The terminology used to describe the crowdfunding process can be a legal minefield.
At first glance, it seems that words with limited legal bearing are used to describe crowdfunding transactions. The terminology is also emotive, meant to elicit a response from the backers.
By developing its own terminology, the crowdfunding sector tries to distinguish itself as a separate financial transaction. This is similar to private equity using its own terminology or the financial derivative markets using its own. But, for a new-comer, the crowdfunding terminology can be confusing and can be mis-used by the various parties in the crowdfunding transaction.
In the crowdfunding process, all parties must understand what the underlying legal transaction is. In the same way as there is an obligation on the backer to provide the funds when the funding campaign ends, there has to be obligation on the project creator; backing a project in a rewards-based crowdfunding transaction with tangible rewards isn’t a goodwill donation or loan to a friend that will never get repaid.
To understand the legality behind the process, we need to understand the terminology and the transactions completed in the process. This post looks at terminology; the transactions and transfer of legal title is examined in another post.
- The underlying legal transaction in a rewards-based crowdfunding transaction, with tangible rewards with a commensurate marketplace value, is a sale.
- The pledge towards a cause would most likely be treated as a gift, but there are limited tax benefits for the backer.
- The main contracting parties are the backer and project creator. The crowdfunding platform simply provides an online platform for backers and projects creators to use.
- Project creators and crowdfunding platforms use emotive words to encourage backers to pledge.
Kickstarter and crowdfunding terminology
The lexicon used by Kickstarter and other crowdfunding platforms is:
“pledge” – used to describe the amount of money you will be charged if you have backed the project and the project meets its funding goal.
“reward” and sometimes “prize” – used to describe the product or service you will receive if the project creator can manufacture and ship the product or create the service.
“backing” – used to describe the act of selecting a reward by committing your money via a pledge. An extended use of this word includes interacting with the project creator.
Because these terms are not standard terms that are typically used in a sale transaction, it can be confusing as to what the rights and responsibilities of backers and project creators are.
This confusion is further compounded by Kickstarter stating that a backer may take legal action against a project creator if the project creator fails to deliver, but on what basis? Who exactly are the contracting parties, and what is the underlying contract between the contracting parties?
Who are the contracting parties?
In a crowdfunding transaction, the contracting parties are the backer and the project creator.
The platform, such as Kickstarter, is an intermediary to this contract, and may even be considered an agent to this contract.
There is an implied contract between:
- Kickstarter and the backer, in that the backer will use Kickstarter to source projects and manage the portfolio of backed project. Kickstarter charges 5% of the pledge for this service, and this contract can be considered fulfilled once the funding goal for the project is reached.
- Kickstarter and the project creator, in that the project creator uses Kickstarter to advertise their project and to manage the funding campaign. The 5% service fee is collected from the backers’ pledges. The contract has zero cost for the backer, and is considered fulfilled once the funding goal is reached.
Legal definition of typical words used to describe sale, loan and crowdfunding transactions
Let’s start by looking at the legal definition of common words used to describe common transactions, namely as sale and donation, and compare these words to the crowdfunding words of pledge, reward and prize.
“An agreement by which one of the contracting parties, called the seller, gives a thing and passes the title to it, in exchange for a certain price in current money, to the other party, who is called the buyer or purchaser, who, on his part, agrees to pay such price.
To constitute a valid sale there must be, 1. Proper parties. 2. A thing which is the object of the contract. 3. A price agreed upon; and, 4. The consent of the contracting parties, and the performance of certain acts required to complete the contract.”
This is the underlying transaction between a backer and a project creator. All four elements are met via the crowdfunding process.
The main issue is that the “thing” which is passed from seller to buyer has yet to be manufactured. But, using an analogy from the financial markets: in a futures contract, you agree to pay a sum of money for a commodity, such as corn, to be received in three months time. Right now, the corn is still out in the field, growing. This does not prevent the futures contract from being written, and both parties have rights and obligations, and expect fulfillment. Another analogy is an insurance contract: you are insuring against a future possibility, but both parties expect fulfillment of their rights and obligations at this time, and in the future. A similar argument can be made for a crowdfunding transaction.
Additionally, because the funds from the crowdfunding processes are treated as income / revenue for the project creator, this also implies a sale has taken place. The evidence for the sales transaction is that the reward is a tangible product, commensurate to the pledge and has an estimated retail selling price in the market place.
The aspect of the crowdfunding process that blurs the sale transaction is that the money is taken from the backers upfront in the process, unlike a pre-order or sale in a shop. Because the project creator is typically a start-up, there is a higher risk of bankruptcy, and the options for options for legal recourse become challenging.
“The act by which the owner of a thing, voluntarily transfers the title and possession of the same, from himself to another person, without any consideration; a gift.”
The use of the word “donation” is critical when backing a project for a charitable or non-profit cause to make it really clear what the transaction is, namely a donation to a registered charity. This is because a donation carries weight for legal and tax purposes, for both the backer and project creator.
The use of “pledge” for a charitable cause by a crowdfunding platform isn’t helpful for either the project creator or backer. Indeed, it muddies the transaction. If the word “pledge” is used, then one must look at the “rewards” offered in return. In the case of “pledges” for a charity, the rewards are typically intangible or not commensurate to the value of the “reward”, for example $40 “pledged” for a T-shirt costing $2. Accordingly, the American tax authorities sees any funds raised in this way as a gift. Only if the project creator is a registered charity will the funds be seen as donations, and only then can be the backer receive tax deductions.
“A pledge is a bailment that conveys possessory title to property owned by a debtor (the pledgor) to a creditor (the pledgee) to secure repayment for some debt or obligation and to the mutual benefit of both parties. The term is also used to denote the property which constitutes the security. A pledge is type of security interest.
or “to make a solemn promise.”
The legal definition of “pledge” does not seem to apply to crowdfunding. I suspect that the use of this word stems from the layman’s understanding of the word “pledge” – namely to make a solemn promise. The solemn promise is made by the backer to the project creator to provide money, and the project creator makes a solemn promise to deliver the rewards. I think that the word “pledge” can be misinterpreted in crowdfunding and the underlying legal contract obscured. I am not making a solemn promise to the project creator; I am giving the project creator money in return for a future product.
“A reward may be a sum of money or other compensation offered by the government or an individual to the public generally, or to a particular person or class of persons, in return for the performance of special or extraordinary services.”
The legal definition of “reward” implies a bounty or a promise of payment if my cat is found by a stranger and now wants the $50 promised as under a “reward contract”. Similarly to the legal and crowdfunding interpretation of “pledge”, the word “reward” can also lead to misinterpretations. My action of backing a project is not a “performance of special or extraordinary services”; backing a project means I am willing to support a project creator to fund their dream, in return for the product.
Both “pledge” and “reward” are emotive words; it conveys an all-over feel good message but also blurs the underlying sale transaction.
“Anything offered as a reward for a contest. It is distinguished from a bet or wager in that it is known before the event who is to give either the premium or the prize, and there is but one operation until the accomplishment of the act, thing, or purpose for which it is offered.”
I saw the word “prize” being used by a project creator in the context of telling me that I need to complete the survey to receive my prize. I think the project creator was trying to use a synonym for the word “reward” but this usage, again, misinterprets the legal contract. I did not enter a contest with other backers! There is no basis for using the “prize” as a synonym for the product or service offered.
The crowdfunding terminology is unique and serves the dual purpose of creating a separate financial sector and embracing the spirit of crowdfunding. But, the terminology only hints at the underlying contract, and this obscures the backers’ and project creators’ rights and responsibilities in the crowdfunding transaction.
Remember, the underlying contract is between the backer and the project creator, and not between Kickstarter and the backer or Kickstarter and the project creator. And, at the end of the day, as a backer, you have entered into a sale transaction with delayed delivery with the project creator.