We’ve written previously on options cannabis companies have when seeking financing. Since passage of Proposition 64, investor activity has noticeably picked up in California. It’s not surprising, as California is both the largest projected cannabis marketplace as well as home to roughly half of the country’s venture capital investors.

Cannabis Financing 101
Cannabis Financing 101

How are these investments structured? Below is a list of the more common types of cannabis investments we’re seeing, mostly in California, but in Washington State and in Oregon as well, in rough order of popularity:

Equity Financings. Our firm is doing “priced rounds” in the form of Series A equity financings with multiple investors, as well as individual investors purchasing minority ownership interests in LLCs. Cannabis companies are generally (but not always) preferring to have all investors within California so that they can do an intrastate offering for securities purposes.

Debt Financings. Companies with a track record of success are often preferring debt, as are investors that prefer not to have the exposure that comes with equity ownership. However, uncertainty on licensure processes and the timing when companies can fully operate has made payment schedules particularly risky for companies counting on revenues to pay back loans.

Convertible Notes. Convertible debt is traditionally used pre-Series A when a company is developing a product and still determining the size of the opportunity. A Convertible Note corrects for the difficulty in determining valuation at such an early stage by kicking the valuation can down the road to the Series A, but ensuring the investor gets at least as much value (and almost always more value) for their invested dollar, compared to the Series A investor. Typically notes have low interest rates, as investors are seeking equity upon conversion rather than by repayment.

For cannabis companies in California, convertible notes are taking on a new purpose: extending the question of valuation until 2018, when more will be known about the state’s cannabis regulatory regime. Conversion that is not automatic, but rather the option of the investor, also gives the investor an “out” should the investor not like the political climate around cannabis in 2018.

A slight variation on a convertible note is a “debtquity” arrangement where an investor provides a line of credit with a sliding scale of equity issuance based on the amount of capital accessed.

Alternative Financing Arrangements. Cannabis companies are proposing some non-traditional financing structures, such as investment via equipment leases, consulting arrangements, turn-key real estate, or investor-funded capital improvements. These are often a product of investor preferences or investor residency restrictions. Though these alternative financing arrangments are sometimes trickier for the lawyers to structure than a traditional investment, they often make for a good vehicle to provide cannabis companies with key resources needed at an early stage.

 

 

Cannabis securitiesLike tech startups, or any new business, cannabis startups need investment. Though most tech startups are organized as corporations, with the ultimate goal of acquisition or IPO, cannabis businesses are more often (but not always) organized as LLCs. But cannabis startups too often fail to realize that if they are seeking investors, they are probably selling securities.

Tech startups begrudgingly accept that compliance with securities laws are a fact of business life. With each financing, their attorney tells them: utilize a securities exemption or register the securities.

LLC membership interests, however, don’t fit into the common perception of the term “security.” Even many attorneys wrongly believe that securities are limited to stocks, bonds, and the like, and that a minority stake in an LLC is not an investment in securities.

In 2008, the case of US v. Leonard defined when a membership interest constitutes an “investment contract” — “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The court wrestled with extending the definition to LLC membership interests but concluded that LLC interests require a “case-by-case analysis” into the “economic realities” of the underlying transaction.

In short, the investor must “exercise meaningful control over his investment.” The touchstone of what constitutes a security is not the form of investment, but rather whether or not it is a “passive investment.” If the investment requires active management engagement by the investor, it is not a security. But if it is a passive investment where the investor relies on others to run the business, it is a security.

Investors often have the right to give input into management decisions but do not ever actually exercise this right. The trend in securities regulation is to look beyond the terms of the agreement to analyze the practical realities. Cannabis businesses should be aware that in US v. Leonard, the individuals were convicted of securities fraud and went to prison.

The big takeaway is that businesses can choose to have all investors as active member-managers, and thus can plan around (and draft their operating agreement around) the need for securities compliance. The following are some practical points to ensure that your investors are “active member-managers” rather than “passive investors”:

  • Investors have voting rights in the LLC operating agreement, and exercise those rights in practice.
  • Investors have a management role and are “actively engaged” – they can have titles or membership on committees tasked with certain aspects of business operations.
  • Investors have input into and negotiate the terms of the LLC agreement.
  • Investors have full information rights, and actually receive and approve reports regularly.
  • Investors have input on key company strategic decisions – major decisions are made after consultation with investors.

Ensuring that your investors have an active, participatory role in management allows you to avoid entirely having to deal with securities law. When choosing your investors, you can help yourself in this context by seeking out investors that, in addition to money, have experience in the cannabis industry or in management so they can provide a value-add to your business.

Of course, this type of active management role won’t be acceptable to investors in every circumstance. As the number of cannabis investors grows and becomes more geographically diverse, however, the more likely they are to be considered “passive.” Marijuana businesses must understand that taking on passive investors means it’s time for securities compliance. At that point your attorney should be telling you to utilize a securities exemption and make the appropriate filing, or register the securities.

California cannabis businesses may recognize “management control” from California’s recently-released proposed regulations. We’ve written about these here and here. The regulations define as an “owner” any person who participates in the “direction, control, or management” of the cannabis business. Individuals having management rights will need to be disclosed to and vetted by state regulators in license application processes. Therefore, securities compliance and cannabis regulatory compliance are now two sides of a coin. Investors either lack management rights, meaning they are passive investors and securities compliance is required. Or investors have management rights, meaning they are “owners” and disclosure to cannabis regulators is required.