Legal Issues with Crowdfunding

“Crowdfunding” has become a popular word in the world of startups.  What is crowdfunding and what legal issues might a new company face with crowdfunding?

Crowdfunding allows startups to raise small amounts of capital from a large number of individuals.  Historically, startups offered their first run product at a discount or offered some other incentive to entice an individual to make a monetary donation, or “contribution.”  Prior to 2012, this was the only real crowdfunding that existed and “equity” crowdfunding did not exist.  That changed in 2012, with the passage of the Jumpstart Our Business Startups Act, or JOBS Act.  On October 30, 2015, the SEC adopted final rules allowing Title III equity crowdfunding. These rules went into effect on May 16, 2016.

The JOBS act was passed to encourage funding of small and startup businesses by easing many SEC regulations for new companies. It allows startups to seek small investments from a large number of individuals, who then own equity in the startup (potentially including voting rights, dividend rights, and other preferred shareholder rights).  Some of the provisions of the JOBS Act include exemptions for crowdfunding, a more useful version of Regulation A, generally solicited Regulation D Rule 506 offerings, and an easier path to registration of an initial public offering (IPO) for emerging growth companies.  The Act also extends the amount of time that certain new public companies have to begin compliance with certain requirements, including those that originated with the Sarbanes–Oxley Act, from two to five years.

The primary elements of the new exemption for equity crowdfunding include:

  1. The company may raise a total of $1,00,000 over a 12-month period.
  2. Investors are limited in how much they can invest based on their income or net worth.
  3. The offering must be made through a broker-dealer or a registered crowdfunding platform.
  4. The company must be U.S. based.
  5. The company generally must file detailed offering statements, progress updates, and annual reports with the SEC.
  6. The offering is limited in its advertising and promotion.
  7. Securities cannot be resold for one year.

LEGAL ISSUES

Now that equity crowdfunding is a viable option for a startup, there are a variety of legal issues that a startup will encounter with crowdfunding.  There are three main categories of legal issues that a startup will face with equity crowdfunding:  liability, intellectual property, and taxes.

Liability

When a startup raises funds through a crowdfunding website, it is actually entering into a contract with the financial backers.   Before the campaign is posted on a crowdfunding website, the startup should create an LLC, corporation, or some other business entity, in order to protect the personal assets of the startup’s founders. (The state in which a startup incorporates is also important.  Delaware is a favorite.)  A failure to do this could expose the founders’ personal assets if there is any liability from a failed business (and a likely breach of contract).  The second thing the startup should do when creating the crowdfunding campaign is to describe, as specifically as possible, what the startup’s obligations are and precisely what benefit the backer will receive if the business is successful.   The failure to fulfill one’s obligations under the crowdfunding campaign could lead to legal liability.

Intellectual Property

The most common types of intellectual property are patents, copyrights, and trademarks.  It is important to be able to distinguish between these types of intellectual property as well as who “owns” the property.  For example, a new product needs a patent; a movie or song needs a copyright; and a name or logo needs a trademark.   A startup must protect their intellectual property before sharing it on a crowdfunding site.  (There have been several documented examples of “patentable” products being “stolen” on crowdfunding sites.)

On the other hand, a startup does not want to run the risk of negative publicity due to possible infringement on someone else’s intellectual property.  That billion-dollar idea you have may have already been thought of (and patented) by someone else. Doing one’s homework in this department is crucial to protecting your product as well as your company’s reputation.

Patents

The first step a startup should take is to make sure someone else does not have an existing patent for “your” product.  Presuming there is no patent and your product is patentable, you should speak with a patent attorney and consider applying (at a minimum) for a provisional patent before launching your crowdfunding page.

Copyrights

If a startup intends to use someone else’s images, artwork, music, etc., on its crowdfunding page, that work is likely already copyrighted.  The startup must obtain a license to use that copyrighted material.  If the startup doesn’t, it could be sued (and almost certainly receive a “cease and desist” letter).  If the startup has original images, artwork, music, video, etc., that it intends to use on its crowdfunding page, the startup should consider obtaining federal copyright protection before placing it on the crowdfunding site.

Trademarks

Every startup has a name and almost all have a logo.  While it is relatively easy to ensure your company has a unique name, it requires additional research to determine if your logo is too similar to another and might be infringing on their trademark.  If the name and logo are both unique, a startup should file for federal trademark protection prior to launching the crowdfunding campaign.

Trade Secrets

Trade secrets should also be protected by the startup.  It should never reveal proprietary information such as customer lists, product processes, business plans, etc.

Tax Liability

While the JOBS Act opened up the world of equity crowdfunding to startups, it did not eliminate the legal pitfalls that potentially await a startup.  Therefore, it is important to have your “legal ducks” in a row before launching your crowdfunding page and seeking investors.

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