In November last year, the U.S. House of Representatives had passed a crowdfunding bill that will allow startups to offer and sell securities via crowdfunding sites and social networks. While the bill passed in the U.S. will not have an immediate impact in India, as the regulations for Crowdfunding are still not defined, but it will surely set a benchmark. Startups can look forward towards new avenues of funding support where the financial support from the Angel investors are still embryonic.
When the startups are facing a lot of trouble in raising capital for transforming their ideas into reality, Crowdfunding has become a favorite spot for them to raise fund. Entrepreneurs would have the ability to raise funds up to $2 million by issuing shares/ securities to small investors, thus providing them the ability to divest a smaller stake in the company for raising fund, as opposed to searching for an Angel who would take a large stake for the funding. “The small investors will have the option to invest in great and attractive ideas at a reasonable entry as opposed to paying a massive premium in an IPO reducing the potential upside,” says Rajeev Srivastava, Managing Partner, Basil Partners.
India already has the existence of crowdfunding for startups and early stage companies, but the only difference being most of the funding thus raised is in the form of debt as opposed to equity, thereby ensuring no benefit for the investors. Basically, crowdfunding is the amount of fund raised through friends, strangers and family for smaller projects. The process functions are somewhat similar to the microfinance that is same for the small and medium size enterprises, where people have great ideas but initially no one funds them due to high risk and low returns.
The investment made by these small investors generates some profit, which is returned to the investors as per their investment proportion along with the principal amount. The profit thus generated from this investment is fully taxable. “Regulation and investor protection are going to be the key to investors looking at crowdfunding as a serious option,” adds Srivastava.
It would also be interesting to see how these small shareholders for a small entity are being managed. But why India lacks the crowdfunding ecosystem? A poor track record of alternative investment options in the past, low risk appetite among investors, especially for unknown individuals, lack of regulation an investor protection, lack of financial transparency, and several other factors have led to a slow growth of the crowdfunding ecosystem in India. “Lack of clarity and understanding on exit options available to them, including trading of securities in case of liquidity requirements is a major hindrance in the growth of crowdfunding ecosystem in India,” adds Srivastava.
Unless there is clarity on the above said points, the small investors would have no negotiation power, as is available to the angel investors, to obtain visibility in the operations and true financial health of the company. Whatever may be the case, but startups are going to give a chance to raise fund from the crowdfunding sites as it is one of the preferred options to minimize the debt component as well as reduce the stake of the company being divested to the Angel investors. Investors will also look forward to explore the option with the hope of getting high exit multiples and focus on promoters who can be vouched for by known associates and friends.
While the concept in itself is quit wide, it does give rise to issues pertaining to securities regulation, especially if fund raised against insurance of securities that provides investors with some interest in the issuing company. So, what will be the change in the pitch that the Angel Investors would expect from such companies trying to raise fund from the crowdfunding sites? “Advisors who might not have funds might be willing to work with startups, may be on the side, which is definitely going to improve things. Retail investors may want liquidity without waiting for 5-10 years, so some sort of secondary market formation, or ability of promoters to buyback might be key,” says Alok Mittal, Managing Partner, Canaan Partners.
Startups tend to be more realistic in exit options and multiples when pitching to Angel Investors. They are likely to present highly optimistic returns in the case of crowdfunding. This would be due to lack of a formal due diligence by the investors in their model. Also, the startups would need to pitch in a way they stand out from the crowd, engage people, and capture their interest and imagination. It is also likely that the startup will focus more on visible trends, and fads to encash upon a hype prevalent in the market.
With so much of benefit for startups, how safe is it for them to sell securities and stocks via crowdfunding or social networking sties? An effective use of technology would aid the issue of securities to investors, which is one of the primary concerns. The transfer of securities to the third parties by investors would lead to logical issues related to share registry management. Mittal adds, “Indian investors need to mature to understand startup risks-otherwise they can lose their money. Also, Indian startups typically require somewhat similar funding as US startups so the pool of potential investors (with sufficient net worth) will be restricted”.