Crowdfunding: an Alternative to “Traditional” Fundraising

In the past five years, there has been tremendous growth in the crowdfunding industry, with over $5.1 billion raised in 2013. More and more early-stage companies are turning to crowdfunding as an alternative means to raise capital for their businesses. 

Sites such as Kickstarter have become household names. The most successful crowdfunding project, Star Citizen, an online space trading and combat videogame, raised $61 million through crowdfunding in 2014. The question is: does crowdfunding make sense for your business?

What is Crowdfunding?

Crowdfunding is the practice of funding a project or venture by raising monetary contributions from a large number of people, typically through internet-based means. The two primary types of crowdfunding are:

  1. Rewards-based crowdfunding:  entrepreneurs propose a product to consumers, and in exchange for different levels of funding, the consumer receives the product on a later date, generally determined prior to starting the campaign; or
  2. Equity-based crowdfunding:  the backer, or crowd, receives some form of equity in the company in return for the capital infusion.

In addition, there are platforms available for companies looking to take on debt, as well as sites geared towards charitable endeavors. This article will focus on the tax and business implications in the primary crowdfunding solutions – rewards-based and equity-based platforms.

Rewards-Based Crowdfunding

Rewards-based crowdfunding, the classic example of crowdfunding, involves the entrepreneur pitching a product or service to the crowd. If the backers decide the proposed product is worthwhile, the crowd essentially pre-pays for the product or service. There are two subsets of rewards-based funding: all-or-nothing, where there is a minimum funding goal that must be reached before the business sees any money; or keep-it-all, where the business receives the cash, regardless of whether the stated goal is reached.

From a business perspective, the rewards-based model can be attractive for a couple of reasons. First, the entrepreneur does not need to share equity with others. Additionally, it minimizes the use of debt in beginning production. For companies ultimately looking to be acquired or go public, all acquisition proceeds will go to the founders. Second, using this type of platform allows the business to test the market for their product before incurring significant expenses.

From a tax perspective, cash received from a rewards based model is considered revenue. This revenue will be taxed, after taking into account expenses incurred in completing the crowdfunding project. For accrual basis taxpayers, revenue is recognized when the orders, or rewards, are finally shipped to the end consumer, thus allowing expenses to offset income. Cash-basis taxpayers must be wary, as the timing of cash receipts may not correspond with the tax year in which expenses are incurred, generating a larger tax bill than if using the accrual basis method of accounting. As always, consult your Andersen Tax advisor for a more comprehensive dialogue about the tax implications of choosing a cash versus an accrual method of accounting.

Equity-Based Crowdfunding

As a result of the 2012 Jumpstart Our Business Startups Act (JOBS Act), the U.S. Securities and Exchange Commission (SEC) lifted the ban on general solicitation and general advertising of certain offerings. Effective September 23, 2013, the JOBS Act opened the door for companies to seek equity investors using crowdfunding platforms. For companies seeking to grow their business, this is a viable alternative to more traditional means, such as angel and venture capital. Equity funding allows the company to minimize utilizing debt as a means to starting or growing the business. In addition, unlike rewards-based crowdfunding, no product or service must be delivered as a result of a successful capital raise.

The tax implications of employing equity-based crowdfunding are in sharp contrast to a rewards-based platform. A contribution of cash in exchange for equity is a tax-free transaction. This results in an increase in cash flow for the company earlier, since there is no corresponding tax bill associated with the receipt of the money contributed. With early-stage companies, this could prove invaluable to the life-span of the company. That said, earnings from the company are shared with the backers or investors, and ultimately, dilution of the founder’s equity could lead to a smaller return in a sale transaction. 

The rules surrounding equity crowdfunding continue to evolve and the SEC may finally issue long-awaited Title III and Title IV regulations in late 2015. Two key changes anticipated are an increase in the maximum on capital raises to $50 million and a widening of the definition of accredited investor to include those with academic and professional credentials. Another area for equity crowdfunders to keep their eye on is action from the states with their own regulations regarding crowdfunding. 

Other Considerations

Other than cash receipts, there are additional benefits to using a crowdfunding platform. Successful projects often lead to a boost in reputation and can raise the public profile of the entrepreneur. Furthermore, most crowdfunding websites require a certain level of communication between the producer and the backers, leading to increased engagement with consumers. Of course the good comes with the bad, as businesses that do not meet their goals can take serious hits to their reputation in large, public forums. Sometimes it is easier to raise money for a project than to make a project a success, and having to continually communicate can be time consuming for the entrepreneur.

Ultimately, while crowdfunding is not for everyone, it is an alternative way to fundraise that can provide additional benefits beyond just an influx of cash. If you are interested in learning more about how to incorporate crowdfunding into your capital raise, speak to your Andersen Tax advisor about whether it makes sense for your business.