Skip to main content

Trading Equity for Investment: Convertible Notes

 

As an LLC, there are many ways to secure financing to help grow your business. Financing and funding are crucial to scaling and reaching that next level of business potential. Entrepreneurs may not be aware of one powerful tool to security early investment: convertible notes. In this article, we will examine how LLCs can trade equity for investment by issuing convertible notes so that your LLC can thrive.

A Key Distinction: Members & Membership Interest

There is one key distinction we need to make between equity for LLCs and equity for other types of entities that will serve as a starting point for this conversation and help sharpen your use of convertible notes as a financing tool. The key is this: the people (or entities) who hold equity in an LLC are called “members” and their ownership is called “membership interest.” Unlike other entity types, a C-corporation for example, LLCs do not have “stock” or “shares” owned by “shareholders.” The terms “stock” and “shares” are reserved for other types of entities, because they grant certain rights to the holder of the stock or shares. LLC members, however, do not necessarily have similar rights based on their membership interest, due to the more flexible structure of the LLC entity.

Here is a specific example of how states might define membership and membership interest. Michigan’s Limited Liability Company Act defines membership interest as “a member's rights in the limited liability company, including, but not limited to, any right to receive distributions of the limited liability company's assets and any right to vote or participate in management.”[1] Specifically, a member of an LLC might have the right to monetary distributions, the right to vote, the ability to add or reduce their membership interest, and any other powers outlined in the LLC’s operating agreement. The specific powers given or withheld from members are flexibly assigned as outlined in the operating agreement. For example, if Danny has a 10% membership interest in an LLC, Danny may or may not be entitled to a certain percent of profit. The LLC’s operating agreement will outline how profits are paid out. Profits could be paid pro-rata based on membership interest, how much the member contributes to the business, who entered the business first, or many other options. 

Now that we are clear on how LLCs are owned by members with membership interest, we can move on to one potential opportunity entrepreneurs can take advantage of to secure financing. 

Securing Funding: Convertible Notes

How can your LLC attract investors? One good option might be to offer membership interest to investors. If your LLC has someone who might be interested in investing, but needs to be convinced, giving the investor the opportunity to own part of your LLC might be very enticing. This way, it is a win-win. Your LLC gains more funding to scale and grow, and the investor gets the chance to potentially own a successful small business and reap the rewards from their investment. Since your LLC can be flexibly set up, it can offer different sorts of ‘rewards’ for this investment.

This financing can be done through the form of a convertible note. In a typical convertible note, an investor gives an LLC money now, and sometime later, that investment might ‘convert’ into membership interest. This type of investment could be perfect for an early-stage LLC that is looking to increase its funding but has been unable to find financing so far.

What role does the investor play once they decide to invest? It is up to the LLC! Again, this is where the flexibility of an LLC comes in. The LLC can issue membership interest to the investors and grant them certain rights but withhold others. The LLC can cleverly use both its operating agreement and the convertible note contract to grant certain rights. For example, you might issue a 10% membership interest to a new investor, but this new investor will only have economic rights, and not voting rights. This would be clearly outlined in the convertible note contract and can be outlined in your operating agreement as well. You can set up your LLC operating agreement to be able to issue these ‘economic right only’ membership interests if your LLC does not want the investor voting on decisions for the company. 

Two Final Tips

Now that you have one more tool to finance your LLC, it is important to keep track of who owns what in your LLC before you start and every time your LLC changes its members or brings on investors as members. LLCs often use an operating agreement that outlines how their LLC will be managed, who will be involved, and what happens in certain scenarios. A sound business practice is to include a membership interest schedule (like the image below) in your LLC operating agreement. You can amend this schedule every time membership interests change. Including a membership interest schedule is an easy and reliable way to keep track of who owns how much of the LLC.

Finally, there are many convertible note templates online, but LLC owners need to remember the distinction mentioned earlier when searching for documents to use. Many of the templates are set up for corporations with shareholders and stock, but for an LLC, this document needs to reflect the nature of the LLC and its “Membership Interest” rather than stock. If you are interested in issuing a convertible note, contact the Clinic or another licensed attorney for advice on how your LLC can best use this great tool.



 

By Thomas Mulholland

[1] http://www.legislature.mi.gov/documents/mcl/pdf/mcl-Act-23-of-1993.pdf

Popular posts from this blog

A Breakdown of Fair Use

Is your small business trying to spruce up your website by adding some new pictures? Want to raise money for your nonprofit by hosting a community movie night? Trying to update your marketing materials with a brand-new promotional video with cool background music? If so, you could be opening yourself up to potential copyright lawsuits and should read up on the doctrine of fair use! An important aspect of starting a small business or nonprofit is exposure, and as organizations work to market themselves and increase awareness of their goals and activities in the communities they serve, they could open themselves up to legal danger. Litigation is expensive, and the cost can be especially devastating to small businesses and nonprofits. In all promotional or informational materials (including brochures, flyers, websites, etc.), organizations need to be sure that they are legally protected from copyright infringement claims.   What is Fair Use? Fair use is a legal doctrine that per...

BIPOC Executive Leadership Representation in Nonprofits

  Halloween has already passed, but as a lowly law student with arithmophobia, I feel compelled to provide you all with some spooky statistics in November. It is no secret that the upper ranks of America’s professional workforce have a diversity problem, and in particular, a racial diversity problem. Unfortunately, this remains true in the nonprofit sector: -           Studies have shown that just 20% of nonprofit executive directors and CEOs are people of color, and 66% of nonprofit Board members are white. [1] -           Another study reported that between July 2019 and January 2024, “ 47% of all staff… 70% of CEOs/Executive Directors (EDs)... as well as 66% of Board members identify as white.” [2] Compare these figures with the general population per USAFacts: over 40% of the U.S. population identified as non-white in 2023, a figure that has grown over 17% since 1990. [3] ...

Michigan Low-Profit Limited Liability Company (L3C): Mixing Social Impact and Profit

              Given the variety of legal structures, it is essential to pick the one that is best for your business and the goals you’ve laid out for them. And, in this age of conscious consumerism, businesses have looked towards merging both societal benefit and profit. [1] With that in mind, businesses are looking towards the sort of entity forms that provide a structure to achieve this dual-pronged purpose. One such entity in particular that has gathered attention is the relatively new statutory business entity the Low-Profit Limited Liability Company (L3C) . [2] An L3C is considered an entity for entrepreneurs who “value purpose and profits,” and is intended to provide entrepreneurs with the opportunity to form an entity that caters to both these goals. [3] The L3C is the states’ response to the demand of a growing number of social entrepreneurs that seek to combine the financial benefits of a traditional for-profit entity with the social benefi...