What is crowdfunding and how does it work?

To understand, the real meaning of Crowdfunding, let’s proceed in knowing the general meaning of the two word individually that leads to form one i.e. ‘Crowd’ &’Funding’. If we refer to the general dictionary meaning of the term ‘Crowd’ it means a large number of people gather together in the public place whereas on the other hand ‘Funding' refers to the act of providing money for a particular purpose. So, if we combine the two and interpret in terms of their usage with respect to the commercial practices where the business or start-ups or organisations and for that matter where even the individuals come together to fund a certain business objective(s) for instance project etc, in which the contribution amount is variable.

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In our Country, there are certain kinds of crowdfunding,to know more about these we would require to know the definition of Crowdfunding defined by SEBI guidelines through it’s consultation paper which is “ Consultation Paper on CrowdFunding in India ” as follows:
“
2.1 Crowdfunding is 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.

2.2 Crowd sourced funding is a means of raising money for a creative project (for instance, music, film, book publication), a benevolent or public-interest cause (for instance, a community based social or co-operative initiative) or a business venture, through small financial contributions from persons who may number in the hundreds or thousands. Those contributions are sought through an online crowd-funding platform, while the offer may also be promoted through social media.
”

Thus, following shall be the essentials of the Crowd Funding:

1) solicitation of funds;

2) multiple investors;

3) usage of internet to access online social platforms;

4) for the fulfillment of the objective(s) which may be commercial or social;

5) may involve promotional activity via social media platforms;


Let’s go ahead and try to know as to how many categories does it can be divided further:

1) Donation Crowdfunding: Donation crowdfunding denotes solicitation of funds for social, artistic, philanthropic or other purpose, and not in exchange for anything of tangible value.The Most recent example of this category of crowdfunding in India as well as around the globe is donation to the Prime Minister Covid Relief Fund established by the government where any person can donate/ invest for social causes which shall be used to provide relief and medical aid to covid victims, Ketto (platform like these only raise money for those projects which are related to social causes).

2) Reward Crowdfunding: Reward crowdfunding refers to solicitation of funds, wherein investors receive some existing or future tangible reward (such as an existing or future consumer product or a membership rewards scheme) as consideration. Most of the websites which support donation crowdfunding, also enable reward crowdfunding, e.g. Kicktstarter, Rockethub, Wishberry etc (platforms like these help only the creative projects to raise funds and offer discounts to the investors as may be reasonably applicable.

Note: The Donor/grantor must expect any  financial return in the form of a yield or return on investment. So, funding in the above two categories does not remain within the boundaries of  the Securities market regulator. (In India, payment of donations are mainly governed by the provisions of Income Tax Act)

3) Debt Crowdfunding : Also known as Peer-to-Peer lending,popularly known as “Market lending”, where an online platform matches lenders/investors with borrowers/issuers in order to provide unsecured loans and the interest rate is set by the platform.Some of the leading examples from the US are Lending Club, Prosper etc. and from the UK are Zopa, Funding Circle etc.

Peer-to-peer lending did not appear to involve securities;loan/notes/contracts can be traded on a peer-to-peer platform or a secondary market. Thus, these loans may become securities, with the contract between the lender and the borrower being the security note. Meaning thereby,the money pledges will later on become a loan that must be repaid at the interest within the predefined timeline. For this only NBFC has acquired special license from RBI who is further authorised to indulge itself in business. For example, Faircent, i2ilending are the names of the platforms who are enabling this to make this happen.

4) Equity based Crowdfunding : It is one of the categories which is declared to be illegal in our Country on grounds that it  has been considered as “unauthorised; irregular”. Inhere, the investor investing money in the company receives in return the fixed number of equity shares for the amount of the investment made by it which is particularly seen to be when the business is in the early stages.

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Why do we need Crowdfunding, is it really beneficial ?

1. Act as an effective source of finance generation for start-ups, and to the Small& Medium Sized Enterprises plays the role of front runner in the areas of handling finance mechanisms supporting sustainability initiatives.

2. Further it shall aid and contribute when there is a need for funding through Alternative Sources when the banking institutes encounter limitations to lend. 

3. Promote raising of funds at a much lower capital cost.

4. It will promote healthy competition and remove unfair practices and hardships created by certain funding providers in the market space.Not only this it creates new opportunities for the investment avenue and further related diversification etc,.

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Considering the above mentioned, we must also realise that there can also be a substantial amount of risk attached to these sorts of investments/crowdfundings. Some of them are as follows:

1. May become a victim of fraudulent practices likewise identity theft, issues related cyber security and attacks etc,.

2. Improper usage of online platforms through the internet can be made in such a way which can influence and affect the young minds or vulnerable group of people irrespective of the age group they may be of.

3. Since it is being done remotely which can be anywhere in the world, there is always a change of non-compliance of the locals/nations laws as may be required by default.

4.  Principles of good diversification are easily neglected or attempted to be ignored by choice.

5. Huge risk of illiquidity and money laundering is always attached.

SEBI has taken various steps & measures with regards to the Funding for the Startups and SME via various routes namely as SME Segment of Exchanges, Institutional Trading Platform (ITP), Category I- SME Fund under AIF Regulations giving them multiple scenarios of claiming relaxation under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 with regards to SMEs listing on SME segment which is also inclusive of  continuous listing requirements for Companies listed in SMEs. Other than these relaxations, to ensure liquidity of the companies listed on SME segment there is a compulsory market making requirement for companies listed on SME segment for a minimum period of three years from the date of listing. This all is to provide an enabling environment for SME and start-up enterprises to flourish so that they can accelerate impetus.
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Subsequently,realising the sensitivity attached with the Alternative investment funding, where all the players may not be registered and holds up a threat of misuse along with other ingrained risks due non registration. SEBI notified the framework for registering and regulating

Alternative Investment Funds (AIF) through SEBI (Alternative Investment Funds) Regulations, 2012 on May 21, 2012 and addressed the regulatory gap and can be vigilant. So, in order to prevent investors from the risk attached with startup ventures it is proposed to allow the participation of the “Accredited Investors” who may also be meeting the eligibility criteria of the ERI’s (Eligibility of Retail Investors) which emphasis upon their investment experience, financial capacity & standings in order to face losses, if any may arise along with the some of the other guidelines which are being issued from which few are as undermentioned:

1. Companies having net worth of 20 crores minimum which are incorporated under Indian Companies Act.

2. Minimum net worth Rs. 2 Crores or more (excluding the value of the primary residence or any loan secured on such property ) of the individuals of high net worth  (HNIs)etc,.

3. Qualified Institutional Buyers (QIBs) as may be in SEBI Regulations, 2009 (Issue of Capital and Disclosure Requirements) with Amendment as may be applicable.

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To be more specific with regards to the, ERI criteria refer the following :
i) who receive investment advice from an Investment Adviser, or

ii) who avail services of a Portfolio manager, or 

iii) who have passed an Appropriateness Test (may be conducted by an institution accredited by NISM or the crowdfunding platforms), and 

iv) who have a minimum annual gross income of Rs. 10 Lacs, o who have filed Income Tax return for at least last 3 financial years, 

v) who certify that they will not invest more than Rs. 60,000 in an issue through  crowdfunding platform, 

vi) who certify that they will not invest more than 10% of their net worth through  crowdfunding. (Net worth excludes the value of the primary residence or any loan secured on such property).

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In 2016, near to the end of this year, SEBI has openly expressed and issued warnings notifying that crowdfunding via means of equity crowdfunding is irregular and unauthorised and further questioned the legitimacy of the private bodies who have emerged and been acting as the stock exchange body keenly up and serving startups leading to the breach of the Indian Companies Act and other relevant laws & regulations where through electronic platforms fundraising is been done in private domains. At the same time, the Crowdfunding category of donation or reward is allowed and has been practiced hugely and can be evidently seen. One of the reasons for its commonly being done via using similar electronic platforms as the equity crowdfunding may be using is the fulfillment of the social interest/objectives(causes) which is in the welfare of the society at large.

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The Role of SEBI with respect to Crowdfunding is highly crucial to monitor and warn for the security risk and issue preventive guidelines as fundraising is mostly via the electronic platforms so a cost efficient & effective method has to be proposed which may be limited to some of the under listed scenarios :

1. Recognise all the electronic portals meant specifically for the crowdfunding;

2. Issue mandatory guidelines to be in compliance with; 

3. Period inspections/ Audits of platforms; 

4. Effective enforcement of rules & regulations relating to crowdfunding;

5. Making sure that it does not at all involve itself in reviewing the offer letters of private companies in relation to it.

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Thus, after considering the above mentioned, one concludes that as per SEBI any facilitation of the funding to startups on the digital platforms is illegal, unauthorised, and not recognized in the eyes of laws leading to the violation of all laws governing the Security Market.

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