The crowdfunding securities that companies offer for sale in early stage seed rounds are called membership units, and they are in the same asset classes as the membership units currently owned by the founder(s) of the company. If their attempt at raising money on crowdfunding platforms is successful, those who invest in startups (people who purchase the securities) become minority owners as a result of these crowdfunded deals. Subsequently, they are subject to the decisions made by the majority security holder, despite their equity investment being of the same asset class. Owning a membership unit gives management voting control of the startup. However, as a minority owner, you can be outvoted on various issues that affect your equity investment (e.g., business development, operation agreements, the sale of company assets, debt, or convertible debt).
What are Membership Interest Units?
In equity-based funding, the startup running the campaign essentially sells shares or parts of its ownership (in the form of shares, membership, or interest) through crowdfund investing and venture capital.
A membership interest (also referred to as member’s ownership interest) has two parts – management rights and financial rights. That distinction is one of the significant benefits of operating as a Limited Liability Company (LLC) rather than as a corporation.
The financial rights include the right to receive financial statements and distributions from the company and share in the profits and losses. These private equity rights are seen as a member’s personal property and may be transferred without restriction (unless provided differently by the operations agreement). In reality, the statutes of most states provide that there are restrictions on the transfer of the remaining interests, meaning that a member can’t transfer or sell their entire interest without the consent of all the remaining members. The separation of management and financial rights protects the company and other members in case a member’s personal creditors want to seize their company interest. When it comes to managing the company, creditors cannot take the member’s position.
Limited liability companies can organize in any way they want, meaning that members can be directors and owners – or not. They are never public corporations, and the regulation crowdfunding exemption allows them to offer and sell up to $1.07 million of their securities without having to register the offering with the SEC (Securities and Exchange Commission). There can be one member or as many members as the company wants (corporations can be members as well), and this makes it easy to add as many accredited investors or investment companies as it wants for further investment opportunities.
Benefits of Membership Interest Units
When it comes to startup investment and company ownership, there are two sides of the coin – private equity stake and membership benefits. The owners support the early-stage business with their equity investments during seed rounds, while the investment company provides certain benefits. Venture capital investors receive liability protection and are indemnified for the company’s conduct unless they personally breach their fiduciary duties or commit illegal acts. These liability limitations protect members against the debts of the company and lawsuits.
Crowdfunding investors can benefit in various ways from membership interest units, and the benefits vary depending on the type of membership units they hold.
- Preferred membership units. These membership units are subordinate to both secured and unsecured debts. These types of investments receive the preferred equity return (percentage of the capital account) and return of their capital investment before other members. They are typically redeemed when their capital is returned, which makes them shorter-term investments (compared to other classes). Also, preferred membership interest unit holders don’t have any voting rights. Sometimes, companies guarantee regular quarterly or monthly payments of the preferred equity returns.
- Common membership units. These units are subordinate to preferred membership units and have a greater risk, more control, and the possibility of a greater gain (than preferred equity units). They typically receive capital return before the manager’s interest receives payment but after the preferred membership unit holders. When their capital is returned, they are not considered redeemed. They usually have voting rights for major decisions, such as whether to refinance, buy or sell securities or assets, operation agreements, or remove the manager.
An LLC or Series LLC can have different types of membership interest units, and members are allowed to sell their membership units. To do that, they must comply with state and federal securities laws, but if they are seeking funds from fewer than 35 accredited investors and don’t advertise the sale of membership interests, they are typically not subject to most of the regulations.
A membership interest is frequently represented in an LLC’s membership transfer ledger, membership certificates (if any), and balance sheet that shows the capital amount of each member. No certificated security instruments may be issued to membership interest holders. If the current value of a company is profitable, the CEO can make distributions to members on a prorated basis. Just like stockholders are entitled to dividends, a membership interest holder is entitled to distributions. In case a company merges or is sold, all members receive cash or other company assets as consideration for their ownership right, based on the company’s current value. LLC companies usually don’t go public, but they can be converted to a C-corporation in anticipation of a public offering, causing membership interest holders to become stockholders.
Issuing more membership units to add a new member can have a positive impact on both existing members and the company. It’s a good idea to bring in new people with different sets of expertise for business development and a client list for raising money because everyone benefits from company growth. To issue new membership units, new members must get a unanimous affirmative vote from all other members. Any current member can prevent ownership from being diluted further thanks to their right to stop the addition of new members.
Unlike corporations, in which investors neither get personal income tax benefits in case of company losses nor are guaranteed that profits will be paid out to them, LLCs are not recognized as a taxable entity by the Internal Revenue Service. This distinction means that limited liability companies can choose the tax treatment of a corporation or of an individual in the case of the LLC only having one owner. Since LLCs receive the tax advantage of being able to decide which tax treatment works better for them, more profit is available to pass through to membership interest unit holders. LLC investors don’t face double taxation like corporate investors (the corporation pays taxes on its profits and capital gains, and investors pay income taxes on their profits).
For early-stage startup investors, these are very exciting times because they can use equity crowdfunding platforms to take advantage of investment opportunities by providing venture capital to a startup that they believe has the potential to succeed and bring in profit. However, many of these funding portals will not provide information regarding rewards and risks for investors to help you do your due diligence. KingsCrowd is here to help you lower the risk and make the most informed decisions. Subscribe today if you want to find out more about the best crowdfund investing practices in the equity crowdfunding ecosystem.
About: Chris Lustrino
A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.