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The technological advancements in recent years have allowed startups and established companies to launch and expand their businesses through attracting financing from private individuals and institutional investors in the form of crowdfunding. Compared to other types of public lending, this type of fundraise includes numerous new opportunities, which gave rise to many new businesses.

Meanwhile, crowdfunding is still a novelty in many jurisdictions despite being in the air for quite a long time and therefore requires a careful approach and professional support of experienced lawyers and advisors. Currently, there are several forms of crowdfunding and platforms available, connecting businesses and private investors worldwide, and choosing the right one takes thoughtful planning to provide for compliance, and successful fundraising.

Advantages and Pitfalls of Crowdfunding

Compared to traditional forms of financing, crowdfunding technology offered startups new opportunities not accessible ever before. Listing projects on crowdfunding platforms provides for worldwide visibility around the clock. It also enables access to the global capital market and brings businesses in direct contact with potential investors. Other benefits of crowdfunding for startups include an opportunity to get prompt customer feedback and make necessary adjustments in the business model if needed.

At the same time, high exposure means a higher level of competition from other businesses, who enjoy the same benefits and try to make their offers most attractive to potential investors. The disclosure of product features at the pre-order stage exposes companies to the risks of intellectual property infringement, which might be too high for early-stage startups.

An unsuccessful fundraise through crowdfunding may be the end of the business in case the cap is not reached, and funds are returned to investors. Mitigating these risks requires a thorough understanding of how crowdfunding works, choosing an optimal crowdfunding platform, and taking all relevant issues into consideration.

How Crowdfunding Works?

Fundraising Cap and Fees. Before launching a campaign, an entrepreneur has to evaluate what is the exact amount of financing needed to develop the project and cover the associated costs, including the fees of crowdfunding platforms. A detailed business plan is vital for any startup, and it’s especially true in case of fundraising through crowdfunding.

Crowdfunding Marketing. Marketing a crowdfunding campaign can be at great expense of time and money. The best campaigns usually start before the official launch on crowdfunding platforms: by reaching out to family and friends or being active on personal and company social media. It also takes professional marketing materials, creating a website, and developing a detailed and well-structured business model.

Successful marketing should aim to get personal with potential investors and to spread the word as much as possible as being visible is vital for any business. An effective marketing strategy can include such activities as interviews on business platforms and event, campaigns on Twitter and social media as well as networking with experts, incubators, and investors. Once investors start funding a startup, keeping communication with them on each stage of the project is essential to build trust.

Crowdfunding Platforms. At present, crowdfunding for startups takes place on online platforms, each of which appeals to different types of companies and investors, and has its own rules and terms of service. While these rules are designed to attract as many investors as possible, they are also intended to protect and serve the interests of all parties involved.

For example, some platforms might let entrepreneurs keep the funds, irrespective of whether the project reached the announced fundraising goals or not.Other platforms might refund all payments to investors if the cap is not reached by the deadline, leaving businesses back to square one. Startups need to understand the requirements set by the platform and what is at stake regarding financing of the project as well as impacts on governance before launching a crowdfunding campaign.

Obligations to Investors. Depending on the chosen type of crowdfunding, entrepreneurs incur various contractual liabilities. For example, a company may be obligated to sell equity shares, or deliver the first finished goods to investors. Startups should carefully analyze their capacity to fulfill such obligations in due time yet at the planning stage and make corresponding provisions in the business model.

Closing the Fundraise. When the fundraising is over, and the cap is reached, an entrepreneur receives the full amount of money raised less the platform fees. If the goals have not been met, the funds raised are either sent back to investors or kept by entrepreneurs, depending on the platform’s rules. It should be noted that in the former case, startups still have to pay the platform fees.

In most instances, platforms are not involved in what happens after a campaign, leaving any disputes between investors and startups to be resolved by mediation or in courts.  This can occur if the funded business doesn’t fulfill its obligations, or if a business model is modified but investors do not agree with the changes.

Different Types of Crowdfunding

Reward-basedAlso known as pre-buy, the reward-based crowdfunding occurs when a company receives financing in exchange for its products. It is used in production-related industries, such as gaming, software development, and others, and helps to determine companies’ potential for the market.  The list of most well-known platforms, offering this type of crowdfunding, includes Kickstarter, Indiegogo, Crowdfunder UK, Pozibble, Vision Bakery, and RocketHub.

Donation-based. Donation-based crowdfunding enables projects to receive financing from individuals without return considerations. This type of crowdfunding is used for personal campaigns as well as for charity fundraising, launched by registered organizations. Among platforms, offering donation-based crowdfunding, are GoFundMe, JustGiving, YouCaring, My Major Company, Ulule, and Piggybackr.

Lending-based.  Lending-based crowdfunding occurs when an entrepreneur gets a loan from numerous different investors through an online platform. This operation has many names, depending on where the funds come from, e.g., debt-based crowdfunding or peer-to-peer lending.

It creates a direct relationship between investors and entrepreneurs, facilitates access to loans, and provides for higher financial return without participation in the company’s management. This form of crowdfunding is also more flexible and cheaper than regular loans.

In countries, which have opened up their banking regulations, for example, most European countries or Canada, securitization vehicles and alternative investment funds (AIFs) are allowed to originate loans. Some other EU jurisdictions, like the UK, Ireland, Netherlands, as well as the US also allow direct lending through funds. However, in other countries, where banking regulations are highly restricted, peer-to-peer loans can be illegal, which means that using this type of platforms would be not allowed.

See more on this on the European Commission, the European Parliament or Mondaq websites.

The financing received through this type of crowdfunding is repaid by direct transfers to the platform, which in its turn distributes payments to the lenders. Disclosure requirements are similar to those in banks, but they are made public to all investors.

Equity-based. Equity-based crowdfunding enables any individual to invest in a new project in exchange for a share in the equity-issuing company, which allows startups to get more initial capital without debt obligations. It opens more investment opportunities and makes investors and entrepreneurs aligned in sharing revenues and risks. At the same time, such crowdfunding can be restricted when local regulations set limits as to the maximum amount, which can be raised, or the number of investors.

The Chinese specificities for equity crowdfunding. China has strict regulations regarding public equity offerings, which can label most of the equity-based crowdfunding platforms as illegal. The only possibility for these platforms to legally exist in China is to conduct private equity offerings, which sets limits to the number of investors, who can participate in fundraising. In addition, all lenders shall qualify as “qualified investors” under the China Securities Regulatory Commission Order No. 105: and have to have a net worth exceeding 3 million CNY (436,000 US dollars) or meet a number of other requirements regarding their personal finances.

See more on this with “Managing the Risks of Equity Crowdfunding: Lessons from China” Lin Lin, 2017. (2017) 17(2) Journal of Corporate Law Studies 327-366. Available at SSRN: https://ssrn.com/abstract=2908123

Royalty-based crowdfunding. This new crowdfunding model applies when lenders invest in campaigns in order to receive a share of possible or future revenue flows. This enables entrepreneurs to obtain capital investment without diluting their shares, while the investor gets an alternative option to participate in a project.  Such transaction is materialized by a contract of sale of future revenues, issued by the financed entity, describing payment conditions, percentage of income, paid to investors, and other terms.

Example of  Comparison of Crowdfunding Models

Each of the described types of crowdfunding for startups works for specific goals and circumstances. When choosing a crowdfunding model for an individual situation, it’s advised to make a comparative analysis of preferred types of financing to see if they have the features for specific project’s business needs. An example of such analysis, describing equity-based, reward-based, and peer-to-peer lending, is provided in the table below:

  Equity-basedReward-basedPeer-to-peer lending
Pre-tradingxyx
Pre-profityy x
Profitable growing businessyxy
Established and steady growingyxy
Established stable businessyxy
Launching new product/service/brandyyy
Making acquisitionsxxy
Expanding into new territoriesyyy
Investing in new facilitiesxxy
Looking to refinanceyxy
In need of capital restructuringyxy

A Word on Taxes

An analysis of the tax consequences shall be a part of any business plan to ensure that the raised finances will be enough to cover the tax burden as well as entrepreneurial costs, the platform fees, and will help to achieve the goals of the project. Startups must carefully analyze the tax legislation of those jurisdictions, which would apply to the funds received from crowdfunding.

Entrepreneurs shall check if the donations, made through crowdfunding platforms, are deductible for the purposes of the income tax. The taxes may differ for various types of fundraise so that the services of professional tax advisors should not be overlooked. It shall be noted that tax impact shall be assessed not only for the beneficiary’s business but also for investors, including institutional investors, such as online banks and incubators as well as individuals, including business angels, friends, and family members.

Summary

Crowdfunding is a comparatively new form of financing, which has proven itself to be quite efficient and gave birth to numerous businesses worldwide, which otherwise may have never materialized.  Startups, listed on international crowdfunding platforms, enjoy instant visibility around the clock, and get an immediate excess to the world pool of investors.

Businesses should employ a careful strategy, starting from choosing an optimal form of crowdfunding, which fits their business models and allows to achieve the fundraising goals. While planning crowdfunding for their startups, entrepreneurs shall consider the choice of an optimal platform, taking into account all the terms of services and platform rules, including the procedure for the exit after fundraising is over.

Finally, companies interested in crowdfunding shall consider the limitations of local and international jurisdiction in order to provide for compliance. The legal structure shall be developed by qualified lawyers and tax advisors, who can address all relevant issues yet on the planning stage.  Such structure, based on an efficient product, solid marketing strategy, and effective crowdfunding platform, is the best guarantee that the goals of both beneficiaries’ businesses and investors are met.

To know more, feel free to contact us:

Bruno Grangier: b.grangier@leaf-legal-com

Jean-Philippe Engel: jp.engel@leaf-legal.com

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