4 Potential Pitfalls of Crowdfunding
Crowdfunding is a good way for startups to raise money for their product/service. Widget makers and apparel designers/manufacturers (including our client, Apricoat®), in particular, have made extensive use of crowdfunding to get projects off the ground. In 2012, then-President Obama signed the Jumpstart Our Business Startups Act (“JOBS Act”) which allows crowdfunding for equity (with some limitations).
It has become a legitimate way for startups to get funding without venture capital or angel investors. The JOBS Act enables companies to crowdfund by selling equity for cash investments totaling up to ~$1.07M in a 12-month period, without prior approval. However, if you’re looking to raise more than $500K, you will need to provide some audited financials.
In addition to the preceding rules (and many others which were not discussed above), below are a few legal pitfalls to avoid:
Your Startup’s Confidential Information
By its very nature, crowdfunding puts your idea in the public domain, and crowdfunding platforms such as Kickstarter take no responsibility for somebody copying your idea. By doing so, you’re opening your know-how, trade secrets, and other propriety information (“Confi” Info”) up to the world.
If your Confi Info is published on your website for all to see, you’re (most-likely) giving up your right to claim trade secret protection. Rather than posting your Confi Info on the site, it’s advisable to provide NDAs to potential investors and contractors if they are asking to review your Confi Info.
Your Startup’s Intellectual Property Rights
If you’re crowdfunding a project that involves intellectual property (“IP”), you should register that IP with the proper authorities. For patents and trademarks, that would be the USPTO. For copyrights, that would be the U.S. Copyright Office. Bear in mind that crowdfunding campaigns can go international, which may require extra steps to protect your intellectual property.
- For copyrightable works such as pictures, books, music, or certain types of software code, registration is not strictly required for protection, but it is necessary to bring an infringement action in federal court and request statutory damages (among other benefits).
- If you are planning on registering a trademark for your brand, do so before you start the campaign. You can file a trademark under an “intent-to-use” basis (1(b)) if you are not selling your product/service in commerce yet.
- It’s also a good idea to get a provisional patent in place before you start crowdfunding, if your product is patent-able. Provisional patents are low cost and last a year or so, which is more than enough time for most crowdfunding campaigns.
Do your due diligence; avoid being the person who uses a copyrighted work or a protected trademark on your crowdfunding page. Please make sure any images or logos you use do not need a license or permission to use them. Google allows you to filter images based on copyrightable use, such as non-commercial reuse, reuse with modification, or reuse.
There are a couple of compliance issues you need to worry about. When you crowdfund for equity, or even for rewards, you are forming a contract with your backers. It is essential to describe what backers are getting accurately. Make sure investors know; (a) what they will get for their investment (a security), (b) what they will get if your business is successful, and (c) what their rewards are (if any). It would be best if you clarified that it all depends on a certain amount of product/service success.
Crowdfunding allows you to set a variety of parameters and restrictions on what you are selling. If you are not crowdfunding for equity, then make sure not to call backers “investors” and to make it clear they are not buying securities. If backers are getting early access to a product/service, then you need to make that very clear. Now that equity crowdfunding is an option, there’s always the risk of confusion.
Taxes From Crowdfunding?
The IRS wants their share. Money that comes in from a reward-based crowdfunding campaign is taxable. For equity crowdfunding, the tax situation is still somewhat uncertain. Backers are usually subject to a “lock-up period” and, thus, cannot sell their equity for 12-months. In some cases, restrictions put on equity subject the seller an ordinary income tax rate on the sale rather than a capital gains rate.
Crowdfunding In Sum
Crowdfunding is a good way to get your startup the funds it needs, but there are a variety of pitfalls. Not protecting your Confi Info and IP, overlooking compliance issues, and not paying your taxes are all pitfalls to equity crowdfunding. Getting legal counsel in place beforehand is a great way to protect your startup and ideas. For more advice and assistance, contact the Law Office of Elliott J. Brown.