Lots of new businesses have blossomed in catering to this market: Kickstarter, Indiegogo, and RocketHub, to name a few. They’ve enabled entrepreneuers to start successful businesses where otherwise they could not have. That’s pretty cool.

 

But crowdfunding is not a panacea for all your funding needs.  Depending on what type of business you have, it might hurt you long term more than it helps you. In that vein, I’ve put together a list of things you might want to consider before you get started.

 

 

Crowdfunding, as defined as the selling of small amounts of equity to a large number of investors, is still not legal, at least according to the Securities and Exchange Commission (“SEC”). As you may be aware, Congress passed the JOBS act (specifically, Title III of the JOBS act) last April to make crowdfunding legal under certain restricted circumstances.  But until the SEC enacts regulations in accordance with that law, selling equity to a large number of investors without formal registration or a specified exemption is still a violation of the law. Violating that law includes the risk of both civil fines and criminal penalties, neither of which are cool or hip. Chat with an attorney if you think you might have an issue here. 

 

 

What is the current incarnation of Kickstarter, then? Kickstarter calls it a "pledge" model. Another way to think of it is as a “donation hub." People donate money to help you get your business started. What’s another name for a donation? A gift. And gifts have tax consequences that are different from equity considerations. 

 

Did you give your benefactors a t-shirt or box of widgets on Kickstarter?  The IRS might determine that’s taxable income. Again, that’s very different from raising equity in terms of tax consequences. 

 

I’m not an accountant, but if you have received money from Kickstarter or sites of that ilk, I would seek out someone who is and ask them about the tax consequences of the money you’ve received. Wherever you are in your stage of professional development, you don’t want the IRS up your butt.

 

 

Imagine two companies making similar sci-fi gaming software.  Both want to crowdfund and both want to raise $100,000.  It’s 2014, and equity crowdfunding is legal. One company offers a proportional equity interest based on the size of the investment and the other offers an opportunity to get a free game (if and when the game is completed). Which one do you think is going to receive funding?  

 

When equity ownership becomes legal, investors aren’t going to be happy getting trinkets any longer; they’re going to want a piece of the pie. So, if you're looking to crowdfund under the "pledge" model, it may be wise to get out there soon.  

 

 

One of the great things about startups is the ability to turn on a dime. Startups are teams with ideas in search of a viable business model. But, almost by definition, companies in search of early stage financing haven’t yet found that business model. Companies with five insider shareholders can pivot instantly to meet the needs of customers. Companies with 624 shareholders to whom they have made representations and owe fiduciary duties don't have that flexibility. If the representations made in your crowdfunding pitch don’t match the business model you pursue, you might have unhappy shareholders. No bueno (see topic 8).  

 

 

Ever seen a capitalization table with 624 shareholders? With five possible funding scenarios and how they impact each shareholder? Suffice it to say that it’s a headache you don’t want to deal with if you’re a small company. It’s also the kind of thing that allows big-firm lawyers to drive Z-class Mercedes while you’re eating ramen noodles. 

 

 

When you have three shareholders and want to make an important decision for your startup, you get those three shareholders to sign a “Consent to Action Without a Formal Meeting” and you do what you need to do. When you have 624 shareholders, the process is far more burdensome. Depending on your bylaws, you’re probably going to have to notify all of them of the meeting, await their response, and then take a vote to see if they agree with what you want. 

 

Annual shareholders meetings are required by law. Plus, startups frequently make changes that require shareholder approval. Having many shareholders entails a compliance burden that doesn’t make sense for most smaller businesses.  

 

 

Your shareholders own your business. And if your shareholders are complete strangers, you might find them making decisions you don’t like. 

 

Certain decisions require the consent of shareholders, and if your shareholders don’t agree with what you propose, you cannot go against them.  These problems can be lessened with careful planning and consultations with experienced advisors, but the fact remains that crowdfunding creates a large block of outsider shareholders whose interests may or may not be aligned with management. That’s something to think about long and hard before pursuing.

 

 

Once someone becomes a shareholder in your company, your officers and board of directors owe them fiduciary duties of loyalty and due care. You don’t become a board member or an officer at a Fortune 500 company without knowing what those things mean. Many startup officers are likely to be less familiar with those concepts.

 

Even if you are familiar with the issues, shareholders get cranky for all sorts of reasons. Big companies have the resources to withstand a derivative or class action suit. Good luck finding a lawyer or law firm who will defend a securities class action on the cheap. 

 

 

Crowdfunding is new and exciting. A lot of companies are going to succeed because of it. But when equity financing and crowdfunding join forces soon, it's going to be Wild West-y for a while.

 

Eventually, we will get a good sense of the types of businesses that benefit from crowdfunding and the ones that would be better off avoiding it. But for now, it’s all a bit of a gamble. And that’s ok. All startups are a gamble. Just make sure you have thought about all the benefits and the risks of crowdfunding. Talk to an accountant. Talk to lawyers. Talk to VCs about what they think. Make sure you’ve evaluated all angles before you make the leap.