The ins and outs of the crowdfunding process

The crowdfunding process is underpinned by two transactions: one with with the project creator, and one with the online platform.

To understand the legality behind the process, we need to understand the terminology of the transaction as well as the actual transactions, when money exchanges hands, and the transfer of legal title.

It is really important to understand whether the transaction is a gift, donation or sale.

The legal boundaries of the types of transactions completed in a crowdfunding process impacts the legal implication of the process as well as the legal recourse options available.

Key takeaways

  • Kickstarter and Amazon Payments provide a service to the backers and the backers pay the service fees.
  • The backer and project creator engage in a sale transaction, if the rewards offered are tangible, commensurate in value and have an external marketplace.
  • Funds raised from rewards-based crowdfunding is treated as income / revenue for the project creator.
  • The main differences between a pre-order and crowdfunding campaign is when money is exchanged and legal title over the products transferred.
  • The funds raised in the crowdfunding campaign can be used to pay for any business expenses as well as for dividend distribution to company owners.

The two types of transactions in a crowdfunding campaign

There are two types of transactions in crowdfunding:

1) The first transaction is the service provided by Kickstarter and Amazon payments. Payment is made once by the backer when the service is finalised, namely when the project funds.

2) The second transaction is very similar to a sale via an online platform. For online purchases on the Europe Union, payment can only be taken once the product has shipped and legal title (ownership) of the product has passed from the producer to the buyer; but in a crowdfunding transaction, the money from backers is pooled, and used firstly, to pay the Kickstarter and Amazon Payment service fees, and secondly, to pay for the various expenses the project creator incurs, such as business expenses or manufacturing.

The backers expect that the money pledged and received by the project creator is used to manufacture and ship the product. Each backer expects that they have an earmarked product that they have paid for. But, in reality, this may or may not happen, depending on the business experience and financial expertise of the project creator.

A relatively easy way to understand the crowdfunding process, when money is exchanged and legal title transferred is by comparing it to a pre-order transaction, as conducted via Amazon. The two types of transactions can be depicted as follows:

Comparing a pre-order to a crowdfunding campaign

Comparing a pre-order to a crowdfunding campaign

The two main differences between a pre-order and crowdfunding campaign are:

i) when money is transferred from the buyer / backer to the seller / project creator;

ii) when legal title of the product transfers from the project creator to the backer.

The transfer of legal title is a formal way of saying that the backer takes full ownership over the product. For example, if you shop in a local grocer, the food in the trolley belongs to the grocer. Once you have paid, then you own the food; legal title has transferred to you.

Because the money from the backers is pooled at the end of the fundraising campaign, the actual crowdfunding process feels similar to a private equity deal seeking multiple capital (monetary) sources. And because the money is exchanged long before the legal title is transferred, it complicates how this transaction is understood.

From my research, there are two common misunderstandings of the transactions of a crowdfunding process:

i) it is not a pre-order; and

ii) pooled money from backers is designated as work-in-progress capital, money used to pay for the manufacturing and shipping of the product. This implies that the funds from backers is a source of capital, similar to debt or stocks.

In Kickstarter’s guide for accountants, it describes the funds raised from backers as:

In general, in the US, funds raised on Kickstarter are considered income (emphasis added) … In general, a creator can offset the income from their Kickstarter project with deductible expenses that are related to the project and accounted for in the same tax year … Beyond deductions, a creator may be able to classify certain funds raised on Kickstarter as a nontaxable gift, and not income.”

Let’s leave aside the issue of donation and focus on the income. For me, this has one clear implication:

For the funds to be considered income (also known as revenue), there has to be a commensurate service delivered or product sold.

Let’s have closer look at this using IFRS, the international financial and reporting standards. This is an accounting methodology that is similar to US GAAP.

As from Wikipedia, there are three criteria that creates the “critical event” in order for income from the sale of goods can be recognised as income, namely performance, collectability and measurability. The criteria consist of:

  1. Risks and rewards have been transferred from the seller to the buyer – performance
  2. The seller has no control over the goods sold – performance
  3. Collection of payment is reasonably assured – collectability
  4. The amount of revenue can be reasonably measured – measurability
  5. Costs of earning the revenue can be reasonably measured – measurability

Accordingly, and very simply, because the money raised from the backers and transferred to the project creator is income, and in return the backer receives a product as reward, the crowdfunding transaction is a sale, with all commensurate rights and obligations attached to it, including refunds.

The main complication is that the crowdfunding process seems to be recognised as a sale as soon as the campaign funds, whereas the backers only get the products bought after a period of time. The risks and rewards (namely legal title over the product) does not transfer to the backer until the product ships. This is contrary to the usual sale transaction, namely that the risk and reward of the product is transferred as soon as the consumer pays for the goods.

I argue elsewhere that the crowdfunding transaction looks and behaves similar to a futures contract written via a stock exchange, or at a minimum, as a semi-secured loan to the project creator. When manufacturing is completed, the security will be the manufactured product. Before and during manufacturing, the backer should on par in the hierarchy of creditors as any other junior debt holders. But, if Kickstarter states that the funds is income, the entire understanding of the transaction between the project creator and backer changes.

Accordingly, the two commonly understood interpretations of the crowdfunding process is not 100% correct.

The transaction is analogous to a pre-order or sale, except that there is delayed delivery.

The funds raised is not a source of capital (similar to equity or debt) designated for work-in-progress inventory costs; on the contrary, the funds is classified as income/revenue and can be used as the business sees fit, including but not limited to paying for work-in-progress or manufacturing costs. The business can use the income/revenue, for example, to pay any other business expense, including taxes, or even to distribute dividends to stock holders.