Many new businesses are looking at crowdfunding as a new fundraising option. There have been some very successful offerings – for example, Exploding Kittens, a card game, raised over $8 million. That is obviously an exception, but it shows the power of Kickstarter and similar sites. However, for every Exploding Kittens, there are campaigns that fail in one of two ways: either the project fails to make its target amount in the time allotted, or it is funded and the campaign organizers never ship their product.
As this new funding medium grows, so do the issues for businesses taking advantage of it. Legal issues abound as state governments struggle to catch up with this new business model. It is important for attorneys to be aware of them in order to best advise clients.
There are two main sites for new businesses to crowdfund: Kickstarter (the more popular) and IndieGoGo. While there are several others, these two are the main ones. A third, GoFundMe, focuses on charitable giving. GoFundMe has very few of the tax and contractual issues that surround Kickstarter and IndieGoGo. It also has its own internal rules and has been known to remove charity campaigns that it, or other people, find objectionable (which is allowed by its terms of service).
Successfully-funded campaigns on Kickstarter and IndieGoGo face contractual obligations that the organizers should be aware of. Both companies have clauses in their Terms of Service that state that prior to fulfilling any other orders, the organizers must send out the orders made through the site. Many campaigns will have multiple levels of rewards or perks, and the Terms of Service for each site establish a contract between the individual backers and the organizers.
Kickstarter itself found that 9% of the projects on its site fail to deliver to backers. These backers technically have the right to bring a claim against the companies that were funded, though I was unable to find any. However, attorneys representing project creators should be aware that this is an unsettled legal area, and one that could result in litigation in the future. Why do these projects fail? Usually for the same reasons that many new companies fail; the project’s organizers fail to fully anticipate how much money they will need to actually complete the project, or discord within the company results in people leaving. A common theme is when a key developer walks away before the game or app is completed and the remaining members of the company are unable to do the work. Because this issue can so severely derail a project, it is important that the attorney for these companies advise them that they need to make sure that they have written agreements that accurately reflect the relationship and rights of the parties. All too often, these companies are run based on agreements that the founders took off of the Internet without reading, and they do not reflect the reality of the company.
While few, if any, backers have sued project creators for failed projects—it is most likely not worth the effort for an individual backer to sue when most perks are worth under $100—that has not lowered the risks for those who would use this as a system for fraud. The Washington state attorney general’s office has filed suit against a creator in the past, and there have been several federal investigations for fraud over failed projects. When working with a company that has been fully funded through one of these sites, it is important to advise them to keep records—at the very least, the best way to head off an investigation or a lawsuit seems to be keeping the backers apprised of the company’s progress and any issues that have arisen which could derail completion of the app or product. In fact, Kickstarter makes it part of the Terms of Service, as part of the contract between the project creators and the backers. Kickstarter, it should be noted, also mandates return of funds if the perks cannot or will not be sent out to backers.
Kickstarter and IndieGoGo present tax implications that most project creators do not consider—the receipt of funds could (and should) be considered income and reported on tax forms. It is likely (although not guaranteed) that the sites will provide 1099s to project creators. This income can be minimized by documenting expenses. What cannot be minimized, and will need to be accounted for, is sales tax. Any perk in either Kickstarter or IndieGoGo that results in a backer receiving a product should be considered a sale, and more and more, states are looking for the sales tax proceeds. Determining whether a project must file sales tax returns (and in fact, get a sales tax authorization beforehand) requires looking at the project’s connection to the state. Having key people working there will probably trigger that nexus. Going into that state for later sales (such as at a convention or through more conventional means) can create the nexus needed. What’s more, some states have taken the position that merely having an internet presence and shipping the product into that state can cause sales tax to be due. All of this requires accurate record-keeping as the backers would need to pay sales tax on sales made in those states. Some states may go farther and look to the companies for income tax on those sales. While these nexus arguments might be successfully challenged in court, you and your client will have to decide if it is worth the costs and risks to become the test case for this new type of interstate commerce.
The easy solution is for project creators to bring on attorneys and accountants before they start. The reality is that a lot of the time, either an attorney or an accountant (but not both) is only brought on after the project is funded. Therefore, attorneys coming in need to be aware of these issues and make sure that the project creators are taking steps to prepare for the consequences, both intended and unintended, of their actions. What’s more, because this is a rapidly changing arena, there are new issues being raised every day. Attorneys practicing in this space will need to be flexible in order to adapt.