Equity Crowdfunding- What is it? Working, Risks involved

The wheels of the Indian economy are said to be going in full swing and the recent GDP figures are a testament to the rapid progress of the country. While there are major banks collapsing in the West and talks of funding winter, India has more than 92000 startups in the country in various sectors like Fintech, Edtech, social impact, Health-tech, and more. However, the main issue faced by a majority of startups is meeting their funding requirements. Equity crowdfunding has proved to be a good source of pooling funds from different segments of investors in the West. But is it possible in India? Check out this blog to know more about equity crowdfunding and if it is possible for Indian start-ups to take advantage of this resource. 

Read More: What is private equity? How does it work? 

What is equity crowdfunding and how does it work?

The term equity crowdfunding is part of the bigger term or the central idea which is crowdfunding. The literal meaning of crowdfunding is attracting funds from the common people who agree or have sympathy for the cause of the fund seeker. The concept of crowdfunding originated for social causes and donations and has now become a source of attracting business investments. There are many types or forms of crowdfunding available which include donation-based crowdfunding, reward-based crowdfunding, equity crowdfunding, and debt-based crowdfunding. 

Equity crowdfunding refers to the funds collected by a person or a business in exchange for equity or shares in the said organisation. The participants contributing to this type of funding are not called donors but are rather known as investors (individuals or businesses) entitled to a stake in the company proportional to their investment. 

Investors do not invest small amounts in this type of crowdfunding but invest huge funds which are usually raised by angel investors or VCs for the startups. Crowdfunding is usually carried out through online or offline crowdfunding platforms like Milaap, Wishberry, GoFundMe, Ketto, Kickstarter, etc. However, these are in the form of donation-based crowdfunding or reward-based crowdfunding as equity crowdfunding is not permissible in India. 

Cases of equity crowdfunding in India

As mentioned earlier, India is now open to the concept of donation-based crowdfunding and reward-based crowdfunding and they are legal in India. However, SEBI has not legalised equity crowdfunding in the country. This is to safeguard the interest of the investors at large and protect them from any fraud like the famous case of the Sahara Scam. 

The Sahara scam resulted in SEBI banning equity crowdfunding in India. It involved millions of small investors who invested in Sahara Bonds under the guise of a private placement, which violated the Companies Act’s regulations. The Apex Court ordered Sahara Group and its subsidiaries to reimburse investors approximately Rs. 17,400 crores within three months, with an added interest rate of 15%. Another case of default through crowdfunding occurred with Deciwood, a startup, raising Rs. 12.50 lakhs via Compulsory Convertible Debentures (CCDs), violating section 42 of the Companies Act 2013.

What are the advantages of equity crowdfunding?

A few key advantages of using equity crowdfunding for startups and investors alike are mentioned hereunder. 

Easy Access to Capital

Equity crowdfunding provides an alternative funding source for businesses, particularly those that may struggle to secure financing through traditional avenues such as bank loans or venture capital. It allows businesses to tap into a larger pool of potential investors, including retail investors, who can collectively contribute smaller amounts of capital. This democratisation of funding increases the chances of securing the necessary funds to fuel growth and development.

Lower capital investment 

Unlike traditional investment channels, equity crowdfunding allows investors to participate with smaller amounts of capital. This makes it more accessible for retail investors who may not have the financial means to invest significant sums of money. Investors can contribute as little as a few thousand rupees and still become a shareholder in promising startups.

Increased Visibility and Marketing

Running an equity crowdfunding campaign can generate significant publicity and exposure for a business. By showcasing their product, idea, or business model on crowdfunding platforms, companies can attract attention from potential customers, strategic partners, and media outlets. The campaign itself becomes a marketing tool that raises awareness about the business, potentially leading to increased brand recognition and customer acquisition.

Access to investment opportunities

Equity crowdfunding provides access to a wide range of investment opportunities that were traditionally limited to venture capitalists and angel investors. Investors can explore and invest in early-stage startups, innovative projects, and social enterprises that align with their interests and investment goals. This opens up avenues for diversification and potentially higher returns on investment.

Portfolio diversification

Diversification is an essential strategy to mitigate risks and maximize returns in any investment portfolio. Through equity crowdfunding, investors can spread their investments across multiple startups or projects, reducing the impact of potential losses. By diversifying their holdings, investors increase their chances of benefiting from the success of a few companies, which can potentially offset any losses from underperforming investments.

High return potential

Early-stage startups have the potential for exponential growth, and if you choose the right ones, your investment could generate significant returns. While investing in startups carries inherent risks, it can also offer substantial rewards if the company succeeds and achieves a high valuation. However, it’s important to note that investing in startups is inherently risky, and there is no guarantee of returns or success.

Support for the local entrepreneurs 

Equity crowdfunding platforms often focus on supporting local entrepreneurship and providing a platform for early-stage Indian startups to raise capital. By investing through these platforms, investors can contribute to the growth of the Indian startup ecosystem and support local businesses and innovation. This can eventually have a positive impact on the economy and potentially lead to job creation and technological advancements.

What are the risks of equity crowdfunding?

Some major risks of equity crowdfunding are discussed hereunder. 

High risk of failure

Investing in startups and early-stage businesses is associated with a high risk of failure. Many startups do not succeed in achieving sustainable long-term growth or profitability. As an investor, there is a significant possibility of losing the entire investment if the startup fails to deliver on its business plan or faces challenges in the market.

Limited information and due diligence

Startups seeking funding through equity crowdfunding may have limited operating history or financial track records. As an investor, the available information for evaluating the investment opportunity may be scarce or incomplete. Conducting thorough due diligence on the business, its management team, market potential, and risks can be challenging. Investors must rely on the information provided by the company and the crowdfunding platform, which may not always provide a complete picture of the investment’s potential risks and rewards.

Lack of liquidity

Investments made through equity crowdfunding tend to be illiquid, meaning it can be difficult to sell or exit the investment before the company undergoes an acquisition or goes public. Investors should be prepared for their funds to be tied up for a considerable period, often several years, without the ability to easily access their money.

Valuation risk

Valuing startups is often subjective and based on future potential rather than concrete financial performance. Determining a fair valuation for a startup can be challenging and speculative. Investors should carefully assess the valuation and consider factors such as the company’s growth prospects, competitive landscape, and market conditions to evaluate the investment’s potential returns.

Failure to meet expectations

Equity crowdfunding campaigns often set fundraising targets to achieve the necessary capital for business operations. A startup must reach its funding goal to avoid facing challenges in executing its business plan and achieving its objectives. Insufficient funds can hinder growth and limit the startup’s potential for success.

Reputation and brand risks

If a startup fails to deliver on its promises or encounters difficulties in execution, it may damage its reputation and brand image. Negative publicity or unsatisfied investors can impact customer perception, partnerships, and future fundraising efforts. Startups need to prioritize fulfilling their commitments and delivering value to stakeholders to mitigate reputation risks.

Conclusion

Many experts believe that equity crowdfunding is the way to go forward to increase access to funding requirements in the country. However, there are many regulatory gaps that need to be addressed like the process of seeking funding, protection of investor’s interest along the way, and ensuring that misleading information regarding such equity crowdfunding is curbed. SEBI is in the process of recognising these gaps and we may see the platforms and the companies seeking such funding coming under the purview of SEBI and related regulators in due course.   

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