constituting the global digital population and 59% of the entire world population online, the internet has paved the way for an alternative ecosystem. Crowdfunding campaigns online have a wider reach, it is cheaper and more convenient compared to using traditional ways of crowdfunding.  

Role of Crowdfunding websites 

The crowdfunding platforms usually charge a percentage of commission from the fund raised as service charge for drawing traffic to the campaign, providing the donors with smooth payment facilities and running and operating the website. Donation crowdfunding websites like Milaap take 5% of the total money raised, Ketto accepts a commission of 6% along with an additional Rs. 2000 for setting up the campaign at the website. 

Usually the websites collecting donations for medical or social purposes, like Milaap, are also responsible for informing the donors of the status of their donation and updates on the campaign.  

Regulating Authority 

There is no particular authority or department that regulates all aspects of crowdfunding. The slight regulation that does exist in this sector depends on the type of crowdfunding, for example debt crowdfunding or P2P lending comes under the purview of Reserve Bank of India, similarly, raising money by allotting ownership of the company and issue of securities comes under the jurisdiction of Security Exchange Board of India (SEBI). Reward-based or donation-based crowdfunding do not have specific regulators but attract laws such as Income Tax Act, 1961, the Foreign Contribution (Regulation) Act, 2010 (FCRA) and the Foreign Exchange Management Act, 1999 (FEMA). 

Tax Implications in crowdfunding 

Tax implications in crowdfunding depends on the organisation used for the purpose. Section 80G of Income Tax Act provides for exemptions from tax deductions for all donations made to charities and non-profit organisations. According to the income tax regulations, any donation made above Rs 2000 in cash is not eligible for deductions, which has prompted web-based platforms to integrate online means to solicit funds.

Types of Crowfunding 

Donation-based crowdfunding

Donation based crowdfunding is where the seeker creates the campaign and spreads awareness about his campaign using social media and marketing. The people supporting the cause and contributing for the same are called donors. There is no threshold for donations and people are free to contribute as much as they want. The donations are in the form of charity and without expectation of any return or incentive. It may also be referred to as Charity Crowdfunding and usually supports philanthropic projects like contributing towards medical expenses, education expenses, emergencies etc. 

Rewards-based crowdfunding

Reward-based crowdfunding is to fund an idea, start-up or organisation offering products or services, for example free development of a software, aiding scientific research and development of new inventions. The donors get rewards based on the amount they contribute. The rewards usually consist of handmade items, prizes or free products by the company being funded. For example, an artist raising funds for an art gallery may include a free art workshop for donors donating a specific amount of money. 

Equity Crowdfunding 

Equity crowdfunding is also known as crowd-investing, wherein donors receive ownership over the company in return of their donations. It is similar to raising funds through initial public offering or further public offering where the subscribers to shares own a percentage of the company. The difference between the two is regarding compliances required and time taken to raise funds, which makes online crowdfunding better than traditional methods of funding. Due to the requirement of large amounts of money and limited percentage of equity ownership, they do have minimum donation thresholds. 

Debt Crowdfunding 

Debt crowdfunding is also known as peer to peer lending or crowdlending. Donations are collected in the form of loans with an obligation to pay back later. It is suitable for companies which would rather pay-back the capital than hand out equity of the company. The campaign for such crowdfunding should clearly mention the purpose of collection and expected repayment period. 

Royalty based crowdfunding 

Royalty based crowdfunding offers the backers of an idea or donors a percentage of revenue accrued when the company becomes successful or starts making profits. The main difference between royalty-based crowdfunding and equity-based crowdfunding is that here the backers or donors receive the royalty obtained from sale of the products or idea which they have invested in. They gain as long as the idea is successful and running, whereas in equity crowdfunding the donors own a percentage of the company and invest in the company as a whole. 

Legality of Equity Crowfunding 

Equity crowdfunding is illegal in India. Security Exchange Board of India has rendered digital equity crowdfunding in India as “unauthorised, unregulated and illegal”. 

Reasons for illegality of equity crowdfunding

The reasons why SEBI is apprehensive about allowing equity crowdfunding in India are as follows:

(a) There are high risks involved in such type of crowdfunding, including unregulated investments and inexperienced and unaware investors who are not skilled to calculate the risks involved. 

(b) The investments are easy and lucrative for small investors who can be manipulated or tempted to invest their limited savings without having full knowledge of the risks involved. 

(c) The investments are carried out on the basis of information available online and in absence of proper due diligence which is the suggested method. 

(d) In absence of laws and regulations on the issuer of security, the investments are more or less unsecured and returns are uncertain. 

(e) The platforms allowing for equity crowdfunding do not meet the critical net-worth to be recognised as stock exchanges. 

In 2016, SEBI declared that the equity crowdfunding websites allowing investors registered with the platforms was in contravention of the Companies Act and Securities Contract Act. In pursuance of this, crowdfunding platforms like Grex Alternative Investments, LetsVenture, Traxcn were asked to stop onboarding new investors and were banned from raising money for securities of the company.  

Alternative provided by SEBI

After banning equity crowdfunding platforms from India, SEBI has provided start-ups with an alternative to raise funds from the public in a regulated manner with much less compliances. In 2015, SEBI allowed entrepreneur driven companies to list on stock exchanges, for this purpose there have been relaxations in listing norms. Institutional Trading Platform was created by SEBI for this purpose which was later renamed as Innovators Growth Platform.

(a) Criteria for listing on Innovators Growth Platform

(i) Companies should be intensive in use of technology, information technology, intellectual property, data analytics, bio-technology or nanotechnology. 

(ii) At least 25% of the pre-issue capital of the Company should be held by qualified institutional buyers, family trust (net-worth more than Rs. 500 Cr.), regulated entities (Category III FPI etc.) or accredited investors. 

(b) Eligibility for accreditation as Accredited Investors

(i) An individual with total gross income of Rs.50 lakhs per annum and minimum liquid net-worth of Rs. 5 Crores,

(ii) Any body corporate with net worth of Rs.25 Crores.

Crowfunding Laws in other countries 

USA

Crowdfunding platforms in the USA are regulated by the Jumpstart Our Business Startups Act, 2012 or (JOBS Act). Tier III of the Act discusses Crowd Sourced equity Funding (CSEF) through a Securities Exchange Commission (SEC) registered intermediary.  

New Zealand

New Zealand treats equity crowdfunding as financial market service covered under the Financial Markets Conduct Act and is regulated by the Financial Markets Authority. The crowdfunding service provider or the intermediary is required to get a license and adhere to obligations stated in the Act.  

Australia

Crowd sourced funding in Australia is governed by the Corporations Amendment (Crowd-sourced Funding) Act 2017. It reduces regulatory requirements while providing adequate measures for protection of investors interests. Platforms providing crowdfunding services are required to obtain license from Australian Financial Services license. Australian Services and Investment Commission (ASIC) has also laid down regulatory guides for companies and intermediaries regarding crowdfunding. 

Canada

Crowdfunding in Canada is regulated by the National Crowdfunding Association. Equity crowdfunding is regulated in Canada. There are several restrictions put in place like the start-ups can only have two crowdfunding rounds in a year, each investor can invest only a certain amount, there is a cap on the total amount of funds that can be raised. The companies are also required to prepare an “offering document” which contains the details and financial status of the company so that an informed decision can be taken by the investors.

Conclusion

The decision taken by SEBI to not allow equity crowdfunding is correct for the reasons that the regulatory body has stated. Digital crowdfunding can pose great risks due to the prevalent information asymmetry about the companies online. There is no regulation to protect investor’s interests, no obligations on the company raising funds and no liability of the websites campaigning to raise funds. 

Crowdfunding can be a huge aid to entrepreneurs and early stage companies because funds can be raised with ease, without major compliances and it’s cheaper than other methods of raising funds. It is pertinent that the government makes proper regulations and laws to regulate digital crowdfunding, decide the rights of investors and liabilities of companies and intermediary platforms.  

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