Watch Out for Hidden Traps in Rewards Based Crowdfunding

To read more by Joseph W. Bartlett, Co-Founder of VCExperts.com, please see Introduction to Venture Capital and Private Equity Finance @ VCExperts.com.

Thanks to an article in the Trade Press by Regina Joseph, [1] I have become familiarized with language in the Kickstarter Terms of Use respecting what is typically called rewards-based or donation-based crowdfunding.

The Kickstarter Terms of Use include the following language, as quoted in the article.

“Throughout the process, creators owe their backers a high standard of effort, honest communication, and a dedication to bringing the project to life. … .

“If a creator is unable to complete their project and fulfill rewards, they’ve failed to live up to the basic obligations of this agreement. To right this, they must make every reasonable effort to find another way of bringing the project to the best possible conclusion for backers … . The creator is solely responsible for fulfilling the promises made in their project. If they’re unable to satisfy the terms of this agreement, they may be subject to legal action by backers.”

The issue is whether the parties seeking donations or rewards on Kickstarter are entering into a contract which, if the project does not work out as predicted, will create the raw material for a lawsuit by the donors to get their money back? One might say, “So what? If they want their money back, we will give it to them.”

However, the real catastrophe may be alleged violations of consumer protection laws.

Thus, the Federal Trade Commission has filed a complaint against an individual who cancelled the project and refunded the money. The FTC action was noted by a member of the Commission, Terrall McSweeney, in a piece called, “Backers, Beware: Crowdfunding Rules and Rewards.” [2]

In fact, according to a recent article by McCarter & English. [3]

“On June 10, 2015, the FTC settled a claim against a company and its CEO, requiring the return of over $122,000 of funders’ money. Money that was intended to fund development of a board game titled ‘The Doom That Came to Atlantic City’ went instead to the CEO’s personal expenses and to costs of another project. Unfortunately, there is still no happy ending for the funders; the judgment is currently suspended due to an inability to pay.”

In fact, the real problem in this respect may be that refunding is not necessarily the key to get the government off one’s back. If consumer protection laws are the vehicle, the sky may be the limit. At least one State attorney general, in the State of Washington has initiated an action based upon State consumer protection laws against a Tennessee company that allegedly failed to

deliver playing cards promised to 810 backers. The money delivered was $25,146. The complaint, however, aimed to collect $1,62 million, which was a $2,000 civil penalty for each of the 810 violations, even though only 31 backers were Washingtonians.

To be sure, there are some egregious success stories in the rewards-based crowdfunding arena. See the piece (Appendix A), a little further down, on combining rewards based and Title II accredited crowdfunding. But it pays to have the whole picture in mind before jumping into the pool.

[1] Joseph, “Crowdfunding Isn’t’ Charity,” Shumaker Loop & Kendrick, June 15, 2015.

[2] June 6, 2015, Huffington Post.

[3] Goldsmith & Smedresman,”FTC Eyes Kickstarter Campaigns for Consumer Protection, McCarter & English Client Alert, July 2015..

Joseph W. Bartlett, Special Counsel, McCarter & English LLP
jbartlett@mccarter.com


APPENDIX A

Rewards-based Crowdfunding and Rule 506(b), Joseph W. Bartlett, Co-Chair of VC Experts & Special Counsel, McCarter & English, LLP, 2014-11-03

You might be interested in a methodology for solving issues which confront the founder or founders of an early stage (the garage version) emerging growth company as the company launches.

The idea, which occurred to me while speaking to an event sponsored by the Crowdfunding Professional Association (“CfPA”) in DC on September 30th and October 1st, involves a dual approach for raising money, combining a pitch for donations under the rewards-based crowdfunding networks and platforms, the most prominent being Kickstarter and Indiegogo, with conventional fund raising under the auspices of Regulation D, Rule 506(b).

Many early stage high growth aspirants stumble because they don’t have enough money in the bank to cover their organizational expenses and therefore, the efforts to raise a Series A Round under Rule 506(b) do not get off the ground, so to speak. There are service providers I am acquainted with which will chaperone an emerging growth company through the rewards-based phase and, of course, there are a variety of intermediaries which can help with the Rule 506(b) offering.

I have not, until very recently, imagined that the organizational money (given, of course, an unusually attractive business model) could be raised alongside or immediately followed by a Rule 506(b) solicitation. The realization that it apparently can happen … because the only offering of securities is the Rule 506(b) process … means that, selfishly, there may be money in the bank to pay some kind of retainer and to cover legal fees of a law firm which (like ours), is skillful in helping founders launch on the trip, as I put it, “from the embryo to the IPO” (or to a trade sale).

According to a service provider in both rewards-based and Rule 506(b) fund raising, not only is it a way to attract the development money needed to pay the legal and marketing costs associated with a larger raise but it is an opportunity for startups to show some traction with initial customers, … which can help the ventures be more attractive to investors in the next round. Additionally, this approach allows entrepreneurs to get some early product feedback from those who support the rewards campaign, which can also result in refining and improving the product so it’s stronger when seeking the bigger dollars. My source says there are a group of famous venture capitalists who say they will not even consider investing in a venture until it has a “crowd round,” as the rewards-based campaign can be so integral to launching with a better product and one with traction.

Next, to every pitch idea there is, of course, an adjacent caution. Thus, another source of information for this piece cited the recent Oculus story, where the rewards-based supporters who provided $2 million of early capital got precisely what they were promised (a set of goggles), but did not participate in the $2 billion payday enjoyed by the entrepreneurs and VCs who bought securities in the Rule 506(b) rounds. There has been much angst and criticism in the crowdfunding world about this (See, e.g., Prosser, “Does Facebook’s Deal For Occulus Spell Trouble For Kickstarter,” April 2, 2014, Forbes.com)

The two prong strategy, in short, probably needs to be approached carefully. If the startup is robust enough that the Series A round is “in the bank” so to speak, a contemporaneous or immediately preceding donation -based round might label the founders as cynics … finding cheap money wherever suckers can be located. That said, in the undersigned’s experience, a large majority of the early stage founders in the U.S. are looking down a long arduous road before the Series A is “in the bank.” The Occulus result looks like an extreme outlier. The better idea is to get enough rewards-based money to join with the founder(s) blood, sweat and tears, enabling the process to pay something to the lawyers, a retainer (maybe) to a placement agent and the startup expenses of traveling the long (typically) road to a closing on the A Round. The service provider mentioned above likes to cite a Smart Thing as a good example, “With an initial goal of $250,000 on Kickstarter, it raised $1,209,424 on the platform and then raised an additional $15.5 million in venture capital and sold to Samsung for $200 million last August.”

Time will tell whether a two-step sequence is the way to go.

2 thoughts on “Watch Out for Hidden Traps in Rewards Based Crowdfunding

  1. However, the real catastrophe is how lawyers and bankers euphemistically calling themselves veecees are determined to destroy one of the few sparks of real capitalism in order to protect their own estates in Atherton and Woodside.

    Like

  2. It does point out a flaw in the Kickstarter model by raising the question as to why someone would want to contribute capital towards product development without getting equity in return.

    Like

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