Legal Considerations When Raising Funds Through Crowdfunding

Recently, we have been seeing more and more instances of fundraising through crowdfunding (CF). Crowdfunding, which allows for rapid fundraising, is expected to continue to be widely used, especially in cases where there are good ideas but insufficient funds to realize them.

On the other hand, because crowdfunding itself is a new mechanism, there is a risk of unexpected troubles. Therefore, we will explain the legal issues that should be taken into consideration when using crowdfunding to raise funds.

The Appeal of Crowdfunding for Businesses

Crowdfunding is a mechanism where a business proposes a new product or service, and raises funds in small amounts from a large number of people who support the realization of that proposal. Therefore, in the process of conducting crowdfunding, you can also find out how many people are interested in the product or service.

For this reason, for businesses, by using crowdfunding, they can raise funds and at the same time see the real reactions of customers. This means that it can also serve as marketing research and advertising.

Also, when using crowdfunding, there is no need to complete the product at the fundraising stage. After achieving the target amount through crowdfunding, the collected funds can be used to mass-produce the product, which can significantly reduce the risk associated with product development for businesses.

From the above, in situations where there is a high business risk of a company entering a new field outside of its traditional business area and there is a split opinion within the company, it is possible to dare to use crowdfunding to raise funds, adopt the plan if it is popular, and withdraw the plan if it is unpopular. For this reason, there has been an increase in cases of major companies using crowdfunding recently.

For more detailed explanations about the mechanism of fundraising by methods other than crowdfunding, please refer to the following article.

https://monolith.law/corporate/method-of-raising-funds-for-stock-company[ja]

Legal Structure of Crowdfunding

While crowdfunding has become widely recognized as an easy method of fundraising, the reality is that its legal framework is not well understood. Depending on how crowdfunding is conducted, there is a risk of it becoming illegal. Therefore, it is necessary to fully understand the legal structure of crowdfunding before starting.

Types of Crowdfunding

Legally, there are three types of crowdfunding:

• Purchase-based
• Donation-based
• Investment-based

Purchase-based Crowdfunding

In purchase-based crowdfunding, the person who provides the funds is treated as having purchased the product or service that is the subject of the crowdfunding through a sales contract. In reality, the product or service is provided after the target amount has been reached through fundraising, so strictly speaking, it is a reservation for sale. For example, a case where crowdfunding is used to raise funds for a movie that is scheduled to be completed, and the fund provider receives a preview ticket as consideration, falls under this category.

Donation-based Crowdfunding

Donation-based crowdfunding is often used in activities that contribute to society and volunteer activities, where the fund provider does not expect to receive a consideration equivalent to the funds provided from the crowdfunding operator. For example, crowdfunding to raise funds to build a medical institution in a depopulated area would be considered donation-based.

Investment-based Crowdfunding

While purchase-based and sales-based crowdfunding are rarely illegal in their mechanisms, the last type, investment-based crowdfunding, is subject to legal regulation and requires careful attention. Investment-based crowdfunding is a mechanism where the party raising the funds literally operates the funds and returns dividends, etc. to the fund provider.

There are three types of investment-based crowdfunding:

• Equity-based
• Fund-based
• Loan-based

In equity-based crowdfunding, the investor invests in the crowdfunding operator, who then invests in the company that raised the funds. As a consideration for this investment, the company that raised the funds issues shares to the investor. In equity-based crowdfunding, the company that raised the funds may often issue new shares to third parties. We explain the details of third-party allotment of new shares in the following article.

https://monolith.law/corporate/venture-capital-investment[ja]

When conducting equity-based crowdfunding, the crowdfunding operator needs to be qualified as a Type I Small Amount Electronic Solicitation Service Provider under the Financial Instruments and Exchange Act. Originally, registration as a Type I Financial Instruments Business Operator was required for the sale and solicitation related to share issuance, but this was a high hurdle as it was something that securities companies, etc. were registered for. Therefore, a system for Type I Small Amount Electronic Solicitation Service Providers, which relaxed the requirements for crowdfunding that receives small investments, was established by the amendment to the Financial Instruments and Exchange Act in 2014 (Heisei 26).

Fund-based crowdfunding is a mechanism where the crowdfunding operator forms a fund for each company that needs to raise funds, and the investor purchases a share of the fund and receives dividends, etc. from the fund.

Crowdfunding operators who implement fund-based crowdfunding need to register as a Type II Financial Instruments Business Operator under the Financial Instruments and Exchange Act. In addition, if they provide advice on investment decisions to investors, they may also need to register as an Investment Management Business or Investment Advice & Agency Business, depending on the content.

Finally, loan-based crowdfunding is a mechanism where multiple investors provide funds to the crowdfunding operator for a project of a company that is raising funds, and the crowdfunding operator lends the collected funds to the company as a whole. In loan-based crowdfunding, the relationship between the crowdfunding operator and the company is a money lending contract. On the other hand, the relationship between the investor and the crowdfunding operator is an investment and payment of dividends, etc. in return for it.

In loan-based crowdfunding, the crowdfunding operator needs to register as a Money Lending Business under the Money Lending Business Act and as a Type II Financial Instruments Business Operator under the Financial Instruments and Exchange Act.

Issues in Crowdfunding

After initiating crowdfunding, there has been a noticeable increase in disputes with fund providers. When starting crowdfunding, it is beneficial to learn from actual cases about what kind of problems can occur.

Issues with Crowdfunding

In the following, we will discuss some recent cases related to crowdfunding and points to be aware of. Please note that the outcomes of the cases mentioned below are not clear, so they should only be referred to as potential issues that could arise.

Case of Reiwa Natto

There was a case where a natto rice specialty store, “Reiwa Natto,” used crowdfunding to solicit support and issued a “lifetime free pass for natto rice set” in return for a donation of 10,000 yen. However, the passport was unilaterally confiscated by the store staff, causing a major uproar on the internet.

In this case, Reiwa Natto issued a statement saying that the confiscation of the passport was justified because it violated the terms of use. However, there seems to have been a problem in that the terms of use, which were said to be the basis for the action, were not explicitly stated at the time of the crowdfunding campaign.

Therefore, it is desirable for companies that conduct crowdfunding to clearly state any rules regarding the use of the rewards they offer at the time of solicitation in order to avoid future troubles.

Also, in this case, Reiwa Natto announced that they had consulted with a lawyer regarding the application of the terms of use. Naturally, companies cannot interpret whether or not there is a violation of the terms of use at their own discretion, so if you want to stop providing rewards for some reason, it is important to consult with an external expert such as a lawyer in advance to confirm whether such action is legally permissible.

Case of Eien Masuyama

There was a case where Eien Masuyama, a junior high school entrepreneur, launched a women’s underwear brand and raised about 800,000 yen through crowdfunding, but the project fell through. Although it seems that refunds were actually made to the investors, he tweeted from Cebu Island at the time of the failure, and people who saw this posted that Masuyama’s crowdfunding was a scam and that he was splurging with the funds raised, causing a backlash.

In this case, if refunds are being made to investors, there is not much of a legal problem. However, it is necessary to understand that if a crowdfunding project falls through, it is likely to be viewed critically by the public. To mitigate such backlash risk, it is important to promptly disclose the circumstances and refund policy officially when a crowdfunding project falls through, and to respond sincerely.

Summary

Given that crowdfunding is a relatively new mechanism, there is a possibility that unforeseen issues may arise in the future. Therefore, when utilizing crowdfunding, it is crucial to consider potential problems and their solutions in advance. At the same time, it is important to have a system in place to consult with experts, such as lawyers who are knowledgeable about crowdfunding, as soon as any trouble occurs. Crowdfunding tends to become a topic of discussion on social media networks, so it is necessary to be aware that mishandling the situation could significantly damage a company’s reputation.