The Legal Pitfalls of Rewards-Based Crowdfunding Campaigns

Rewards-based crowdfunding sites, such as Kickstarter and IndieGoGo, have become a common way to get innovative businesses and products off the ground. The premise behind these crowdfunding sites is that, by raising small monetary contributions from a large number of people interested in supporting the business idea via the Internet, companies and entrepreneurs can amass enough capital to fund a fledgling project or venture. In exchange for supplying the funds, the funders are to receive the product being developed or certain other specified incentives, assuming that the entire funding goal is met by a certain deadline. If it’s not, the funds are to be returned to the backers.

The concept of crowdfunding has actually existed for some time. Players in the music industry launched online campaigns to fund tours and albums as far back as the late 1990s. It wasn’t until the mid to late 2000s when the word “crowdfunding” began to be used, and with the launch of major crowdfunding sites like IndieGoGo in 2008 and Kickstarter in 2009, the phenomenon took off and reached the popularity it sees today.

This post describes the common legal pitfalls associated with conducting a rewards-based crowdfunding campaign and the steps to take to alleviate those pitfalls.

Top Issues Associated with Crowdfunding Campaigns

The legal landscape surrounding failed crowdfunding projects is largely untested. Recent lawsuits have begun to shed light on the issues that project creators need to be aware of and the risks that should be avoided. While the law is still developing in this area, there are certain steps you can take to minimize the risk of lawsuits down the road.

Contract Law Claims

Many of the legal issues presented by rewards-based crowdfunding campaigns arise from the language used to describe and present the project. When you agree to accept funding in exchange for offering perks or rewards, it’s likely that you are creating a contract with your backers (whether intentionally or unintentionally). That means you’ll be held to delivering whatever it is you promised to deliver. When viewed in that light, the importance of being crystal clear in what you’re offering and managing your funders’ expectations is obvious. Problems arise because the terms of the contract are often vague – when everything goes right, there’s no issue, but when things don’t go as expected, questions arise as to exactly what was promised and whether those promises were met.

If you promise a specific product, reach your funding goal, and fail to deliver the product, you could face a breach of contract claim. For that reason, you need to be very careful in determining what rewards you plan to offer. Failure to deliver or delivering a sub-par product that doesn’t live up to the promised description can bring a claim from the funders for breach of contract, either on an individual basis or as a larger class action.

The terms of service of many crowdfunding sites provide that if you can’t deliver on your promises, you’re expected to refund the money you raised. While that sounds fine in theory, the problem with that is that usually, by that point, the funds raised have already been used up. That means you’re responsible for coming up with the money some other way or risk facing a lawsuit. You should always keep track of exactly where the dollars you raise are going, be transparent with your donors about where things stand, and update them on any potential delays. Good communication can go a long way toward diffusing problematic situations down the road.

To protect yourself from potential liability resulting from a failed crowdfunding project, you should strongly consider forming an LLC or other corporate entity and making it clear to your funders that they are dealing with a company and not just you as an individual. Without such an entity, your personal assets will be fair game if you have to satisfy a legal judgment. While most crowdfunding sites do include generic language addressing liability, these passages exist largely to absolve the hosting site from liability, leaving the creators and funders to settle things amongst themselves. You can’t rely on the crowdfunding site’s terms of service to protect you from liability.

Fraud and Consumer Protection Claims

Overpromising or overstating what you’re offering can open you up to more than just a breach of contract claim if you fail to deliver. It can also expose you to claims under consumer protection laws, false advertising laws, or claims under common law, such as fraud or negligent misrepresentation, on the theory that you convinced people to give you money by misstating what they’d receive in return. While a limited degree of puffery and exaggeration is allowed, it’s crucial that you avoid crossing the line into promising things that you know you can’t or don’t intend to deliver. In addition to claims brought by your funders, governmental agencies are also empowered to enforce many of these laws and have indeed taken action against sponsors of crowdfunding campaigns that have gone awry.

The best way to protect yourself from such claims is to put yourself in the shoes of your backers when you’re describing your project. If you read the description or what would you reasonably be expected to receive, and does that line up with what you’re actually offering? Having potential liability in mind from the outset will help steer you away from making false inducements or misrepresentations.

Securities Law Issues

Equity-based crowdfunding is a fairly new phenomenon. These crowdfunding platforms specifically seek investors who hold equity or some other investment at the end of the fundraising campaign. That, however, is not the case with rewards-based crowdfunding.

In a typical crowdfunding campaign, your project description should explicitly state that your backers will not receive equity in your company or any share of the profits from your venture. The words “invest,” “investor,” and “investment” should not appear anywhere in the pitch, as this could create false expectations and open you up to legal action when your backers receive nothing more than the promised perks.

Tax Issues

It comes as a surprise to some sponsors of rewards-based crowdfunding campaigns that they must pay taxes on the proceeds of the campaign. Unlike proceeds from the sale of debt or equity securities or donations to a non-profit, the money received is indeed taxable income. Therefore, when planning the budget for your project, you’ll need to consider the amount of taxes that will be due. If you are able to expense all of the proceeds in the same taxable year, this may not be an issue, but if the expenses will be incurred in future years or you must capitalize the expenses, this becomes a concern. You should strongly consider consulting a CPA to help in the planning.

The Takeaway

Crowdfunding is undeniably a great new way for entrepreneurs and startups that might not otherwise have access to traditional funding to get their projects off the ground. The popularity of crowdfunding has grown rapidly to the point where billions of dollars are being contributed to crowdfunding campaigns each year. But while using sites like Kickstarter and IndieGoGo might seem easy, especially in contrast to equity crowdfunding, entrepreneurs who understand the legal risks and take the time to structure their project in a way that minimizes those risks can save themselves a lot of money and hassle down the road if the project doesn’t turn out as planned.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Alexander J. Davie

Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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