The Legal Basics of Crowdfunding

Crowdfunding, a new form of online financing, now allows individuals to harness the Internet’s potential while funding their startups.  

Indeed, this novel financing method has already been used for many years by authors, individual borrowers, and philanthropists through portals such as Kickstarter, IndieGogo, and GoFundMe. Andrea Doshi, for instance, has fascinated thousands of young women with her hit children’s book series, Queen Girls, a crowdfunded saga that inserts real women into fairy tales. Responsible newlyweds have turned to crowdfunding intermediaries for a honeymoon advance. And Good Samaritans can forge life-long connections with natural disaster victims through donation-based crowdfunding sites, like YouCaring.

Before 2012, users could only solicit donations or loans through crowdfunding sites. But now, many small business owners have turned to equity crowdfunding sites to fund their firms after President Obama signed the Jumpstart Our Business Startups Act (JOBS Act), which legalizes retail investment crowdfunding. Under certain conditions, the JOBS Act allows startups to raise investment funds online by creating a narrow exemption in the 1933 Securities Act. More specifically, this exception allows small companies to raise capital among a diffuse group of investors in exchange for stock. While the JOBS Act does increase access to startup investment opportunities, business leaders must be aware of three potential legal issues with crowdfunding. First, there is a mélange of substantive and procedural restrictions on fundraisers and investors. Second, business leaders must be sure to read the fine print on the terms of agreement with their crowdfunding site in order to avoid a breach of contract suit. Finally, fundraisers may inadvertently violate federal copyright, trademark, or patent laws when providing information to potential investors.    

While the JOBS Act does increase access to startup investment opportunities, business leaders must be aware of three potential legal issues with crowdfunding. First, there is a mélange of substantive and procedural restrictions on fundraisers and investors. Second, business leaders must be sure to read the fine print on the terms of agreement with their crowdfunding site in order to avoid a breach of contract suit. Finally, fundraisers may inadvertently violate federal copyright, trademark, or patent laws when providing information to potential investors.    

 

SEC Regulations

Businesses seeking to raise funds through crowdfunding must comply with several Securities and Exchange Commission (SEC) regulations.

As a preliminary matter, companies that are not incorporated in the United States, investment companies such as mutual funds, and public companies may not raise capital through crowdfunding.

In some situations, crowdfunding firms must comply with extensive due diligence requirements by, for example, conducting background checks on management and large stockholders, filing disclosure papers with the SEC that include the company’s stock price, target offering amount, deadline to reach the target offering amount, and relevant financial statements (i.e. balance sheet, income statement, etc.). It is worth noting, however, that companies using crowdfunding for the first time need not comply with SEC’s full financial auditing requirements. As a general matter, firms that engage in crowdfunding activities, are advised to organize as a limited liability corporation or a regular corporation in order to avoid giving passive investors a role the firm’s day-to-day management.

Crowdfunding firms may only raise a maximum of one million dollars in a rolling twelve-month period and, must surrender all of the funds they raised if they do not reach their stated goal in a certain time period. All fundraising must be conducted through a “fundraising portal” that is registered with the SEC.  

 

There are also restrictions on investors who fund projects via crowdfunding sites.

 

For instance, these contributors may not transfer ownership of their firm’s crowdfunded stock for one year. Moreover, investors making $100,000 or more per year can only allocate 10% of their annual income in crowdfunded stock over a period of twelve months. On the other hand, investors making less than $100,000 can allocate the greater of $2,000 or 5% of their annual income in these securities.

 

Contract Law Issues

Almost every crowdfunding transaction is based on a contract. In the crowdfunding context, two types of contracts are particularly common.

The first contract, a click-wrap agreement, refers to a standard “terms of agreement” page that users must consent to before proceeding to the main site.

The second contract, a browse-wrap agreement, refers to terms and conditions that bind users as soon as they begin browsing a website’s contents – regardless of whether they consented beforehand.

Crowdfunding participants are incentivized to enter contracts because they can rely on courts to enforce them during disputes. In general, a party must be able to prove that (1) someone has made an offer to do something for someone else who has (2) accepted the offer and (3) given up something of value in exchange for the good or service in order for a court to recognize a contract’s existence. Conflicts between funders and firms are strictly between those two parties, and the crowdfunding platforms typically don’t get involved. Given this criteria, browse-wrap agreements are harder to enforce than clickwrap agreements because crowdfunders typically do not have the ability to read the browse wrap terms and conditions they must follow before acting.

Nonetheless, firms should read and understand the terms and conditions of the services they want to use before settling on a crowdfunding platform.

 

Intellectual Property Issues

Firms that use crowdfunding portals often place content that has already been copyrighted or patented on their page in order to inform potential investors about their product or service. While this activity may be well-intentioned, it violates federal law and can lead to serious consequences.  

Crowdfunding companies take intellectual property violations very seriously. Some funding portals even reserve the right to disable accounts linked to IP violations. It also goes without saying that firms may also be subject to an infringement lawsuit by a private party.

As you can see, starting a crowdfunding campaign sparks a myriad of legal questions. As with anything legal related, it’s important to make sure you’re protected beforehand, rather than trying to play catch-up if something goes wrong. Crowdfunders routinely turn to us at LawTrades for quick and comprehensive legal help that won’t break the bank. Hope to help you soon as well (:

 

By Habib Olapade

 

 

 

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