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Startup crowdfunding platforms expose investors to grave risks by skirting securities regulations, writes Narayan Kedia, a legal expert at financial services conglomerate Indiabulls

Recent years have seen crowdfunding platforms become a new fundraising avenue for startups, with businesses that are seeking funding, particularly at the early stage, offering equity interests or equity-linked interests to investors through online platforms. Under this method, “securities” of a startup or instruments of a similar nature are offered and issued to retail investors through a crowdfunding platform or website, which serves as an intermediary between investors and the startup.

Raising funds through such platforms is an easier option for startups, as the issuers can reap benefits such as easier access to capital, reduction of costs and advertising. The platforms can also benefit investors, who can make relatively modest investments across a range of opportunities with relatively low transaction costs and obtain equity positions in companies that may eventually prove to be successful and profitable.

However, allowing such structures without regulating them properly exposes investors to a number of risks including systemic risk and default risk. Investments in small-scale companies and startups involve high risk and low liquidity, and uninformed and unsophisticated retail investors not possessing the skills and experience needed to assess risks before investing may act with a herd mentality.

In the case of default or fraud, such investors do not have any direct recourse against the issuer, promoters or directors, given that the issuer did not make an offer through a prospectus, and the promoters or directors of the issuer would not be incurring civil liability or criminal liability for any misstatements.

High information asymmetry is associated with these platforms, where one party may invest or trade based on some information that is unknown to other investors. Since there is a lack of hard information, there is too much reliance in this model on soft information based on social networking platforms, which increases risks. The primary concerns around allowing such platforms to facilitate the raising of funds include lack of transparency and disclosures, information asymmetry and monitoring of funds.

Multiple platforms such as Tyke and Planify allow startups to raise funds from a host of investors, including retail investors, by allowing them to subscribe to instruments such as community subscription offer plans (CSOPs) and compulsorily convertible debentures. Such platforms have access to hundreds of thousands of investors registered on their sites, and advertise offerings by startups or invite subscriptions from a huge base of retail investors registered with them.

Analysis of the Tyke model

Tyke works on a model whereby any entity seeking to raise funds enters into a service agreement allowing access to Tyke’s hundreds of thousands of registered community members. Knowledge about the business of startups or terms of the issue are widely disseminated through Tyke’s website, or “ask me anything” sessions, or recorded sessions uploaded to social platforms. The purpose of these sessions is to aid investors in taking investment decisions.