India, over the past few years or so, has been recognised globally as a centre for successful startups. India’s success story amongst many other factors may be attributed to available opportunities to create efficiencies in (read as disrupting) existing business models; availability of talent; creating new markets using technologies; and brave innovations. In addition to these factors, founders in India were able to attract global capital at the early stage, growth stage and late stage in the form of funding through convertibles, equity, debt as well as structured products. However, getting capital from investors, whether globally or from India, takes humungous amount of time and effort. Further, it can be safely assumed that not every pitch or introduction of the startup opportunity will result in a successful fund raise. On the contrary, investors typically refuse more than a majority of the opportunities they see. For instance, from this article it is seen that the chances of being funded by Andreessen Horowitz, a leading venture capital fund, is approximately 0.7%. Accordingly, the entire fund raising exercise by founders of these ventures would be to reach out to as many investors - big or small, global or domestic; institutional or ad hoc - to ensure that their ventures are able to sustain themselves for as long as possible!
Most of the startup ventures in India are incorporated as a company limited by shares registered under our company law, currently, the Companies Act of 2013. The company law stipulates the rules and regulations a company needs to follow for raising funds by issuing securities, such as equity shares, preference shares, convertibles, etc., to the investors. One such stipulation is that an offer for shares by a company cannot be made to more than an aggregate of 200 persons in a financial year. Further, all persons who may be given an offer to invest must have been identified by the board of directors of the said company. Additionally, once an offer to subscribe is made by a company, the company may not issue any fresh offer to subscribe to shares until the previous offer has been completed, withdrawn, or abandoned. The law also does not permit a company to use public advertisements, or any form of media, marketing, or distribution channels to inform the general public about any such issue of securities by the company.
Further, the Indian securities market regulator, SEBI had in the year 2016, cautioned investors against using electronic platforms that facilitate fundraising as such platforms may be considered to be similar to stock exchanges and may breach the Securities Contract (Regulation) Act, 1956, which stipulates the law in India for establishing stock exchanges.
In view of the above, the startup industry in India has received a serious jolt as: (a) limitation of reaching out to maximum of 200 investors in a financial year may impact fund raising; (b) it may not be feasible for the board of directors of a startup company to identify all persons with whom the offering document is being shared; and (c) if the fundraising attempt is unsuccessful, each such attempt must be declared as withdrawn or abandoned by the board of the company. Additionally, the bar on use of any form of marketing or distribution channels, or public advertisements for any pitch sessions, or events, may in itself be considered to not be in strict compliance with the law.
The above provisions of the law were recently analysed by the Registrar of Companies, Delhi, in the matter of Anbronica Technologies Private Limited (Anbronica Order). In this case, a startup and its founder directors, who had used the services of a digital platform to access potential investors, and subsequently raised funds had been held to be in breach of applicable law.
While the above case was limited to use of an electronic platform for raising funds, the relevant provisions of company law will apply similarly to physically conducted startup pitch sessions and networking events, where in aggregate a startup may offer its securities to more than 200 persons in a financial year, or may make use of digital channels for generating awareness for such events.
Another point to note in the Anbronica Order were the observations in relation to the concerned digital platform that while the platform had clearly facilitated the non-compliance by the company, the platform itself could not be penalised under the Company law. Considering the earlier advisory by SEBI on the issue, it remains to be seen whether SEBI may initiate any action against platforms currently operating in the industry, or take any other steps to address this regulatory arbitrage.
Our Thoughts
We are of the view that the relevant provisions of the company law were enacted with the primary purpose of prohibiting the issue of capital by private companies or closely held companies to the public. The intent of enactment of the law was not to curtail the needs of the startup industry.
In the current landscape, where startups have become an important part of the Indian economy, fund raising limitations as stated above may not be in the best interests of all stakeholders. While it is certain that the existing law had been put in place with investor protection as its key objective, it must be noted that persons participating in these fund-raising may be aware of the high risks associated with such investments. It is recommend that as the government is pro-actively working to resolve the angel tax issue, this issue is also resolved right away before it starts hurting the Indian startup story!
Authors: Souvik Ganguly and Aman Bagaria
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