Cannabis patentsOur previous post in this series discussed the legal sources for cannabis patent rights. This post and later posts will address some questions about what patents could mean for the cannabis industry.

Today’s question is: Do cannabis patents create monopolies?

Today’s short answer is: Yes and No, but probably less than you might think.

A patent is a government-created monopoly, giving the patent holder an exclusive right to make, use and sell the patented invention. A patentee doesn’t have to let anyone else use her patent (there is no mandatory licensing in the United States), or even use the patent herself. Once the patent expires, it belongs to the public forever. Though the law abhors a monopoly, patents are an exception. The theory is that granting inventors a few years of exclusivity encourages the creation of products beneficial to society.

A patent is not an unlimited monopoly, however. To start, a patent is only good for a limited time, usually about 20 years from the patent filing date. Since it can take three or more years to get a patent granted, that often means a patent lasts 17 years or less in the real world. Patents cannot be renewed; once the patent expires, anyone can practice it at no cost.  Compared with trademarks, which could have indefinite terms, or copyrights, some of which can last as long as a century, the patent term is short.

Also, only inventions that are new and not obvious can be patented. If something has been publicly used or on sale for at least a year, it’s probably unpatentable by anyone. The legal meaning of “obvious” is different and more complicated than the dictionary definition. For our purposes, if a claimed invention could be readily made by a skilled person who was familiar with the prior art, it is obvious. These two requirements of novelty and nonobviousness are intended to ensure that the patent system narrowly rewards creators, not merely collectors or aggregators of products to which the public already has access.

Perhaps most importantly, a patent’s coverage is often much narrower than it appears. You can consider a patent to be like a real estate deed. The deed for your house may refer to the property at “1st and Main,” but that doesn’t mean you own everything at that address. Your actual property lines are set out in the deed’s legal description, e.g., by detailed surveying designations. Similarly, the scope of a patent is limited by the claim or claims, which are found in the last part of the patent following the words “I claim” or “What is claimed.” Here is a hypothetical cannabis utility patent claim, based on an issued patent:

What is claimed is:

1) A cannabis plant that produces a flower comprising:

[a] a terpene profile where myrcene is not the dominant terpene;
{b] a terpene profile defined as terpinolene, alpha phelladrene, and myrcene;
[c] a terpene oil content greater than 1.5%; and
[d] a CDB content of less than 3%.

Properly interpreting a patent claim is a notoriously squirrely activity. Even if you understand the technical features of the claim, there is an entire body of often-conflicting law on claim interpretation. But one principle is paramount in determining the scope of a claim: the patent covers only inventions that have each characteristic, known in patent law as an “element,” set out in the claim. If a plant had elements [a], [c] and [d], but did not have terpinolene in its terpene profile as required by element [d], it would not infringe that patent.

Our next post will consider more issues about patents and their effects in the cannabis industry.

Receiver time?

Back in 2014, we wrote that bankruptcy is not an option for marijuana businesses. That issue has been litigated here and there since then, but as of today, cannabis businesses are no better off than before. The hard reality is this: all bankruptcy cases are handled in federal courts under rules outlined in the U.S. Bankruptcy Code. Those courts have held that it would be impossible for a U.S. Trustee to control and administer a debtor’s assets (cannabis) without violating the federal Controlled Substances Act.

Bankruptcy laws are designed to afford a fresh start to honest but unfortunate debtors, while providing equal treatment to creditors. Without recourse to bankruptcy, parties can only: (1) liquidate without court supervision, or (2) explore state court receivership. Liquidating without court supervision offers no protection to pot business creditors. State court receivership does afford protections, but adds complexity because states closely regulate who is allowed to possess and sell marijuana (through licenses). For a while, it was an open question as to whether a state court receivership would actually work in the cannabis context. Recently, one actually did.

In the case at issue, a landlord (creditor) had leased space to a licensed marijuana business tenant (debtor). The tenant failed to pay rent, and the landlord evicted the tenant and acquired a judgment for unpaid rent. Because RCW 7.60.010 et seq. provides that a Washington state court may appoint a receiver over a marijuana business, the landlord convinced the court to issue an order appointing a receiver to sell the tenant’s cannabis and satisfy the judgment. The landlord then successfully navigated the licensure issue with the Washington State Liquor and Cannabis Board, sold the pot, and collected on its judgment.

Washington is not the only pro-cannabis state with statutes and administrative rules that seek to bridge the bankruptcy gap by allowing creditors to seize and sell cannabis. In Oregon, OAR 845-025-1260 provides “Standards for Authority to Operate a Licensed Business as a Trustee, a Receiver, a Personal Representative or a Secured Party.” Our Oregon and Washington cannabis lawyers have assisted numerous clients in acquiring and perfecting security interests under the relevant rules. We expect California to adopt a similar regime.

One of the reasons creditors get such high rates of interest for loans to cannabis businesses—in addition to the fact that banks won’t lend to them—is because many pot businesses lack lienable collateral. For many of them, the net worth of the business is mostly tied up in the cannabis itself. It is now clear that, at least in Washington, the cannabis can be liquidated by a third party, whether or not the pot was initially proferred by the debtor as collateral for a loan. In that way, cannabis businesses are being treated by progressive states much like non-pot concerns.

That we finally have had one successful state court receivership probably won’t nudge circumspect lenders to reach out to the cannabis industry. However, cannabis businesses can feel encouraged that their number one asset (their cannabis) may have marketable value when looking for loans; and lenders can feel hopeful that if everything falls apart, there may be liquidation value in the cannabis crop. None of this “solves” the bankruptcy issue, but it’s a step in the right direction.

How to structure your cannabis empire
How to structure your cannabis empire

Market consolidation in the cannabis industry was always going to happen, and it is already starting to happen. States like Washington and California have or will have limits on the number of marijuana-licensed businesses that individuals can own, but those limits are likely to erode over time. The market simply puts too much value on the efficiencies that come with consolidation — more consistent retail and product experiences, lower prices, etc. There are negatives that come with market consolidation, especially if markets move past standard consolidation to anti-competitive consolidation. Market efficiency is good, but oligopolies are bad. For government regulators, the value in market consolidation is that companies that earn more money have more resources to put into compliance — enforcement is likely to be easier. But market consolidation also makes it easier for businesses to coalesce and participate politically, and business political power can come at the expense of regulatory political power. For a thoroughly enjoyable Ted Talk on “Big Marijuana,” I cannot recommend highly enough this talk given by Hilary Bricken, our lead cannabis business attorney in Los Angeles.

But we are still in the early stages and the possible negatives of market consolidation still appear to be a long way into the future. Acquisition and merger activity continues to be hot in the cannabis industry, as is organic growth and expansion. If you are one of those growing businesses, there are a ton of ways to put it all together. You can have a single corporation that holds everything. You can have a corporate holding company with multiple wholly-owned subsidiaries. Or you can have a number of parallel entities with common ownership but without a direct corporate relationship to one another. Here are a few considerations to keep in mind when putting it all together.

  1. Liability structuring: There are two schools of thought on how many entities to have for a business that has multiple locations and holdings. On the one hand, having multiple corporate entities is great for limiting liability. If you own five retail stores and have each of them in separate legal entities and one of them gets sued, the worst-case scenario is you totally lose one store and have to shut it down. If they are all owned in one large entity, all of the assets are at risk. On the other hand, properly managing many different companies can be a governance and accounting nightmare. The efficiency gains of internally consolidating as many things into single entities can be worth it regardless of the additional liability exposure.
  2. Investment: A cannabis business’s valuable assets can generally fit into the following categories: trademarks and other intellectual property; real and personal property and other physical assets, inventory, cash receivables and ongoing profit interest. When that business goes out to raise capital, a fundamental question to ask is whether the investor is buying into the whole pie, or if the return on investment is targeted. With a multi-entity structure, an investor can invest in Facility A, while having no stake in Facility B or IP Holding company C. But be warned — different ownership structures in related companies come with serious risks of conflicting interests for the management of those companies, and the business must adopt cross-company conflicts policies.
  3. Employees: Multi-company structures often involve employees providing services to multiple entities. This is especially true for internal marketing employees, bookkeepers, and anyone else involved in business strategy. But it can also be the case where employees at one entity are asked to cover a shift at a different location. This can be a major headache if the business doesn’t have clear employment policy. There are three main options. First, the companies can all maintain clear separation and treat the employee as separately employed by each company. This isn’t really a good plan, however, because for many government purposes, like the Family and Medical Leave Act, the Affordable Care Act, and overtime rules, the business entities will likely be treated as an integrated employer anyway. Another option is to use “paymaster” rules, where a single entity within the chain can pay the employees and be reimbursed by the other entities. Finally, an affiliated entity within the business structure can serve as a professional employer organization and be licensed to formally provide paid employment services to the various entities within the business empire.
  4. Company Separation: No matter how closely aligned, different legal entities should not commingle their funds. Work done by third parties should be invoiced to the recipient of that work, and transactions within the business empire need to be invoiced and paid at reasonable market rates. Without following clear structures and formalities, there could be tremendous tax and liability consequences — the liability shield that exists between entities can be pierced if the companies don’t act as if they are truly separate.

As cannabis businesses grow, the time and money spent on internal compliance and good governance processes needs to grow as well. Policies and procedures that work for a single location company don’t work when that company outgrows its original home and multiplies.

Cannabis patents
Cannabis patents

In cannabis intellectual property (IP) law, as in most areas of cannabis law, separating the flowers from the weeds is difficult. There is a lot of misinformation available on the internet and elsewhere about whether pot is protectable under patent or similar laws, and what patentability means for the industry.

This post gives an overview of IP protection potentially available for cannabis strains and related plants. Under U.S. federal law, new plant varieties can be protected under the Plant Variety Protection Act (PVPA), as a plant patent under the Plant Patent Act (PPA), or as a utility patent under the Patent Act. Plant varieties could also be trade secrets or subject to contractual (licensing) protection.

PVPA: The Plant Variety Protection Act protects sexually reproduced (by seed) or tuber-propagated plant varieties, except for fungi or bacteria. The statute, which is administered by the Department of Agriculture, usually provides 20 years of almost-exclusive rights after the date on which the plant variety is certified. A variety for which PVPA certification is sought must be new, which is similar to the novelty requirement under the Patent Act. The variety must also be distinct, uniform, and stable, accordingly to USDA regulations. A certificate holder may pursue civil infringement remedies in court.

PPA: The Plant Patent Act protects asexually reproduced (e.g., by cuttings, grafting and budding) plant varieties, which are not tubers. For PPA protection, the Patent and Trademark Office requires that a variety be new, nonobvious, and have some de minimus utility, among other things. These requirements are common to all U.S. patents, and are the subject of extensive statutory and case law interpretation. In addition, a patented plant must differ from known plants by at least one distinguishing characteristic which is more than that caused by different growing conditions or fertility. A plant patent is limited to one genome of the plant, so that mutations or hybrids would not be covered in the patent, but would be separately patentable. Plant patents expire 20 years after the filing date of the application for the patent. A patentee may pursue civil infringement remedies in court.

Patent Act: Utility patents under non-Plant Patent Act law can be granted for plants, seeds, plant varieties, plant parts (e.g., fruit and flowers), and processes of producing plants, plant genes, and hybrids. As with other patents, a variety sought to be patented must be new, nonobvious, and have some utility, among other things. Civil infringement remedies are available in court.

Trade secrets/licensing: Though trade secret protection might be available to plant varieties, the ability of a skilled person to independently reproduce the variety in question could eliminate any protectable secret. Some breeders have sought to protect plant varieties by licensing contracts that purport to limit the use or distribution of the variety. Often known as “bag-tag” or “seed-bag” licenses, these are generally covered by state law.

The PVPA, the PPA, and the Patent Act all provide exclusive rights for 20 years, which can be enforced in court. The PVPA and the PPA differ primarily depending on whether the plant is sexually (PVPA) or asexually (PPA) reproduced. Utility patents may have more stringent requirements for applications than plant patents, but generally offer broader protections than plant patents. In particular, whereas a plant patent has only a single claim that defines the scope of the patent, a utility patent can have multiple claims, each addressing different parts of the plant or ways of using the plant that are disclosed in the specification of the patent. Also, utility patents are available for both sexually and asexually reproducing plants.

IP protection for cannabis plants used to be theoretical, but this changed recently. In the last two years, the PTO has issued plant patents, e.g., U.S. PP27475 P2 (Cannabis Plant Named ‘Ecuadorian Sativa’), and utility patents, e.g., U.S. 9,095,554 (Breeding, Production, Processing, and Use of Specialty Cannabis). In the next installment of the Cannabis Patent Primer, I will discuss what cannabis patents mean to the cannabis industry and try to dispel some of the patent myths common to the industry.

cannabis Intellectual property
I want my own IP….

If you co-own a cannabis business, you probably have a formal operating agreement that sets out who owns what—at least if you’ve been reading this blog. As I noted in my previous blog post, your cannabis company probably owns some intellectual property (IP): trademarks, copyrights, trade secrets, or patents. But who owns the IP, if, as is common, the operating agreement is silent on this issue? You may not have thought much about this, but you should. As any divorce lawyer can tell you, many assumptions about who owns what turn out to be mistaken.

LIke any other kind of property, IP is subject to general default rules that establish ownership, at least to begin with. The default owner of a patent is the human inventor. The default owner of a trademark is the entity (human or not) that uses the mark in commerce. Caution: it is easier to state these IP default rules in the abstract than to apply them in the real world. For example, though there is an ownership rule in copyright law called “work for hire,” it turns out it doesn’t apply to many people who are hired to create copyrightable works. Making mistakes about these default rules can lead to disappointment, or litigation.

You can diminish this risk, however, by making your own IP ownership rules. Virtually all of the default IP rules can be contracted around. A well-drafted IP ownership contract allows the parties to arrange their conduct knowing who will own the resulting IP. It will also discourage those who might try to take advantage of uncertainty to claim ownership of IP.

Co-owners of a business: IP issues arise in connection with a business formation in at least two situations: (1) some or all of the owners come to the business with preexisting IP, like brand names or trade secrets; and (2) the business will create new IP during operation. An IP agreement can define ownership so that the business will not be left without important assets (such as the brand name of the company) if the partner who brought IP to the business decides to leave. It can also provide ways to protect IP owned by the corporation, such as by requiring inventors to assist with patent filings or assign IP rights.

Deals with other businesses: Many deals between businesses have IP consequences. For example, a joint venture to create new growing processes could result in creating trade secrets or patentable inventions. In a distribution agreement, it is common for one party to have a license to use the other party’s trademarks. Determining the ownership of IP is critical when two companies work together.

Employer/employee/independent contractor: Any time a business entity pays a human being to create something, IP ownership issues will arise. Many businesses assume they know the default rules that apply depending on whether the human is called an “employee” or an “independent contractor.” The rules distinguishing these categories, however, vary from state to state, and are notoriously hard to apply. So, an IP agreement should not turn on the classification of the worker. Having a solid IP ownership agreement will allow both parties to concentrate on creating IP, and will lower the risks of disputes if and when the relationship ends.

IP ownership agreements need not be separate documents. The appropriate language can be included in your cannabis company’s operating agreement or even in its employee handbook. If you really want your own IP, however, don’t rely on the default ownership rules.

For more previous posts on cannabis litigation, go here for Cannnabis Litigation: Spotting Criminal Law Issues in Cannabis Cases and here for Cannabis Litigation: How to Avoid IP Disputes by Changing Your Oil Filter.

Our Oregon cannabis lawyers are often asked to include noncompetition provisions in employment agreements to ensure our cannabis clients don’t lose top talent to their competition. In many states, such as California, noncompetition provisions are flat out prohibited. Though Oregon allows noncompetes in principle, the reality is they are still strongly disfavored by the courts and the legislature. An Oregon cannabis employer must jump through a number of hoops to get an enforceable noncompete, but even that looks likely to change.

In Oregon, noncompete provisions are governed by ORS 653.295, which provides some severe restrictions:

  • At least two weeks before the first day of employment, a prospective employee must receive a written employment offer explaining that a noncompete will be required. Alternatively, a new noncompetition provision can be created when an employee receives a legitimate advancement, such as a promotion that expands job responsibilities to include protectable company information along with a raise.
  • The employee must:
    • have access to trade secrets; or
    • have access to other competitively sensitive confidential business or professional information, such as product development plans, product launch plans, marketing strategy, and sales plans.
  • Unless the employer is willing to pay 50% of the employee’s previous compensation during the noncompetition period then:
    • The employee must be paid at least $62,000 annually (this is tied to US Census Bureau data, so will sometimes fluctuate).
    • The employee must be engaged in administrative, executive, or professional work and
      • perform predominantly intellectual, managerial, or creative tasks;
      • exercise discretion and independent judgment; and
      • earn a salary and be paid on a salary basis.
  • The noncompete can only last 18 months after the termination of employment.
  • The geographical area for noncompetition must be reasonable (“Southern Oregon” might be reasonable, “the Continental United States” is probably not).

The first take away is that noncompetes in Oregon can’t currently bind your rank and file employees unless you want to continue paying 50% of their previous wages after they leave. If you want to prevent your trimmers and budtenders from seeking greener grass next door, it is going to cost you. The second take away is that your employment agreements should include nondisclosure provisions to prohibit your employees from sharing trade secrets, such as processes and procedures, with their new employers when they do jump ship.

As we said above, it looks like the Oregon legislature intends to clamp down even more severely on noncompetes. As initially introduced this session, Oregon SB 977 would follow California’s example and effectively void all noncompetition provisions. SB 977 was referred to the Oregon Senate Committee on Judiciary, where certain amendments are being considered. Once it gets back into session, the Judiciary Committee will consider amendment SB 977-2, which would require an employer to keep paying a terminated employee their full salary during the restricted period.

If SB 977, as introduced or as amended, is ultimately adopted, then noncompetes as we know them in Oregon will be gone. They will either be voided outright, or become so expensive to maintain as to be effectively useless. Either way, this will make nondisclosure provisions even more critical in the future. You may not be able to stop your key employee from heading next door, but you should still try to stop the flow of critical information to your competitors.

E-commerce Taxes for cannabis businessesMore non-cannabis companies are getting into the business of manufacturing or selling their products to cannabis growers, retailers, and consumers. Some of these ancillary cannabis businesses sell their products online using third-party marketplaces like Amazon. Ancillary cannabis businesses using marketplace providers may be required to collect sales tax from their customers and pay income tax. This post discusses some of the sales tax issues these ancillary cannabis businesses face.

Sales Tax Compliance. A business that sells to an out-of-state customer is generally not required to collect sales tax on shipments to that customer unless it either owns property or employs people in the customer’s state. Less contact is required for a state to impose state income tax from an out-of-state seller. A business may be subject to a state’s income tax merely by selling products to customers located in that state. For example, a business that owns inventory located in California must collect sales tax from its California customers and pay income tax to California. A business with no physical connection to Oregon other than selling to Oregon customers is subject to the Oregon income tax. This is the bad news.

Sales through Marketplace Providers. Business that sells their products on-line often use marketplace providers like Amazon.  These marketplace providers typically list products on their website, processes the sales transactions, and ship the product from its own fulfillment center. Though the product is physically in the possession of the marketplace provider, the selling business still has legal title to the product. Because the selling business holds legal title to the inventory, the selling business is responsible for collecting sales tax from the customer. A state may collect past taxes at any time from a business that does not comply with state tax law. On audit, it is common for a state to ask for 10 years of back taxes. To encourage sales and income tax compliance, the Multistate Tax Commission, a quasi-governmental agency, is offering tax amnesty for past due taxes in 24 states. This is the good news.

State Tax Amnesty. Under the tax amnesty program, most participating states will automatically forgive all prior year income and sales tax liabilities (including penalties and interest) of businesses that sold through marketplace providers if the selling business agrees to collect sales tax and file income tax returns going forward.  A few participating states will consider tax amnesty on a case-by-case basis.

Medical marijuana is still illegal in many of the participating states. However, the following medical marijuana states are offering to forgive past income and sales tax, penalties, and interest: Arkansas; Connecticut; District of Columbia; Florida; Louisiana; Massachusetts; Minnesota; New Jersey; and Vermont. The State of Colorado, will forgive a business’s prior year’s sales/use tax liability; however, a business with more than $500,000 of sales to Colorado residents must pay Colorado income tax from 2013 onward.

To qualify for this tax amnesty, a business must meet the following requirements:

• Not be registered in the state;
• Sell through a marketplace provider such as Amazon;
• Have no other physical contact with the state;
• File an application no later than October 15, 2017.

Every ancillary cannabis business that has ever sold any of its products through an online marketplace provider should analyze — and soon — whether it might be able to benefit from this tax amnesty.  Furthermore, every ancillary cannabis business that has ever sold online and shipped directly to its customer, should examine its compliance with state sales and income tax law.

Cannabis business lawyers
Why so few cannabis warehouses?

Among several changes to marijuana laws that SB 5131 enacted in July, Washington’s license cap on retailers moved from three licenses to five licenses. The Washington State Liquor and Cannabis Board at first wanted to delay implementation of the new license allotment to 2018, but has now consented to begin processing license acquisition applications immediately. This isn’t for new license issuance — that window is still closed. But existing retailers that own three licenses can now acquire two more.

As market consolidation occurs in Washington’s retail cannabis space, our cannabis business lawyers have been working with retailers on the problem of inventory management in the marijuana space. Inventory issues represent a misunderstood but glaring headache for marijuana businesses across the state.

Any time a retail operation has more than one location, that operation wants to run its inventory processes as efficiently as possible. Many multi-location retail operations in other industries utilize centralized warehousing as a key cog in their inventory management systems. Having a single regional warehouse able to directly supply many retail stores has significant benefits. First, the per square foot price of storage at a warehouse location is significantly cheaper than at a high-traffic retail area. Additionally, if a retailer controls the warehouse, it effectively separates itself from the friction point of dealing directly with suppliers. All outside vendors can deliver to the warehouse and the warehouse can distribute the goods to the individual retail stores at a time and method convenient for the retail stores — delivery becomes less of a hassle and negotiation.

But, as always, this is significantly more challenging in the cannabis space. The state’s tied-house rules and tiered licensing severely limit the movement of marijuana product and who can control it at any stage in that process. A single retail license works for a single retail location   — a licensed retailer cannot maintain a separate warehouse and a retail store with a license. Every retail location must negotiate and organize shipments from licensed processors that, because of the tiered licensing rules, are third parties. If I own five retail locations and I want to stock them all with a specific product, I must organize five different shipments of that product.

There are two different fixes to this predicament. One is to take advantage of WAC 314-55-079(8), which states: “A marijuana retailer may transport product to other locations operated by the licensee or to return product to a marijuana processor . . . .” So if I own four retail locations, I have a little bit of flexibility. I could maintain a networked internal distribution model, where each location transports to each other location when necessary. Or, I could use one location as my de facto warehouse. If I have three retail stores in the city and one out in the county, I could expand the county’s inventory space, direct all deliveries there, and manage distribution from that central location.

There’s a catch, of course. This rule only applies if all the retail stores are owned by a single entity — a real liability concern. Most companies with multiple retail cannabis locations that each carry their own liability insurance hold the locations in separate business entities. This limitation of liability strategy is a core component of U.S. corporate law. If there is a massive tort or contract claim against a single retail location held in its own entity, the plaintiffs have access to every asset and insurance policy of that specific entity, but they don’t have any claim to the parent company or to other affiliated retail entities. Managing liability exposure through different business entities can represent the difference between a disastrous occurrence killing your profits for a year and killing your business forever. Retailers in that context must undertake a cost benefit analysis by figuring out whether the liability risk is worth the gain from increased inventory management efficiency?

The other solution is to negotiate a form of symbiotic relationship with a licensed processor. As stated, before, tied-house rules limit the ability of retailers and processors to engage in many business arrangements. Retailers cannot borrow money from, get discounts from, or receive gifts from licensed processors. They cannot enter any binding agreement where the purchase of one product is contingent upon the purchase of another product.

However, the rules don’t prohibit communication between cannabis retailers and processors and they don’t prohibit processors from making purchases based on the needs of retailers with which they do business. In theory, then, a processor could know the demand schedule of a retail group with whom it does business and act as an intermediary purchaser for that retail group. The retail group would probably end up paying a higher price for the product, as it would be adding an additional middle-man to the transaction, but this model pulls in some of the benefits of centralized warehousing. This system does present some risk to both parties, though, as their ability to enter contingent contracts is severely limited. A processor making a bulk purchase it assumes the retailer is going to buy may find itself in deep financial straits if the retailer chooses to buy elsewhere.

There are a few rule changes that could make things easier for retailers here in Washington State, but the WSLCB’s goal isn’t necessarily to make things easy for marijuana retailers. Outside of increased lobbying, cannabis business owners will need to continue doing the best they can within the system we have.

Cannabis lawyers
A good look indeed.

The Irish poet and dramatist Oscar Wilde once said, “You can never be overdressed or overeducated.” There were no cannabis companies in those times, but the idea that a little formality never hurt anyone holds true today. In the context of running a pot venture, Wilde’s aphorism remains particularly useful as a matter of policy. So, this is a post about cannabis companies doing things right.

We represent a large number of marijuana companies up and down the west coast. Though they are all eager to comply with state and local laws, some of our clients are dangerously informal regarding company structure and documents. These companies may suffer from inexperience, budgetary constraints, practical hurdles (i.e. lack of banking services), or lack of discipline. In nearly every interaction we have with informal businesses, we admonish them to get some basic paperwork in order. Today.

Marijuana companies are similar to other companies in that a lack of formality can be fatal. Take your standard C-corporation, for example. At a minimum, this type of company should have bylaws, a shareholder agreement, stock certificates, subscription agreements and articles of incorporation that comport with state statutes. When key company decisions are made, they should be documented through consent resolutions. Company funds should be kept separate from personal funds, and actions by directors and officers should be taken in their official capacities. Failure to follow these touchstones will expose shareholders to both legal and tax liability (through “piercing the corporate veil”). Often, lack of basic documents defeats the purpose of having a company altogether.

Long-time marijuana entrepreneurs are accustomed to informality. Historically, these individuals come from black and gray markets, and are used to operating underground. New market entrants tend to be more cautious, but as a general matter, they too have a belly for risk, given the status of federal law. But, although federal illegality is a difficult risk to mitigate, running an unstructured and improperly documented business is wholly unnecessary. It is taking risk for risk’s sake, and it is unwise.

In seven years of representing cannabis businesses, our firm’s cannabis lawyers have yet to see a client shuttered by federal agents. We have, however, seen plenty of them buckle under from disputes or tax headaches that were foreseeable, preventable and directly attributable to either a lack of basic documentation, or a lack of adherence to protocol. Often, we meet these clients for the first time mid-stream: sometimes the situation is salvageable; other times, not.

Even a company with the tightest, most polished documents possible may stumble if its owners or agents fail to follow formalities. Having an exquisitely tailored operating agreement, for example, will not avail an LLC member if he commingles business and personal funds. Similarly, if a corporation’s president ignores her company’s bylaws for an end-run around the board, she could find herself in peril. It is not enough to have good paper: good governance is also needed.

Getting appropriate documents in place should not be terribly challenging for a cannabis venture. It is something that should be done thoughtfully at the outset with guidance from an experienced corporate cannabis attorney, and it should not break the bank. As the business grows, existing documents will be amended or restated from time to time, and new documents will be generated. And if company owners and agents keep it formal enough — as Oscar Wilde would have it — things are likely to work out fine.

Cannabis business transactionOur cannabis attorneys see many cannabis deals and on a daily basis we see term sheets, pitch decks, prospectuses, fund summaries, etc. Though we’re always on the legal side, we are also often asked for advice we’d label “business advice” — ranging from the specific (here’s our deck, what valuation can we demand?) to the very general (as investors where should we put our money ahead of what’s going to happen with California cannabis in 2018?). In this post I offer our thoughts on some common issues.

 

Company Founders Ask: What are Investors Looking for?

If you spend too much time and thought reworking the numbers on a term sheet, or even believing those numbers play a big role in driving investor interest, you’ve got it wrong. I for one have never heard an investor say “the product misses the mark and the team is mediocre, but with these investment terms I’d be crazy not to jump in!” Though Shark Tank isn’t what life is really like out in the trenches, it does get the investment decision process in the right order: first the sharks meet the team and get their pitch, then they discuss and negotiate numbers.” If you’re too focused on the numerical terms, you’re better off not having a term sheet — a pitch deck (or even a one-pager) that focuses on the following is much more likely to drive an investor discussion forward:

  • the size of the opportunity
  • capturing the imagination of the investor
  • selling the investor on the team – the people – as the right ones to execute and seize the opportunity

 

Investors Ask: Where are the Big Returns?

Many investors assume higher risk companies will mean higher returns. And with this assumption often comes another one: companies that “touch the [cannabis] plant” (and are therefore unsuitable for nearly all institutional capital) will generate the highest returns. For investors using debt instruments and looking purely at interest rates as their ROI, this may be true. But for equity investors, it’s all about scale, and companies whose primary business is one that “touches the plant” rarely have the highest scalability. Though there aren’t nearly enough company exits to say for sure, the big returns are far more likely to be found in business-to-business ancillary cannabis companies – software, data metrics, equipment leasing, and other business services.

 

Everybody Asks: How can we insulate ourselves from federal criminal liability?

You cannot, not with 100% certainty. You cannot be involved in the cannabis industry and be completely insulated from federal criminal liability. That said, there are tiers of risk, and they generally break down as follows:

Tier 1 (highest risk):

  • Business operators that cultivate and sell cannabis
  • Business operators that process, test, extract or otherwise “touch the plant”

Tier 2:

  • Investors in Tier 1, above

Tier 3 (lowest risk):

  • Advisors and service providers to Tier 1 businesses and Tier 2 investors
  • Vendors and others that enter into “arms-length” transactions with cannabis companies

 

Company Founders Ask: Where do we meet investors?

  • Introductions
  • Industry associations
  • Conferences and networking events
  • Not cold-calling

Speaking of great places to meet investors, keep your eyes and ear peeled for our California Cannabis Investment Forum, coming soon in San Francisco!