Crowdfunding - Legal Issues for Small Businesses

Equity Funding and Intellectual Property Issues

3 young female entrepreneurs discuss plans to launch startup company.
Crowdfunding - Legal Issues for Small Businesses. David Shopper / Getty Images

Crowdfunding, sometimes called "online financing," is a new way for individuals and businesses to fund projects and products (like books and inventions) by using the power of the Internet. Crowdfunding has been used for many years by the entertainment industry and now others have begun using the Internet to set up websites and take money as donations to help fund their ideas.

How crowdfunding works

Most crowdfunding websites allow individuals or companies to present an idea to others, who donate money with no expectation of anything (other than a small token gift) in return.

One of the largest crowdfunding sites, Kickstarter, sets itself as a middleman between creative types, who are given approval to present their creative projects on the site to others, who give small amounts of money as donations. For example, an author might give copies of the book to donors, or someone creating a product might give one of the products to those who contribute a specific amount.

Crowdfunding examples

Some successful examples of crowdfunding are a crab shack in New Jersey (Littleneck), a book project, and an invention - a 3-D printing pen.

Peer-to-peer lending as crowdfunding

Another type of crowdfunding is peer-to-peer lending (P2P), which is basically a way for individuals to get loans from other individuals, at specific interest rates, through an online intermediary. P2P services like Prosper.com must comply with state and federal laws.

Before you get too excited about this new way to raise money for your business, you should be aware of the potential legal issues involved.

As usual, when a new idea gets ahead of current regulation and laws, some issues arise. This article addresses some of those issues.

Current legal status of crowdfunding

Under current U.S. federal law, the sale of securities to the public as an investment is regulated by the Securities and Exchange Commission (SEC), and it is illegal to receive a payback on an investment unless the company is approved by the SEC.

In 2012, the Jumpstart Our Business Startups (JOBS) Act became law, and one of the key provisions was to instruct the SEC to find ways to exempt crowdfunding from some of the more onerous provisions that restrict access to funds from non-registered securities offerings by non-accredited investors. The SEC has yet to issue its work (July 2013). But companies like RockThePost.com claim they can offer securities to accredited investors.

Crowdfunding issues and equity funding issues

Some issues that have been raised for crowdfunding as a way to raise equity funds from investors:

  • Equity investors typically want some say in how the business is managed. Annual shareholder meetings are required and information must be provided to shareholders. Small businesses don't have the resources to manage such a large pool of unruly investors.
  • Startups accepting crowdfunding may find it difficult to find venture capital funding or other most sophisticated investors later.
  • Investing has been regulated for a good reason: the protection of investors. While investment in a business doesn't guarantee a return, taking away some of the information available to potential investors, and the potential for misrepresentation, could be an issue.

    Eric Savits at Forbes says equity funding through crowdfunding is a "legal disaster waiting to happen."

    Intellectual property issues and crowdfunding

    Intellectual property refers to business assets that have no substance but which have value. The most common types of intellectual property are patents, copyrights, and trademarks/service marks. These assets require funding to bring them to market and are a popular type of crowdfunding offering. For example, a new product that is patentable might be presented, or a book or play that is subject to copyright. Protecting rights to intellectual property is an important consideration when presenting projects to a crowdfunding site.

    Two types of intellectual property issues are showing up in relation to crowdfunding:

    • People are putting up content that someone else lays claim to, so there are lawsuits about who owns a patent or copyright. For example, if Person A puts up a photo on their crowdfunding page and Person B claims to own the copyright, Person A can be sued for copyright infringement.
    • Ideas on crowdfunding pages are being stolen by others; knockoffs of patented products or theft of books or trademarked items, for example.

    IPWatchdog cites several instances of theft of patentable products or copyrighted content on crowdfunding sites.

    Patents
    Putting a new product on a crowdfunding site exposes the inventor to the possibility that his or her idea could be copied. The head of IndieGoGo said, "We are not liable for any of that stuff." And Kickstarter says:

    Being open and sharing ideas is an essential part of Kickstarter. The platform is collaborative by nature, and is a powerful community-building tool for project creators. If you are unwilling to share information about your project with potential backers then Kickstarter probably isn’t for you.

    If your business has a patentable product, you might want to file a provisional patent to give you some protection while you do additional testing.

    Copyrights and Trademarks/Service Marks
    To use images, music, artwork, video, or other copyright protected content on a crowdfunding site, you must have the copyright or a license to use the content. If you want to protect content that you own, copyright it before you put it up on a crowdfunding site. The same suggestion applies to trademarks and service marks. Use the appropriate symbols to show that you have applied for a trademark/service mark or that you own the copyright.

    Research first, then protect

    Before you put content on a crowdfunding website that might be owned by someone else, check to see who owns the patent, copyright, or trademark. Then begin the process of protecting your work:

    More information on crowdfunding and the JOBS Act by the Small Business Administration