Crowdfunding has aided in bringing the Internet’s power to investment. Major businesses creating market-disrupting technologies like the Oculus Rift have gotten their start by accumulating tiny donations from a very broad number of individuals since the debut of sites like Kickstarter in 2009. Here’s a rundown of what crowdfunding is and how to avoid common crowdfunding legal blunders.
What Is Crowdfunding?
Beyond typical fundraising approaches such as soliciting financial help from friends, family, banks, angel investors, and venture capital companies, crowdfunding may be a valuable tool. A startup can raise modest sums of cash from a big number of people to support a new business endeavor by creating an account on an internet crowdfunding platform.
Offering a first-run item or any other reward in exchange for a monetary contribution is the classic approach to crowdfunding. Contributors are not given any equity and have no right to be reimbursed.
In many situations, the procedure is more akin to a pre-sale of your product than an investment, and it is unregulated by the federal Securities and Exchange Commission (SEC).
Equity crowdfunding, which was made possible by the Jumpstart Our Business Startups (JOBS) Act, is a newer alternative that enables you to seek small contributions from a big number of people. Similar to a typical crowdfunding campaign, you utilize a crowdfunding site to submit a listing, only your funders become shareholders. As specified in the shareholder agreement, this includes voting and dividend rights.
Kickstarter, Indiegogo, and GoFundMe are three of the most popular crowdfunding services for small businesses. MicroVentures and Angel List are two crowdfunding platforms targeted more toward investors.
General Legal Issues Related to Crowdfunding
While traditional crowdfunding (in which no equity is exchanged) is not subject to federal securities laws, there seem to be a few legal considerations to be aware of:
If entrepreneurs post someone else’s copyrighted material without permission, they risk being sued for copyright infringement. Furthermore, you should consult an attorney before discussing your innovation on the internet; for example, it may be prudent to file a provisional patent application to protect your rights.
Before you upload specific material on a crowdfunding website, you may wish to register for a copyright or trademark. Uploading your intellectual property on the internet raises the likelihood of it being copied or stolen. In this short guide to IP for startups, you can learn more about how to effectively protect your intellectual property.
Form a Business
There are advantages and disadvantages to every sort of business structure, but it is critical for businesses seeking to crowdfund to establish a company and open a business bank account as soon as possible (instead of operating as a sole proprietor by default). In addition, specified business structures can help shield the founders from personal liability.
For businesses seeking funding, LLCs are a common structure. You can learn more about why Delaware is the most popular choice for incorporating a potentially large company seeking venture capital here.
Seek Tax Advice
Income taxes may apply to the proceeds from “rewards” and the pre-sale of products. Seek the advice of a tax specialist.
If you don’t keep your end of the bargain with your backers or otherwise do something that violates state consumer protection laws, you might face legal repercussions (such as making misleading statements). In Washington State, for example, enforcement action was taken against a crowdfunded project that failed to produce as stated.
Additional Legal Issues for Debt Crowdfunding
Because debt crowdfunding involves the sale of securities, the legal concerns become considerably more difficult.
The Jumpstart Our Business Startups (JOBS) Act of 2012 included a provision in Title II that provided an exception from a federal security statute, allowing for widespread debt crowdfunding. The SEC then issued regulations to implement the JOBS Act, which became effective in 2016.
The following are the main features of the new equity crowdfunding exemption:
- Over the course of a year, the firm can raise a total of $1 million.
- Based on their income or net worth, investors are limited in how much they may invest. Furthermore, throughout a 12-month period, investors can only contribute a total of $100,000 in all such campaigns.
- A broker-dealer or a licensed fundraising portal must be used to make the offering.
- The exception does not apply to firms based outside of the United States.
- The SEC usually requires the firm to file a very detailed offering statement (including financials), progress updates, and yearly reports. For many small businesses, the administrative overhead of reporting required for crowdfunding may be too great.
- The amount of advertising and promotion that may be done for the offering is limited.
- For the first year, securities cannot be resold.
Furthermore, several states have passed their own crowdfunding laws, so you need to conduct some further study for your jurisdiction.
The Bottom Line
Raising money for a crowdfunding campaign is not the same as raising funds for your company. You must be mindful of both federal and state securities law in order to avoid running afoul of regulators.