Failure Of Startups: Need For A Stringent Regulatory Framework In India
Introduction
The evolution of our lives on this planet has been marked by conscious and sometimes subconscious attempts by the human race in pursuance of activities that will make the life of everyone on this earth, easier and more comfortable. Such attempts involved understanding the universe, the way it functions, and the inter-relationship of various materials available thereon. This resulted into the systematic development of various disciplines such as science, which basically understood the order of the universe and captured it in form of laws of science and then put it into practical applications making various machines and appliances for the use of all of us.
The development of science from understanding the law of gravitation by the great Sir Isaac Newton, noticing the fall of an apple from the tree, to launching of a Chandrayan 3 by space scientists, is an excellent example of the continuous human endeavors to understand the law which are in-built in this universe and use the same in combination with the various resources available on this planet and devise something more useful for humans. Such naturally developed activities over a period of time became fulcrum and center point around which the life of the people across the entire globe started evolving.
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Industrial and economic activities necessitated a global system for mobilizing resources, particularly finances, to sustain operations. Financial intermediaries like banks and stock markets provided loans and facilitated share capital inflow and trading. Commercial and corporate laws, including company law, taxation laws, labor laws, employment laws, and security laws, have evolved to regulate entrepreneurial activities in the economy. The primary function of these laws is to ensure smooth resource movement, fostering confidence among stakeholders and protecting investors who invested in business activities.Still, there do exist some unscrupulous elements that steer their unlawful and unethical intentions by exploring loopholes in the system.
Indian Start-up Ecosystem
A startup is defined by the Department of Industrial Policy and Promotion (DIPP), as an entrepreneurial endeavour to create a marketable good or serviceIt may be defined as a scalable business model with high potential for employment generation or wealth creation. The DIPP defines a startup as an entity that will be a startup for 10 years from its foundation, with yearly turnover not exceeding Rs. 100 Crores. Startups can take several forms, including Limited Liability Partnerships, private, public, listed or non-listed, and can be. However, start-ups often start with high costs and limited revenue, making it difficult for them to mobilize capital from traditional channels like the stock market or financial institutions. Consequently, they seek capital from venture capitalists and crowdfunding.
Startups require capital for growth, particularly at the early stage. Venture capitalists, online crowdfunding, and angel investors are a few popular sources of fundraising for these startups. Government grants and loans are also available for startups in various industries;two of the most popular government schemes for startups are The Startup India Seed Fund Scheme and the Startup India Initiative. These initiatives aim to facilitate the growth of startups in India.
The Failure Analysis
It has been observed that 90% of the startups have failed within the first five years.
Zomato Case
The Initial Public Offer (IPO) of Zomato which came in July 2021, was not only oversubscribed but also the share with the face value of Re. 1/- was offered with a premium of about Rs. 115. That is, a share of the face value of Re 1/- was purchased by the initial investors at a price of Rs. 116, paying Rs. 115 over and above the face value. The share was over-subscribed about 38 times and enabled the company to garner about Rs. 9375 Crores.
Zomato had been making substantial losses, with its operational losses being about Rs. 467 Crores in the Financial Year 2020-21 and increased to Rs. 1844.5 Crores in the Financial Year 2021-22.
The company was making a loss even at the time when the IPO came to the market. Subsequently, its financial situation worsened with increasing losses.
Byju’s Edtech Case
This Start-up was formed about a decade ago when it held an excellent promise of business and became highly successful in its activities. Its evaluation had reached beyond Rs. 1 Lakh Crores. However, in the later stage, the company borrowed heavily and inflated revenue by misrepresenting the accounts. The company also deviated from its core business activities. This resulted in the default in the repayment of the loans and a liquidity crunch, as a result faced litigation from the creditors.
Byju is facing regulatory scrutiny from the Securities and Exchange Board of India (SEBI) regarding the allegations that the company inflated its revenue and profits. The Ministry of Corporate Affairs (MCA) and the Competition Commission of India (CCI) are investigating Byju’s alleged anti-competitive practices and accounting practices.
In both these cases, it was observed that the startups, which are issuing shares and expanding their business without being in a sufficiently robust and stable state, affect the market and the interests of the investors and may attract litigation.
In the case of Zomato, the company was making losses even at the time when the IPO came to the market. Subsequently, its financial situation worsened with increasing losses. Through the funding from the investors, the company could garner about Rs. 9375 Crores by selling a share of the face value of Re.1/- at a price almost more than 100 times.
While this enables the promoters or start-up entrepreneurs to get out of the business and even make money or fortune from it, it gets funded by ordinary investors, many times investing unknown and unaware of the high risk or rather certainly of his investment getting duped.
Similarly, in the case of Byju’s Edtech, it had been a promising startup which went wrong by losing sight of its core mission and values, pursuing unsustainable growth, comprising on quality and ethic, and ignoring the warning signs of financial distress.
Need for a Regulatory Framework
While it can be said that caveat-de-emptor, that is, “let the buyer be aware” principle, should apply here as well, we cannot ignore the ground reality and ultimate objective of the entire ecosystem, which intends to mobilize the financial resources from every nook and corner of the economy, where it is available and channelize it to a genuine entrepreneurial activity.
Given the above real-life scenarios, the issue of capital can be seen as a major cause for trepidation for entrepreneurs and venture capitalists alike. For start-ups, it poses the obvious dilemma; is it worth sacrificing one’s vision, talent and unique idea for the sale of capital? Capital, undoubtedly is important, but does it necessarily have to be at the cost of creativity and control over one’s own idea?
There is a need for more stringent regulations to ensure that the start-up business activities (whether listed or unlisted) in whatever form being conducted, needs to ensure that do not deploy the funds in an activity that is deviating from the core business for which the investors had invested the money. A regulatory framework which in matter of IPOs, especially floated by the start-up ventures clearly brings out the risk factors un a conspicuous manner along with a report of the Risk Analyst with regards to various risk factors associated with the business.
Moreover, these reports shall be made public within a stipulated time, periodically, giving a clear assessment report of the risk profile of the business such that it facilitates the investors to make a wise and informed choice.
Regulatory Framework in the USA (a developed country) – A Comparative Analysis
The ecosystem that a country provides to its start-ups, plays a vital role in their advancement.In its nascent years, a start-up cannot be expected to meet procedural compliances as it neither has the resources, nor the time to do so.The Indian Companies Act, 2013 was amended by the Central Government of India on June 13th, 2017, to align with ‘Start-up India’ and simplify the incorporation process. The Act recognizes the Department of Industrial Policy and Promotion’s definition of start-ups and integrates various pre-incorporation forms. Sections of the Act were also amended to include exemptions for procedural compliances during the first five years of raising deposits from shareholders and preparing cash flow statements during submitting financial statements. However, these changes raise the potential for fraud for investors due to the lower degree of regulations. The ecosystem provided by a country plays a crucial role in start-ups’ advancement.
The Jump start Our Business Startups (JOBS) Act, 2012, is a US legislation that allows startups and small businesses to raise capital through crowdfunding by offering securities, both debt and equity. This act relaxes the strict regulations imposed on small businesses by the Securities Commission (SEC), allowing them to advertise securities offerings and reduce reporting and disclosure requirements for companies with less than $1 billion of annual revenue. It also increases the number of companies that can offer stock without complying with SEC regulations and facilitates greater access to crowdfunding.
The JOBS Act benefits entrepreneurs by removing barriers to raising capital and allowing them to directly solicit potential investors. However, it also increases the riskof fraud for investors due to a lower degree of regulation and decreased disclosure requirements. To address this issue, the SEC adopted Regulation Crowdfunding (2015) in 2015. This rule set investment limits to securities-based transactions and mandated disclosure of information in filings with the Commission, investors, and intermediaries that help with the offering. However, certain companies are not eligible to use the Regulation Crowdfunding exemption, such as non-US companies, Exchange Act reporting companies, certain investment companies, companies that fail to comply with annual reporting requirements, or a specific business plan.Another drawback of the JOBS Act was to make it more difficult for retail investors to participate in private placements.
In 2019, the SEC adopted Regulation A+, which allowed the companies to raise up to$50 million from both accredited and non-accredited investors and provided more transparency to investors before investing, than other types of private placements
Recommendations
The legal framework for IPOs in India needs to be adapted to ensure a conducive environment for innovation and technical pricing algorithms. Indian regulators should emulate developed nations like the US, promoting venture capital communities and mitigating investor risk. More detailed regulations should be implemented for start-up conduct, including diversification from core activities, financial statement publications, and transparency in accounting practices. Additionally, start-ups should be transparent about their financial health and risk analysis reports, preventing the irony of loss-making promoters selling shares at high face value and duping investors. This will help ensure a safer and more transparent IPO process.
Conclusion
Although startups are often perceived as a faster route to success and wealth, they inherently entail unpredictability and danger. A stringent regulatory ecosystem would safeguard the interests of investors. In order to ensurelong-term prosperity and advancement, protect the interests of the investors and provide a thriving entrepreneurial ecosystem, it is necessary to have a structured and robust ecosystem.
Author: Vaishnavi Choudhary, in case of any queries please contact/write back to us at support@ipandlegalfilings.com or IP & Legal Filing
References
- A Critical Comparative Analysis of the Emerging and Maturing Regulatory Frameworks: Crowdfunding in India, USA, UK, by Divya Ashta
- Allowing Ideas to Change our World: An Analysis of the Corporate Regulatory Framework for Start-ups in India, by Nitansha and Shivam Sinha Burghate
- Regulation Crowdfunding, US Securities and Exchange Commission
