Since the advent of crowdfunding, there has been much discussion and confusion about the true nature of what the internet community refers to as a “crowd” process. On the one hand there are traditional crowdfunding venues which allow projects to set a goal and a term for their campaign and award them the funds if they reach both. There are also subscription crowdfunding options that allow a smaller contribution on a regular schedule.
On the other hand there are crowdsourcing initiatives where a large group of people contribute labor, ideas, and properties to the completion of a project. The two terms are sometimes confused, as they both describe roughly the same process. Once it is clear what crowdfunding actually is and how it is viewed legally, some of the confusion subsides. However, the details often inspire more questions than they answer.
One of the key questions regarding crowdfunding is the legal relationship between contributors and the person or persons responsible for the campaign. What exactly is a crowdfunding contribution from a legal standpoint? Do contributors have any rights? Does the person running the campaign? If so, what are those rights and how to they interact?
Does the campaign even need to use the funds for the stated purpose?
It isn’t surprising that crowdfunding emerged as a means of capitalizing creative and productive enterprises on the web. The idea of gathering investors, pooling capital, and creating useful products is the essential foundation of America’s entire economy and way of life.
In the classic capitalist model, a principal will recruit a group of investors and offer them equity in his or her company in exchange for the funds necessary to build a factory or office, hire employees, design products, establish distribution, and so forth. This exchange of equity for money is the fundamental equation that drives both capital formation and wealth in a capitalist model.
When an investor buys equity, they are issued stock and from a legal standpoint they own a share of the company itself. What proportion of the company they own depends on several factors including how many investors there are, what the value of the company is and how much of the company was initially offered. That stock gives an investor a wide array of rights, often including the right to participate in shareholder votes, the right to elect directors, and the right to approve or block major transactions like selling company assets.
Crowdfunding operates on practically the same model as classical capitalism with one very important difference. When an individual contributes to a crowdfunding campaign, there is no equity offered or transferred. In fact, most crowdfunding platforms prohibit solicitation for the sale of securities like stock in a new company. The reason for this is the Securities and Exchange Act of 1933 prohibits any individual from soliciting the sale of equity or stock without taking several fairly exacting regulatory steps including the offering of a prospectus, qualifying investors in advance, and making audited financials available.
To avoid these fairly expensive and time-consuming regulations, crowdfunding platforms simply prohibit the exchange of shares, equity or stock for contributions to the crowdfunding campaign. Once this exchange is prohibited, crowdfunding goes from capitalism to a gift.
And once it’s a gift, all the legal requirements vanish.
One of the basic tenets of law is the concept of a contract. Party A and party B reach an agreement. Consideration (i.e., something of value) is exchanged. Both parties must live up to the requirements of the contract. This is one of the major misunderstandings about crowdfunding.
Although a campaign might say it wants to raise money to do certain things, from a legal standpoint, no contract exists between the campaign, the company, the principals, and the contributors. No stock is exchanged. No equity is awarded. In most cases, the crowdfunding platform itself prohibits any ex parte relationship between contributor and campaign. Once all of the potential relationship categories are foreclosed, all that is left is the fact that any contributions are gifts. The campaign can give its contributors products, rewards, and perks in the form of souvenirs or products – but the person contributing can’t own any interest in the company or endeavor.
So the question of whether a campaign must use its funds in any particular way is relatively easy to answer from a legal standpoint. Since there is no agreement or contract in place, the campaign has no legal obligation to perform in any particular way. The contributions are gifts. No equity is exchanged. Even if the campaign makes elaborate and specific promises, from a legal standpoint that’s all they are: promises. There is no legal basis to enforce them, especially when you take into account that most crowdfunding platforms involve worldwide participation.
While it might not be ethical or good for a particular organization’s reputation to gather up a lot of contributions and then run off with the money and fail to deliver anything, the truth is there is really no way to force the recipient of a gift to dispose of it in any particular way. Whether this is good or bad really depends on the relationship between the campaign, its principals, the contributors, and the community.
Most crowdfunding is conducted in minimal amounts, so the average contributor isn’t facing much risk if their contribution ends up disappearing. And while it might be nice if contributors could have some assurance their money will be utilized properly, at some point more regulations will simply turn crowdfunding into investing. Worse yet, it would be investing without the delivery of anything of real value to the contributors – other than the satisfaction of being part of a new idea and helping to build and deliver it.
Crowdfunding and crowdsourcing both are considered emergent properties of the internet. When a community of a certain size forms, conventions and institutions like crowdfunding are inevitable, as there will always be a market for inventors and their patrons. The next step will be to find a way to help both inventors and patrons build wealth through the distribution of equity and ownership.