Startup Law: Crowdfunding 101

Written by León Lanis

Since the 2008 economic crisis, entrepreneurs have been left with very difficult barriers to enter and be able to compete in their respective markets. Oftentimes the economic policies made to guard the economy have paved a tremendously difficult road for startups: less credit issuance, market barriers, inflation, etc. In order to thrive, many entrepreneurs came up with new ideas to raise capital. Through this, crowdfunding was born.

 

What is crowdfunding?

Crowdfunding can be defined as the raise of small amounts of capital from a large number of individuals in order to finance a business. Commonly, those large numbers of people who fund a project receive a reward or a benefit from the company, be it discounts, exclusive insights, etc. Crowdfunding is mostly done through internet forums specialized in venture capital raising, some of the most common sites are: kickstarter.com, Indiegogo.com, Patreon.com, etc.

 

How does it work?

Let’s use a fictional company as an example. Sunshade is a company that makes sunglasses with 100% recycled material, they need X amount of US Dollars in order to start their business, so they go to a crowdfunding site and upload their project. They add the characteristics of their products, a sunglass catalogue and a video showing the innovation of their recycling system. Once they are uploaded, they must offer something for the possible clients, so they offer a 20% discount for the first 100 people who give ten dollars and 10% discount for those who give five dollars to fund the project. In a couple of weeks, they raise enough money to start their business, they issue the discounts to those who funded the project and pay a fee (commonly between 3-5% of the money raised) to the website used.

 

What are the legal issues?

Under this model, crowdfunding allows companies to raise capital for projects, create product awareness, study their target market/audience, create fidelity with future clients, and many more benefits. But, we must not let aside possible legal challenges within crowdfunding. Many crowdfunding ventures may be considered within the breach of securities law, such is the problem of Initial Coin Offerings (which we discussed in previous blogs). Some crowdfunded startups raise capital while promising a return in money to clients or decision participation within the company, this is a huge complication for government organisations, such as the SEC in the United States or the CMF in Chile. In 2012, the United States issued the Crowdfunding Act, in order to regulate these activities. In the aforementioned act it is stated that any crowdfunded venture must be done through a Federal and local government licensed company. Companies are limited to raise up to US $5 million dollars in the period of no more than 12 months and the startups using such methods to raise capital must disclose to the SEC any relevant information for a transparent funding. In Chile, there’s a bill being discussed in congress to regulate any fintech company. This bill, created by the CMF, seeks to regulate activities such as Cryptocurrency issuance, Crowdfunding, alternative payments, open banking, etc. Regarding crowdfunding, the Bill states that any company seeking this method of funding must be registered in the CMF as a “CrowdFunded Company”, with the requisites of informing the CMF: characteristics of the venture and possible conflicts of interest.

 

What do we recommend?

When designing a project which is or will be funded through the mentioned method, we recommend first run the Howey Test. This will help define if the venture’s funding will be considered or not a security. This test asks the following:

  1. Is it an investment of money?
  2. Is there a common enterprise?
  3. Is there expectation or promise of profit?
  4. Are those expectations made through the effects of who’s promoting it?

Also, in order to protect your project from Money Laundering schemes, we recommend that you run a KYC (Know-Your-Client) test for those seeking to fund the project. In such tests, you should consider asking: proof-of-identity, address and a utility bill in order to confirm the address.

These simple steps will ensure you can safely start a crowdfunding campaign.

 

Conclusion

Crowdfunding is a very interesting method for raising capital for your company. Crowdfunding will allow you to create product/service awareness, company culture, marketing, client loyalty, study your target market and fundamentally, gain the capital you need to start your projects. While there are a number of benefits to this way of raising capital, it is important to not overlook the possible legal issues and challenges involved in your business and the funding method.

 

Harris Gomez Group opened its doors in 1997 as an Australian legal and commercial firm. In 2001, we expanded our practice to the international market with the establishment of our office in Santiago, Chile. This international expansion meant we could provide an essential bridge for Australian companies with interests and activities in Latin America, and in so doing, became the first Australian law firm with an office in Latin America.

We provide innovative technology and resources businesses with legal and commercial expertise to realise their global potential. Our goal is to see innovative businesses establish and thrive in the global market. We are proud members of Austmine.

To better understand how we can support your management team in the Region, please contact contact@hgomezgroup.com  

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