Crowdfunding: A Primer, Part 2

Here in Part 2 of this post sharing information about crowdfunding from a recent seminar hosted by the Boston Bar Association, I’ll discuss some of the risks that can come up with crowdfunding.

The risks of crowdfunding

Despite its attractiveness and popularity, each crowdfunding platform carries its own risks. First, you will want to be aware of whether the particular site you’ve chosen to crowdfund on is an “all-or-nothing” site. “All-or-nothing” sites, which include popular platforms such as Kickstarter, don’t actually provide the money raised unless the funding goal is actually reached. Of course, there are plenty of platforms that do let campaigns keep whatever they can raise; however, the fees they charge (all platforms charge some sort of transaction fee to run a campaign on their site, generally a percentage of the total raised) tend to be higher than sites that have the all-or-nothing approach.

All crowdfunding platforms do some sort of due diligence on each campaign that signs up, to ensure that each campaign is actually legitimate. Even if your campaign is perfectly legitimate, the big risk that carries across every type of crowdfunding platform is making promises your venture can’t keep. What happens in the event your project goes belly-up? Many of us in the legal community wonder if there may be a cause of action for false advertising, or unfair and deceptive business practices (Chapter 93A of the Massachusetts General Laws, although every state has a similar statute on its books). What happens if you spend the crowdfunding money not exactly in the way you promised? And if there is liability, would you be subject in your state, or in the state or states where your crowdfunders are located?

There are also IP issues that can come up in all crowdfunding platforms. In the terms of service of many crowdfunding platforms there are IP license clauses you should pay particular attention to make sure that they comport with your venture’s IP strategy. In addition, it is also considered wise to begin the process of registering your venture’s trademarks and web domain when you begin crowdfunding to protect them. However, on the other side, crowdfunding campaigns may announce to third-party IP holders that you may potentially be infringing on their IP, which could bring about infringement litigation that you venture likely has neither the time nor the money to handle. Finally, if your crowdfunding campaign involves the creation, development, or refinement of a patentable product, the mere act of launching the campaign may trigger deadlines that you have to file patent or provisional applications by, so it is best practice to speak with a patent attorney to ensure that you aren’t unwittingly putting yourself on the clock, or so that you at least know when you need to have applications filed.

Donation and reward crowdfunding raise a few tax issues that you should be cognizant of. First, be aware of whether you need to pay tax on the money you raise through your campaign. Secondly, find out whether you may have to pay taxes if your reward crowdfunding campaign involves sending contributors the actual product you are developing with the money — it may be categorized as a sale, which requires the payment of sales taxes (in fact, Kickstarter has recently begun discouraging ventures from simply trying to sell their product through the Kickstarter platform).

With P2P platforms, you should remain cognizant that it is a loan, and as a result your company and/or you personally may be subject to a credit check. If you default, it can significantly damage your business’ credit (or your own if you personally guaranteed the loan). Furthermore, you should read the fine print with P2P platforms; some platforms involve banks, so you will want to be sure who is the actual note holder, whether it is the crowdfunders or a bank (or if the bank is just the servicer of the note).

The risks of equity crowdfunding are unclear at this point, as we’re still waiting on SEC regulations to flesh out the equity crowdfunding mechanism. As a result, for right now, crowdfunding involving any equity or securities is, at the very least, in a legally grey area, if not outright illegal. Once equity crowdfunding becomes fully legal, it will raise additional issues that entrepreneurs considering it will have to think about. First is the question of whether a small startup will want to have dozens, or potentially hundreds, of shareholders, the administrative burden of which may take up valuable time from the company and its employees. Next, it is unclear how VCs will view and treat equity crowdfunded companies that come to private equity looking for a Series A round. A VC may not want to share a company with dozens or hundreds of shareholders each owning tiny fractions of the company (but that collectively may constitute a significant equity block). Finally, there remains the issue of how securities issues in equity crowdfunding may be resold — the legality of the issue will hopefully be resolved by the forthcoming SEC regulations, but the practicality of resale has no good solutions as of yet.

Although this all may seem like a daunting laundry list of pitfalls that would discourage most ventures from crowdfunding, it shouldn’t necessarily by itself discourage ventures from crowdfunding. Entrepreneurs thinking about crowdfunding should consider these risks and whether they are comfortable with them, or can mitigate them. And, of course, if your venture needs the money crowdfunding can provide in order to survive, that is usually the main determining factor in whether to proceed with a crowdfunding campaign.