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.
