The curious case of crowdfunding rewards as dividends

The buyout of Oculus VR has renewed interest in the possibilities of securities crowdfunding.  The tricky part of recreating the crowdfunding success of Oculus VR is to generate the same excitement as a rewards campaign within the bounds of a serious securities offering.  In our previous post, CrowdCheck noted some of the issues that can arise when undertaking a combined securities and donation/rewards crowdfunding campaign.  This post will look at a slightly different transaction that accomplishes a similar end: providing donation/rewards crowdfunding style perks as dividends, which some commentators have floated as an option for companies with limited cash.

As a quick refresher, a dividend is a payment made by a company to its shareholders.  The first question for a company is, how is it going to “pay” the dividend?  (After all, there’s a cost to those perks.) The two possible sources of funds to pay a dividend are the retained earnings of a company or its paid-in-capital.  An early-stage company without current, steady revenues is likely not going to pay for its perks out of the retained earnings of the company.  Nevertheless, dividends paid out of the retained earnings would be a taxable event to the investors.  In this situation, the company would be required to issue a 1099-DIV to investors because it gave them dividends in the form of a product.  The company will need to be sure it can accurately value the product; investors may disagree with the valuation because it affects their tax liability.

If the perk is being paid for out of the paid-in-capital of the company, that is not a taxable event to the investors.  Instead, it is viewed as a partial refund of the capital contribution of investors.  One result of paying dividends out of the paid-in-capital is that the basis for the purchased securities is adjusted downward (i.e., the investor will have a larger capital gain or a smaller capital loss at the time the security is sold).  The exact change in the basis should be provided to investors by the company.  Before paying for the perk out of its paid-in-capital, the company should also be sure that its Certificate of Incorporation allows it to make that type of dividend payment.  A company may be restricted from paying dividends out of its paid-in-capital capital.  Without such a restriction, directors and major shareholders could demand the company pay dividends and deplete its capital assets until the company is no longer solvent.

One means to get a similar result without conducting a combination campaign or paying out dividends option would be to separate the two contributions by contract.  For example, as a condition of the original purchase agreement for the securities, the investor could also have the option of contributing to the company as a donation for a future reward.  Here, the contract for the donation/reward contribution would have to be optional to investors, otherwise it could be viewed as requiring the securities sold to be “assessable stock” which could be materially different than the representations by the company that it makes when selling shares that the securities offered are “validly issued, duly authorized, fully paid, and nonassessable.”  From a tax standpoint, the company faces the same issues as it would in a traditional donation/rewards crowdfunding campaign.

The appropriate means for a company to both issue securities and deliver a reward to investors that drives excitement in the offering — the same way backers were excited about the Oculus Rift development versions — will differ from company to company.  Each method comes with its own legal and tax concerns that will affect companies differently.  Entrepreneurs need legal, tax and accounting advice before getting too innovative with combined campaigns.

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