Tax and valuation of crowdfunding initiatives

by | 10/07/2014 | Digital Assets & Ebusiness, Finance Law

This is a backgrounder, guide and checklist for crowdfunding from an Australian perspective. It ends with a list of 14 crowdfunding sites worldwide. Our related articles are Australian crowdfunding law, current and proposed and Start-up funding framework in Australia.

In Australia there is no crowdfunding-specific law. This is probably a good thing at this time. It appears not to have been too great an obstacle over the last five years for the Australian Small Scale Offering Board (ASSOB) which raised $138 million for equity in about 300 small businesses.

The latest position on crowd sourced equity funding is set out in a 283 pages Crowd Sourced Equity Funding Report of May 2014, by Australia’s Corporations and Markets Advisory Committee (CAMAC). It proposes new rules to “overcome current legal impediments” for equity funding affecting issuers, platforms and investors.

Crowdfunding is a virtuous circle linking:

  • promoters or issuers (often start-ups)
  • intermediaries (crowdfunding platforms)
  • backers or investors (members of the public)

in a common initiative, project or venture which needs early stage capital-raising.

Crowdfunding exposes investors to relatively small potential losses by requiring some risk minimisation, due diligence or checks and by limiting the amount that may be invested by an individual investor. Typically sums contributed are less than $1,000.

""Commercial efficiency for crowdfunding arises from the early market research it provides. Before full-scale and expensive production or operational systems are put in place, promoters can gauge whether an initiative is attractive to investors or the public.

Legal efficiency arises from a crowdfunding platform’s online terms of service, which roll up into one set of legally binding terms and conditions, a range of deal points, procedures and legal formalities governing the promoters, platform and investors. Along with this there are many approaches for legals, ASSOB for example charges $5,000 dollars upfront for its legal process and 8% from the money raised.

These efficiencies do not remove all legal and related considerations. For equity crowdfunding in Australia, legal obstacles are overviewed in the CAMAC report. This article focuses on practical considerations especially for crowdfunding promoters.

Around the world crowdfunding permits investors to build an investment portfolio or back their passion. It raises $60,631 every hour according to a report published by the Crowdfunding Centre. It also indicates that in the first quarter of 2014 alone, US$156 million was raised.

In 2014 crowdfunding become a constant feature in business news worldwide. Indiegogo raised $44 million having hosted 190,000 campaigns in around 190 countries. More recently, Sir Richard Branson invested in crowdfunding website KickStarter, which has raised US$1 billion in crowdfunding projects.  Crowdfunding in Australia could potentially draw into the circle the 207,000 wealthy individuals sitting on $684 billion worth of assets, according to Artesian.

Crowdfunding is a distinct category even though it overlaps with start-up support activity by incubators, accelerators, mentors, crowdsourced co-development sites, peer-to-peer funding, angel funders and seed funders. Distinctions between these categories are provided in Start-up funding framework in Australia. See also Phil Morle’s excellent list and profiles in Funding options available for startups in Australia.

Crowdfunding currently involves three models: donation, loan, reward and equity. These models are based on returns to the investor or participant. Each results in different taxation outcomes, and they can be helpful indicators as to what to give in return to investors.

  • ""Donation: With this pledge model, there is nothing at stake except to live up to the pledger’s benevolence. The model particularly attracts projects which may not be commercially profitable but which the pledger may find worthy, significant or meaningful. Pledgers may be rewarded with small gifts or discounted products. A significant tax advantage is funds received will not be taxable in the hands of the investee and be deductible for the investor if the investee is a Deductible Gift Recipient (DGR). This is a status given under Australian taxation laws and involves a process of application and approval. Very few business ventures can qualify as a DGR.
  • Loan: Crowdfunding can be modelled as a loan from a crowd funder. To treat funding as debt, the contribution must satisfy the definition of debt according to the debt equity rules in Division 974 of the Income Tax Assessment Act 1997 (Cth). If the funding fails to qualify as debt, it is treated as equity. All taxation consequences that accompany that characterisation thus follow (e.g. income tax and withholding tax from investors abroad).
  • Rewards and equity: Funding in return for rewards (e.g. pre-orders and patronage) and equity are probably the most common models of crowdfunding. They too carry with them taxation implications, including capital gains tax.It is no surprise that increasing number of crowd funders are looking for ownership interest in crowd funded businesses, however small. So it is worthwhile focusing on this model in further detail.

Give equity with caution

Initiatives benefit from control, confidence and trust. Maintaining them requires strategic thinking, in such matters as giving equity to others. Equity can be thought of as an ownership stake or slice of an initiative that currently or in the future may become a business.

Company law and many other areas of business law provide various protections for investors. Thus legal treatment is advisable to avoid investor-investee disputes.

Without such legal treatment over time it becomes increasingly difficult to steer an initiative along the path to become sustainable. Some legal work can be postponed, but beyond a certain point previously untreated complexity becomes a worthless legal mess.

Value equity in context

The metrics useful for valuation, especially of digital media ventures, have undergone dramatic change. If shares are under-valued you risk selling too many shares and losing control over your business. When valuing shares it is prudent to consider several factors including those overviewed below. This valuation will also link back to the crowdfunding project budget and the target sum or goal for fundraising.

  • ""Relative value of your shares:If there is a better alternative investors will turn away or complain later. Therefore it is crucial that you do your research to find out the price at which similar businesses are selling their shares.
  • Share price discounts: Because it is hard for investors to dispose of shares in private companies you may have to consider discounting your shares to attract interest, at least in the initial stage. Since an investor may not have control of a business, buying some shares at a discount is often expected.
  • Economic boom or downturn: The economic cycle or climate at the time offers are made will influence perceptions and pricing of shares. Boom times are good for higher prices. Conversely, in an economic downturn prices should not be set too high.
  • Good business plan and prospect: Positioning an offering can involve distinguishing yours from others, eg., yours is local or a niche player, whereas one doing well is located abroad or is non-niche. If your positioning, business plan and profitability can convince potential investors of future business returns then higher prices for the shares can be anticipated.
  • Intellectual property ownership and licences: Intellectual property (such as valuable branding, a portfolio of copyright assets or a patented method or process you have discovered or devised) is relevant to valuing the shares of the business. The potential of such intellectual property should be considered when determining your offer to the market. With tech start-ups this is more of a case of futurism through technology forecasting (for example) than archaeology (i.e. backward looking bean counting for similar tech ventures years ago). Payments to be made by the business for the use of software, bandwidth and various services should also be factored in when pricing or shaping your offer to the market.
  • Timing of offer: Finally, the timing of the offer can be critical. A common error is making offers too early, when too little has been done. Towards the end of a financial year investors are inclined to make business investments to minimise their tax liability or to lock in their savings. Announcements affecting interest rates and exchange rates should also be taken into account in deciding when to offer shares.

Obtain legal advice

Changes have taken place in how ventures are being funded. For example, venture capital tax changes in the last decade were intense and convoluted. It was recently reported in the Rust Report that: “Venture capital funds have reduced. New capital committed to Australian venture capital and later stage private equity funds slumped by $2.4 billion in fiscal 2013, down 77% on the previous financial year, according to the latest ABS stats.” This data was drawn from the Australian Bureau of Statistics report titled, Venture Capital and Later Stage Private Equity, Australia 2012-13.

Another measure to note is that venture capital funds are a fraction of the $1.7 trillion in superannuation in Australia. As noted by The Australian Financial Review in “Venture capital investment has fallen steadily since a height of 2008 to $111 million in Australia last year [2013], according to industry group AVCAL, while angel investment hit $22 million in 2012, compared to $22.9 billion in the US that same year.”

It is possible that Australian company and tax regulations on crowdfunding will evolve soon. A waiting game is also evident in crowdfunding law in the United States for the JOBS Act 2012, as well as in New Zealand and the United Kingdom. Local activity revolves around CAMAC’s May 2014 report mentioned above, which followed its October 2013 “Crowd Sourced Equity Funding” discussion paper.

Nonetheless, Australian authorities, including the Victorian State Government, have begun to recognise the significance of crowdfunding. A law reform on the issue of equity in return for crowdfunding is imminent with the Australian government’s release of a discussion paper on that subject.

For law reform it is relevant to note that equity investment is already in a maze of corporations law that is complex for even experienced commercial lawyers.

Currently the existing framework of the Corporations Act 2001 (Cth) applies to certain funding arrangements, as warned by ASIC (Australian Securities and Investments Commission) on 14 August 2012. The maximum penalty for contravening the restrictions involves major fines, years of imprisonment, or both.

It is crucial for entrepreneurs seeking crowdfunding to keep up with these developments to maximise the prospects of success of a crowdfunding project. Obtaining professional advice on laws concerning companies, consumer protection, tax and financial regulation, etc. will surely prove to be a rewarding investment.

Anton Joseph is a tax lawyer and Noric Dilanchian is a business lawyer specialising in technology and intellectual property law, management and commercialisation.

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Noric Dilanchian
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