The lack of sufficient funding has been cited as an important reason for the failure of many Indian startups. The case of redbus.in is a classic example of the high handedness of venture capitalists (“VCs”) that have traditionally been the main source of funding. All this may change soon because of regulatory developments in the United States and in India aimed at making it easier for startups to access capital from the securities markets.
Last week, the Securities Exchange Commission of the United States (“SEC”) released Regulation A+ to implement Title IV of the Jumpstart Our Business Startups Act, 2012 (“JOBS Act”) and SEBI released a discussion paper proposing an alternate platform for raising capital for startups. Though there are many parallels between the two frameworks, Regulation A+ is the SEC’s second attempt to meet the funding requirements of startups. For India, the question is whether the SEBI will get it right in its first attempt.
High compliance costs under Regulation A
Under a previous avatar known as Regulation A, small and medium sized companies in the United States could raise upto USD 5 million in a year without registering with the SEC. Companies however, still had to file prospectus with the SEC and comply with the registration requirements of the applicable state securities laws, known as “blue sky laws”. The USD 5 million limit on the size of the offering, along with the cost of compliance, made the offers unattractive. Regulation A+ has now increased the offer size to USD 50 million and with the JOBS Act authorising the SEC to preempt blue sky laws by framing new regulations, reduced the cost of compliance.
IPOs on the ITP
In October, 2013, SEBI launched the Institutional Trading Platform (“ITP”) where small and medium-size enterprises and startups could list their securities without bringing an IPO and by complying with Regulation 106Y of the Issue of Capital and Disclosure Regulations, 2009. Till now, companies listed on the ITP could raise funds only through private placements and rights issues of their securities. Now, SEBI has proposed a new route through which professionally managed startups having innovative business models and belonging to the knowledge-based technology sector can bring an IPO for listing on the ITP.
Interests of retail investors
Capital markets regulators are sentinels for the interests of retail investors and they need to be sensitive to the risks associated with the high rate of failure associated with the startups.
Regulation A+ envisages two tiers. In the first, companies can raise in a year, up to USD 20 million and in the second, USD 50 million. The first tier requires SEC qualification along with state approval. The second requires only SEC approval. Unaccredited investors can invest in Tier 2 offerings up to ten percent of their annual income or net worth, whichever is greater. They will need to provide representations and warranties about their income or net worth to ensure compliance with these limits, thereby freeing issuers from extensive documentation reviews and verification procedures. There is no such limitation on the investment of unaccredited investors under Tier 1. Since Tier 1 is subject to blue sky laws, unaccredited investors are protected by the respective state laws. Companies can raise funds on the basis of reviewed financial statements under Tier 1, but Tier 2 requires audited financial statements.
SEBI’s proposed framework bars retail individual investors from investing in the offers for listing on the ITP. Only qualified institutional buyers (“QIBs”) and non-institutional investors (“NIIs”) would be eligible. The minimum application size for the offers has been proposed at 10 lakh rupees. These provisions ensure that only high net-worth individuals can participate.
Only professionally managed startups with innovative business models and belonging to the knowledge-based technology sector will be eligible issuers under the SEBI proposal. Only startups in which no person (individually or collectively) holds 25 per cent or more of the pre-issue share capital will be considered professionally managed. Often, after many rounds of funding, the holding of promoters in startups falls below 25 per cent.
Regulation A+, on the other hand, does not restrict the issuers only to the knowledge-based technology sector. All development stage companies with a specific plan or purpose are eligible.
Lock-in requirements intertwine the fortunes of the promoters with the success of the company. Under the ICDR Regulations, 20 per cent of post-issue capital should be locked in for three years. Lock-in requirements do not ordinarily apply to venture capital investors in regular IPOs. Under the new framework, SEBI has proposed that the entire pre-issue share capital should be locked in for six months. This requirement will apply uniformly to all shareholders. This proposal bars venture capitalists from selling their stake at the time of the offer. They will only be able to sell their stake after the cooling off period of six months, which is enough time to settle the frenzy surrounding the offer.
Under Regulation A+, existing shareholders can sell securities worth not more than USD 6 million under Tier 1, and not more than USD 15 million under Tier 2 during the first and second years (See, pages 34 and 35). However, in second year, the limitation applies only on affiliates shareholders.
While SEBI has ensured that the proceedings from an offer should only result in capital for the startup companies by locking-in the entire pre-issue share capital for six months, the SEC has allowed existing shareholders to make secondary sales of securities during a Regulation A+ offering. The SEC also has ensured that promoters remain invested for at least two years.
SEBI has also proposed that the prospectus should be in compliance with the various ICDR Regulations subject to exemptions that align with the the needs of startups and to ensure that prospective investors make informed decisions. Startups do not need to outline the objects of the issue in greater detail as required in a regular IPO. Rather, they can indicate general corporate purposes. The proposed framework gives greater autonomy to startups in pricing their issue, except that there cannot be any forward looking statement while disclosing the basis of the pricing.
Offers under Regulation A+ need to file Form 1-A with the SEC for its approval. This form contains itemised information similar to Form S-1 for registered IPOs, but is scaled back. It has three parts: notification, offering circular, and exhibits. Companies cannot use an offering circular without the SEC’s approval.
Surya Kumar Geda is a student in his final year at the Faculty of Law, New Delhi.