Crowdfunding: What’s best for your business?

CORP - June 20In recent years, many entrepreneurs have turned to crowdfunding in their efforts to raise capital. Platforms like Kickstarter and Indiegogo largely popularized this method of financing, but the industry is only in its infancy, with options in this space growing day by day. With the implementation of federal crowdfunding rules in May 2016, startups and small businesses in the U.S. now have a legal framework for equity-based crowdfunding, allowing for private offerings of securities to a much wider pool of investors. There are, however, significant restrictions in place making this option less attractive for some business owners.

So how do you decide if crowdfunding is right for your business? Here are the basics:

Reward-Based Crowdfunding

The word “crowdfunding” is often synonymous with the crowdfunding site Kickstarter, a reward-based platform. With this type of crowdfunding, individuals pledge money to your business idea in exchange for some type of benefit. A significant upside to reward-based crowdfunding is that you are not giving up ownership of your business in exchange for capital: reward-based crowdfunding is more analogous to selling a product than taking on investors.

Some start-ups have found enormous success using this method of crowdfunding, with projects like the Pebble smartwatch raising $2.6 million on Kickstarter in only three days. However, this method tends to work best for creative projects or consumer goods that grab attention and are easy to understand. Software or tech companies looking to raise significant amounts of capital are often better served using other types of fundraising.

Equity-Based Crowdfunding

Equity-based crowdfunding platforms are akin to online venture capitalists, connecting companies seeking investment to a wide range of small investors. Even reward-based platforms are branching into this space, like Indiegogo, which recently partnered with equity platform Microventures to form a new securities crowdfunding portal.

True equity crowdfunding was only made possible through the Jumpstart Our Business Startup (“JOBS”) Act, passed in April 2012, and its implementing regulations, adopted by the Securities and Exchange Commission (“SEC”) in October 2015. These rules now allow companies to raise up to $1 million in a crowdfunded offering during any 12-month period, although individual investments are capped at certain amounts depending upon the investor’s income and net worth.

Companies who choose this route should consider the significant requirements placed upon them, including sharing an annual report, with financial statements, on the company’s website and filing this report with the SEC. For early stage businesses, preparing such a report may be too burdensome, and the risks of sharing sensitive information with the public too great.

Under the JOBS Act rules, all equity crowdfunding must be conducted through registered intermediaries, meaning the platform itself must be registered with the SEC. This registered intermediary is also required to have a financial interest in the company raising funds. As a result, often 10-15 percent or more of each fundraising round will be given over as an upfront fee to the platform. For smaller businesses, this cost is simply impractical.

When financing your business, remember you have multiple options. Consulting with the right attorney may help you figure out which decision is best for your company.

Profits Interests Transform Employees into Partners, and Why You Should Care

CORP - June 6.pngBusinesses frequently wish to incentivize and reward key employees with equity ownership. Those businesses operating as pass-through entities will often find a profits interest a convenient and tax favorable way to accomplish this goal. The profits interest can generally be structured to be received by the employee without triggering a current tax liability while still incentivizing the employee with participation in the up-side of an exit.

However, many are unaware that the granting of a profits interest to an employee transforms the employee into a partner for tax purposes. Profits interest holders are partners and the longstanding position of the IRS, as laid out in Revenue Ruling 69-184, is that a partner in a partnership may not also be an employee of that partnership.

What are the consequences of this transformation? Employees are subject to income and FICA tax withholding (and Form W-2 reporting) while partners, on the other hand, receive Form K-1 and pay income and self-employment taxes on a quarterly estimated basis. Further, this transformation may increase new partners’ employment tax burden because employment taxes for employees are borne equally by both the employee and employer, while employment taxes paid under the self-employment system are born 100% by the self-employed (i.e., by the new partner).

Also, only employees are eligible to participate in cafeteria plans, including flexible spending accounts, whereas partners are not.

What are the consequences of treating a partner like an employee anyway? Aside from potential over or under paying of employment taxes or potentially disqualifying a cafeteria plan by virtue of enrolling a non-qualified participant, future grants of profits interests to a partner who is incorrectly being treated as an employee may lose the benefit of the profit interest safe harbor and be taxable to the partner upon receipt.

The increase in self-employment tax burden caused by the issuance of a profits interest can be mitigated through a salary gross-up or may be overshadowed completely by the up-side of being able to participate in an exit. Complications of profits interest related to cafeteria plans and the future grant of more profits interests can be avoided through understanding the employee’s transformation into a partner and treating such individual accordingly.

Planning opportunities may exist for those businesses that wish to grant equity ownership to their key personnel while retaining the employment status of such personal. Such businesses should carefully vet these opportunities with their tax advisors.