Helping start-ups

02 Aug 2018

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OUR existing legal and regulatory landscape is not conducive for crowdfunding, which is one of the ways that start-ups can finance their growth. Recently, the SECP has stepped in and issued advisories cautioning individuals against investing directly in start-ups. The new government may want to reconsider this policy.

The start-up industry, specifically technology start-ups, has only begun to pick up pace in Pakistan. Start-ups, by design, identify a gap in the market and come up with a solution to fill the gap. Erecting regulatory roadblocks that prevent them from accessing capital through crowdfunding would foreclose the creation of new markets.

At present, start-ups have limited options for financing, which include debt financing and venture capitalism, ie selling ownership of the venture to a class of investors who fund businesses in their early stages. But these have their own set of problems.

Crowdfunding can help boost new ventures.

For example, to raise capital through debt, ie taking loans from financial institutions, one prerequisite is an asset that can be used as collateral to back the loan. It is improbable that start-ups initially would have assets valuable enough to be used as collateral. This limitation is more pronounced in the case of tech start-ups, where the underlying asset is intangible, since the financial service industry is yet to make a cultural switch to recognising intellectual property as valuable collateral. Hence, an increasing number of tech start-ups turn to pitching their business idea to venture capitalists but, given the risks associated with investing in young companies, only a selected few can secure financing this way.

Given the circumstances, crowdfunding serves as a decent alternative for emerging business ventures to raise capital by pitching their business idea directly to a large audience without the need to go through cumbersome financing procedures and security regulations.

Interestingly, crowdfunding is proving to be a successful mode of capital formation for emerging businesses around the globe. Sadly, Pakistan is not following the same trend. In fact, the legal and regulatory scheme blatantly favours the incumbents, ie banks, financial institutions and companies that have been in the business for a longer time.

By way of example, Section 27A of the Banking Companies Ordinance 1962 prohibits any person, company, firm, etc from inviting deposits of money from the public for investment in their venture or for borrowing. The section not only prohibits crowdfunding indirectly but gives an edge to the existing players in the market that provide financing by specifically exempting banks and authorised government entities. Consequently, start-up founders are forced to approach exempted entities who enjoy dominance by virtue of Section 27A.

In another example, the nature of crowdfunding, ie appealing to the public for capital, itself makes it susceptible to complex regulations. The Public Offering Regula­tions, 2017, mandates every company raising finances by offering securities, including shares to the public, to comply with the onerous requirements, eg Regulation 3 permits companies to issue shares to the public only where they have been in operation for at least three years and have had a profitable track record for two years. Naturally, for start-ups these requirements operate as an implicit embargo on raising finances from the public and are, therefore, a no-go zone.

To be fair, the rationale for regulatory burdens imposed through the securities and banking laws is mainly grounded in a) the paternalistic instincts of the state to prevent citizens from making bad business decisions and b) to prevent fraud. But protecting against fraud is one thing and restricting the choice of individuals is an­­other. Co­­m­p­le­tely outlawing crowdfunding treads on the latter, and is counterproductive for the start-up industry. Perhaps the new government can follow in the footsteps of the US to strike a balance between deterring fraud, reducing business risks and easing restrictions.

For example, in 2012 the US Congress enacted the JOBS Act that allows small businesses to raise capital from the public provided the transaction is conducted through a broker or funding portal registered with the regulator. The act shifts the burden on the intermediary to reduce the risk of fraud by running background checks on the business, providing complete disclosures to the public and ensuring that the investor understands the business risk. To reduce the risk of investors, the act limits the amount an investor can invest depending on the net worth of the investor.

The good news is that access to capital is a part of the 100 Days’ Agenda proposed by the incoming prime minister. But, whatever scheme parliament adopts to make capital more accessible for businesses, it must immediately makes legislative changes to ease restrictions on crowdfunding for the sake of the start-up industry.

The writer is a lawyer with an interest in intellectual property law.

samar.masood2@gmail.com

Published in Dawn, August 2nd, 2018