Crowdfunding pitfalls: The legal risks startups need to know before running an equity crowdfunding campaign

Changes in crowdfunding legislation, equity dilution and fraudulent dealings are all risks a startup can face when running an equity crowdfunding campaign.

Crowdfunding has become a valuable way of securing funding outside of traditional venture capital investment, and has seen everything from champion racehorses to potato salad funded through individual consumers backing a product, yet there are inherent risks when securing this type of investment.

Equity crowdfunding in particular has sparked heated debate, with new legislative provisions coming in to effect this September that may see startups able to benefit from an impending cash inflow from smaller investors.

Here are some key pieces of legislation relating to equity crowdfunding that startups should be aware of, as well as common equity crowdfunding pitfalls and how founders can avoid them.

Read: Not all fund and games — all the different types of crowdfunding explained. 

Relevant legislative provisions

Startups should be aware of and familiar with the key legislative provisions relating to equity crowdfunding before they some of them take effect on September 29, 2017, according to Shaun Restorick-Barton and Kurt Wildermuth from LawSquared, a Melbourne-founded law firm providing counsel to startups and entrepreneurs.

The Corporations Amendment (Crowd-sourced Funding) Act 2017 provides the legislative framework for crowdsourced equity funding (CSF) in Australia. The Act comes into effect from September 29 and amends the Corporations Act 2001 and Australian Securities and Investments Commission Act 2001.

“The new CSF regime allows unlisted public companies to seek out investors on licensed crowdfunding portals to raise up to $5 million a year. Retails investors will be able to invest up to $10,000 per offer per year, in an unlimited number of businesses,” say Wildermuth and Restorick-Barton.

As a part of the 2017-2018 Budget, the federal government indicated it would extend the equity crowdfunding regime to proprietary companies, and has released draft legislation for the change.

While some members of the startup community say the proposed change will mean a greater number of startups and small businesses will be able to raise capital through equity crowdfunding, Restorick-Barton and Wildermuth says there is still uncertainty for some business operators.

“Although this draft legislation represents a massive leap forward for crowdfunding in Australia, startups looking to access the CSF as soon as possible will need to decide whether to convert to an unlisted public company structure in September or make an uncertain wait for a CSF regime that may be better suited for their needs,” they say.

Crowdfunding risks

The common risks entrepreneurs face when running an equity crowdfunding campaign include the campaign failing, equity being diluted, and additional costs and fraudulent dealings, according to Fiona Lu, a consultant at Sydney-based legal services startup LawPath.

Failure

“Like any other business venture, there is a risk of not succeeding. If a project or idea fails, investors will not only lose their financial benefits but it can have an effect on a company’s reputation,” Lu advises.

“If a startup organises a crowdfunding campaign that is visible to investors and competitors, and then the company fails, the business may lose public and investor confidence … [and] money collected during the campaign will need to be returned to investors,” she says. 

Equity dilution

“Investor’s [share in the company] could be diluted by subsequent equity issues, particularly if a company requires further funds to be raised,” Lu says.

Lu points out two risks that are inherent in crowdfunding rounds, the first of which is over-funding of the round, and second, that future capital raises may dilute the stakes of existing shareholders.  Moreover, Lu says if the company suddenly issues new shares, it’s possible that not all investors will remain equal.

Underestimating the costs

Lu warns startups that undertaking equity crowdfunding may create additional costs. In some cases, the startup may be unable to deal with the expense of providing ongoing information about the project, or manage the time costs of dealing with multiple new investors.

Fraudulent dealings

There is a risk that a platform operator may misappropriate or mismanage funds, according to Lu, who advises a startup to check the credibility of the crowdfunding platform it is hoping to use before committing. 

Mitigating risks

To ensure your startup doesn’t run into any of these pitfalls on its equity crowdfunding journey, there are a series of steps that founders can take to mitigate the risks of fraud, equity dilution and hidden costs, according to Lu.

These steps may also apply to businesses that are contemplating running a rewards-based crowdfunding campaign.

Set up realistic budgets and timelines

Lu says startups should set realistic budgets and timelines prior to committing to crowdfunding campaigns to ensure targets are met and investors are not left disappointed.

Check the credibility of crowdfunding platforms

“In order to avoid fraud, it is important businesses and investors check the credibility of the crowdfunding platform they are hoping to use before committing,” Lu says, recommending startups look for “established and mature companies” when seeking a suitable platform.

“Startups should beware of red flags that can reveal whether or not they will fall prey to investment fraud. For example, does it sound too good to be true?” Lu asks.

“Be wary of platforms that promote an investment will achieve ‘incredible gains’ … with low risk and high returns.”

Clarity

In the event a startup’s funding target is not reached, contractual arrangements should be made to provide clarity on rights and obligations of the parties involved, Lu advises. 

Protect your intellectual property

Because crowdfunding typically involves many people knowing about the business and ideas, Lu says there is a risk it may give other businesses the opportunity to copy ideas before they are implemented.

Lu recommends businesses consult with an intellectual property lawyer who can help give advice on obtaining copyrights, trademarks or patents before posting their campaign online.   

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