Crowdfunding has helped bring the power of the Internet to investing. Since the launch of sites like Kickstarter in 2009, major startups producing market-disrupting technology like the Oculus Rift have gotten their start by amassing small donations from a very large group of people. Here's a look at what crowdfunding is and crowdfunding legal mistakes to avoid.

What Is Crowdfunding?

Crowdfunding can be a powerful fundraising tool beyond traditional methods like gathering financial support from friends, relatives, banks, angel investors, and venture capital firms. By registering an account on an online crowdfunding platform, a startup can gather small amounts of capital from a large number of individuals to finance a new business venture.

In the traditional approach to crowdfunding, you offer a first-run product or some other incentive in exchange for a monetary contribution. Contributors receive no equity and are not entitled to be repaid.

In many cases, the process is essentially a pre-sale of your product and not an investment - and not regulated by the federal Securities and Exchange Commission (SEC).

Equity crowdfunding is a newer option made possible under the Jumpstart Our Business Startups (JOBS) Act - which allows you to seek small investments from a large number of investors. You use a crowdfunding platform to post a listing similar to a traditional crowdfunding campaign, but your investors become shareholders. This includes voting and dividend rights as outlined in the shareholder agreement.

The top crowdfunding sites for smaller ventures include Kickstarter, Indiegogo, and GoFundMe. Crowdfunding sites geared more toward investors include MicroVentures and Angel List.

General Legal Issues Related to Crowdfunding

While traditional crowdfunding (where equity is not exchanged) is not subject to federal security laws, there are a number of general legal issues you need to keep in mind:

  • Form a Business. There are different pros and cons for each type of business structure, but it is important for businesses seeking to crowdfund to set up a business and get a business bank account early (instead of operating as a sole proprietor by default). Certain business structures also will help protect the founders from personal liability. LLCs are a common structure for businesses seeking crowdfunding. If you are looking to build a potentially large company seeking venture capital, you can read more here on why incorporating in Delaware is the most popular choice.

  • Seek Tax Advice. The revenue from “rewards” and pre-sale of goods may be subject to income taxes. Consult a tax professional.

  • Intellectual Property. Entrepreneurs may be sued for copyright infringement if they posts someone else’s copyrighted material without permission. In addition, you need to talk to an attorney before you discuss your invention online - for example, you may find it wise to file a provisional patent applicable to preserve your rights. You also may want to file for a copyright or trademark before you post certain information on a crowdfunding page. Posting your intellectual property online increases the chance it could be copied/stolen. You can learn more on how to best protect your intellectual property in our easy guide to IP for startups.

  • State action. You could theoretically face adverse legal action if you don’t fulfill your side of the agreement with your backers or otherwise take action that runs afoul of state consumer protection laws (such as making misleading statements). For example, in Washington State, an enforcement action was brought against a crowdfunded project that didn’t deliver as promised.

Additional Legal Issues for Debt Crowdfunding

The legal issues get exponentially more complicated with debt crowdfunding because it involves selling securities.

Title II of the Jumpstart Our Business Startups (JOBS) Act of 2012 created an exemption under federal security law that opened the door to widespread debt crowdfunding. The SEC then adopted rules implementing the JOBS Act that went into effect in 2016.

The primary elements of the new exemption for equity crowdfunding includes:

  • The company may raise a maximum of $1 million total over a 12-month period.

  • Investors have caps on how much they can invest based on their income or net worth. In addition, investors can only invest a total of $100,000 in all such campaigns in a 12-month period.

  • The offering must be made through a broker-dealer or a registered funding portal.

  • Non-U.S. companies are not eligible for the exemption.

  • The company generally must file a fairly involved offering statement (including financials), progress updates, and annual reports with the SEC. The administrative burden of reporting necessary for crowdfunding may be too much for many small startups.

  • There are limits on advertising and promoting the offering.

  • Securities generally cannot be resold for a year.

In addition, some states have adopted their own crowdfunding regulations and so you would be wise to do some additional research for your state. For example, click here for information about Oregon’s rules.

How to Conduct Crowdfunding Legally

The legal issues that could come into play, especially for crowdfunding where company stock is involved, are complex and rapidly changing. Be certain you are on firm footing, but don't neglect this very smart financial tool that could put you out ahead of the market. Open up your discussion in the UpCounsel's marketplace to get tips on the legal route to intelligent crowdfunding.

If you need help crowdfunding, you can post your question or concern on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe and Twilio.