Investors are savvy. Make sure you know your terms!

Equity financing has only recently become a viable option for companies in the cannabis industry. As a result, many industry entrepreneurs are unfamiliar with equity financing terms. Also, many entrepreneurs (in many industries) don’t dig deeply into terms they don’t understand, which is a dangerous game. For example, trying to read the National Venture Capital Association Model Term Sheet–all 16 pages of it–is not helpful for someone starting from scratch, because the document assumes knowledge of its terms, and no matter how many times you read “liquidation preference” on a term sheet, the meaning will not become clear.

Asking your attorney to walk you through the terms you don’t fully understand can be helpful, particularly so she doesn’t assume that you understand things that you don’t, and which are about to affect your pocketbook. It’s also a great way to vet your attorneys’ understanding of the terms. However, reviewing with your attorney is unlikely to be a comprehensive education; or, if it is, will be an unnecessarily expensive education.

In the end, the undeniable truth is: If you’re an entrepreneur who is serious about raising funds through an equity financing, then you owe it to yourself, your company, your investors and shareholders, to educate yourself. In business, “depending on the kindness of strangers” is not a viable strategy. If Tennessee Williams wrote “A Startup Named Desire”, it would certainly be a tragedy. There are many resources for your self-education, but top of my list for recommended reading is “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist” by Brad Feld and Jason Mendelson.)

Until you complete your education, below is a primer on five equity financing terms that you must understand before you ever sit down with an investor to write a term sheet. I’ve gone with top five because these are the terms that are most critical, most likely to be negotiated, and the ones you need to understand to get the core of the financing right for your business. Of course, this list is by no means exhaustive.

1 – Valuation

Valuation is always the most critical term of an equity financing: it’s how much of the company you are selling, in exchange for how many dollars. Valuations are straightforward with the exception of two aspects that perplex entrepreneurs:

  1. There is no one-size-fits-all science to the process of arriving at a valuation. It is a negotiation between the company and the investor. There are models, there are metrics, there are comps, there are hopes, dreams, and business plans, but ten investors could look at a company and arrive at ten different numbers. Cannabis business valuations are especially unique, as we have covered here and here.
  2. Valuations are expressed as the value of the company before the investment round (the “pre-money valuation”) and the amount it will be worth after the investment round is completed, accounting for the “new money” the company has received (the “post-money valuation”). The confusing aspect of this is that this can be expressed in any order, and not necessarily using “pre-money” and “post-money” (which are almost always shortened to “pre-” and “post-” because syllables = time = money, right?). Often the expression will be stated as a total dollar figure based on pre-money valuation (“I’ll put in two million, based on eight pre-“), or as a a percentage using the post-money valuation (“I’ll put in two million to own 20% post.”)
  3. And one more, which I get often: Remember that you are not selling a set-in-stone percentage of your company. You are selling shares, a.k.a. stock. An expression of a percentage will determine the number of shares of stock to be sold (which will be newly-issued “Preferred Stock”) and the purchase price of the shares, based on the number of shares currently outstanding. But you don’t get to 100% and run out of equity–more shares will be issued in the next financing, the number of shares will increase over time, and percentages will change. Expanding the size of the pie is the focus, rather than the size of each slice.

2 – Liquidation Preference

A liquidation preference is an investor right that is triggered when the company is sold, merged, or otherwise liquidated, and it allows the investors, who are holding preferred stock, to be paid (and sometimes paid multiple times over) for their stock before the common holders receive anything. In theory, this can result in preferred stock getting a large portion of a sale, or even theoretically all of the sale (although the company is unlikely to pursue such an acquisition, if the price was only sufficient to cover the preferred shareholders’ liquidation preference). A liquidation preference may seem unfair if you equate the sweat equity of the founders and employees who built the company with the investors’ dollars that funded it. But, the liquidation preference is central to why VCs invest: Any acquisition, even a modest one, will be favorable for the investor, and offset all of the other, inevitable company failures in the investor’s portfolio. Company founders are unlikely to remove a liquidation preference entirely, but should be able to keep it at 1x or 2x at most. Liquidation preferences of 2.5x or greater are only appropriate in the riskiest, moonshot-style deals.

3 – Participating Preferred  

Participating Preferred is another “pot” sweetener for the investor that is triggered upon a sale (must ensure that rate of return doesn’t disappoint the fund’s limited partners!). Again, it involves the preferred stock being paid on more favorable terms than common stockholders receive. Here the participating preferred gets to first receive a liquidation preference, and then receive a share of the sale proceeds as if its preferred shares had been converted to common stock. Even an investor would admit this is a “double dip”, and companies are wise to push investors to choose the liquidation preference over participating preferred rights (but not both), or at the very least introduce a “cap” whereby an investor can either use their participation rights to receive a set multiple of their original investment (say, 3x). Or, if it’s a better outcome, they can choose to convert to common and share in the proceeds of the sale. If it’s a home run they’ll choose the latter, but even a home run gets you one trip around the bases, not two.

4 – Anti-Dilution Protections

There are a number of types of anti-dilution protections, which fall broadly into categories of structural anti-dilution protection, right of first refusal or preemptive rights, price-based protection, and full ratchet anti-dilution protection. They all boil down to protecting investors in the event later financings result in the sale of cheaper equity, a.k.a. a “downround.” Luckily term sheets usually deal with anti-dilution protections summarily, and at the term sheet level the big takeaway would be that “Customary NVCA broad-based weighted average anti-dilution protection” is generally considered fair (whereas “full-ratchet anti-dilution protection” is not). In theory, full ratchet would seem fair to the investors who invested in a higher-priced earlier round, giving them the equivalent deal as later investors. In practice, however, the presence of full ratchet is likely to scare away subsequent investors, or force a workaround, meaning hybrid equity and debt financing to prevent triggering full-ratchet.

5 – Voting Rights (and Board Seats!)

That a Series A lead investor will receive a board seat is a given, but custom voting rights giving the Series A Board Member the right to veto day-to-day transactions, employee hires, etc., shows mistrust in the company’s leadership and existing board. I always push back on voting rights that misalign interests or shift power dynamics between the company and investor, or on the Board.

Also to look out for: Protective Provisions and “Matters Requiring Preferred Shareholder Approval.” I’m increasingly seeing investors–in cannabis businesses and elsewhere–seek the right to veto any transaction of total value exceeding X dollars, which I’m seeing as low as $50,000. This threshold for investor involvement is low enough to capture employee hires, purchase of equipment, and standard business partnerships. Wrangling shareholder signatures is not how company leadership should be spending their time, or holding up deals. At most, companies should agree to a higher dollar threshold or types of transactions, and board approval.

Why the First Terms Matter the Most

If you’re raising your first round (likely a Series A) it’s important to note that the rights you grant to investors now will form the basis for all subsequent rounds. This means that the Series B investors will seek equivalent rights as the Series A investors, and so on. If offered only inferior rights, they may seek a discount on valuation to compensate for this imbalance. All in all, if you’re considering equity financing to fuel the growth of your business, then the time to learn the terms is now–before you meet with investors and before you put together your first Series A term sheet. You certainly should not be “learning on the fly” over the course of your Series A round. Your investors will know the terms they want, and you should understand how the terms work and what will work for you.

marijuana cannabis board of directors
(Boehner not pictured.)

Last week it was announced that Former Speaker of the House John Boehner and Former Governor of Massachusetts William Weld would be joining the Board of Directors of a multi-state cannabis company, Acreage Holdings.

First, it’s worth noting the significance of John Boehner–once third-in-line for the US Presidency–taking such a position in a marijuana company. Under California regulations, John Boehner would be considered an owner of the company. If you’re reading the tea leaves, this is as strong an indication as any that those in the know don’t foresee any sort of federal crackdown; instead, they see a path to federal legalization. This was one of a series of encouraging events over the past few weeks, including the McConnell hemp bill, the Schumer decriminalization bill announcement, and the Trump assurance to Cory Gardner that the feds will respect the states’ rights to regulate cannabis. All positive developments, and primarily from the Republican Party that is generally more anti-cannabis.

But returning to the Boehner’s joining the Board at a cannabis company. Why did Acreage want Boehner on its Board? Consider the following possibilities:

  1. Great Public Relations for Acreage Holdings
  2. A sign to investors as to the safety of their funds
  3. Boehner’s connections to, and influence with, government regulators
  4. Boehner’s connections to, and influence with, capital
  5. Boehner has served on other corporate boards and thus brings knowledge and vision
  6. Boehner knows the cannabis business inside and out, as he studied the industry in-depth during his many years casting anti-cannabis votes in Congress

Removing point #6 which is tongue-in-cheek, each of #1-#5 has some validity.

For cannabis companies, what’s the “right blend” to have on the board? Should it be limited to the largest shareholders and investors, or does it make sense to elect outsiders, or well-connected individuals, or public figures? Let’s take a look.

Very Early Stage: Set up Your Board.

As we’ve previously written in “Do You Actually Own Your Cannabis Business?” you must appoint initial directors, adopt bylaws, and issue shares in order to own your business. None of this is overly difficult, and your experience corporate attorney (*ahem*) can do it in little time and expense.

Early Stage: Keep it Simple, Consider a Board of Advisors.

At an early stage, prior to financing rounds, you want your corporation to be straightforward and highly fundable. On the corporate legal side this means a clean slate without variables. Early stage is generally not the time to add non-founder board members or introduce custom proxy voting structures. However, as an alternative, many early-stage companies get benefit from having a “Board of Advisors” composed of experienced and well-connected individuals in the field, that meet regularly to give the company feedback–in a non-binding way–on corporate strategy. These Advisors can also be granted observer status and attend board meetings (although not vote). Further, these advisors can connect the company to potential investors. (Note: Do not state that an Advisor is required to introduce investors, or tie Advisor compensation to “bringing in” investors or investment. That is “Broker-Dealer” activity and engaging unregistered broker-dealers is illegal).

Growth Stage: Get Strategic with your Board.

The right time to look at strategic board members is after a company has received equity investment, has the commensurate investor board member(s) in place, and is focused on scaling and growth-stage. These strategic board member(s) are also the “independent” board member(s) for voting purposes. And they may be compensated (most often in equity) for the service and reimbursed for out-of-pocket expenses. (Note: Founder and investor board members are typically not compensated for their service on the Board, but a strategic / independent board member will typically receive some equity, up to at most ~2%. In my view, this equity should be subject to vesting.).

Strategic board members should fill a need with their skills, experience, and ability to help the company achieve its mission. Within this context one can see why a company like Acreage–as a direct operator cannabis company operating primarily in East Coast states, where there is much more uncertainty on the government level–would consider a former Speaker of the House and east coast Governor, to assist in government relations and ease the fears of investors.

Other cannabis companies could consider board members such as technical experts, medical professionals, sales gurus, or (the safest bet) someone who has previously built a successful company and/or achieved a successful exit that may be on the company’s horizon. The overall board strategy that works for your cannabis company will be unique to your company, and should be developed collaboratively with your officers, board members, and your (*ahem*) excellent corporate lawyers.

merger cannabis marijuana

The cannabis industry in California in 2018 is still finding its feet on many fronts – with both a regulatory framework and a banking solution being very much under construction. As these normalize, companies will establish their business metrics and get a firmer idea of the size of their opportunity, and then naturally increased M&A activity will follow, as has been the norm in other states, like Oregon and Colorado.

There’s a strong argument to be made that the M&A market for cannabis ancillary technologies will be very active in coming years, with companies having tremendous opportunities for exits at high valuations relative to their business metrics. Certainly those companies that create technologies and prove business models now stand to gain from future expansion in legalization of adult use, and any future, positive change in federal policy. With a few exceptions, such as Constellation Brands (makers of Corona) buying a minority stake in a Canadian medical cannabis company, almost all large U.S. companies cannot be owners in the cannabis industry, meaning the future acquisition of established companies is likely to be at a premium.

M&A activity for direct operators will continue to be driven by regulatory concerns, including local ownership requirements, political pushback against widespread “big marijuana” acquisitions, and the transferability of underlying permits and licenses. State licenses are not transferable in California, or Oregon, and if other states follow this model, then acquisitions are unlikely to be a primary means to achieving scale for direct operator businesses.

Preparing for M&A Opportunities: Get Your House In Order Now

The M&A diligence process is notoriously comprehensive, invasive, and painful – an acquirer is not only confirming the business assets and backing up the numbers, but just as importantly they are trying to avoid acquiring any liability or future regulatory issues. Therefore, by taking the steps below, you not only minimize the pain of any diligence process, but you also get out ahead of any the issues, and even without M&A on the horizon, you’ll never regret paying more attention to organization and compliance in your business. Here are some steps you can take now to best prepare for future M&A:

  1. Create a Secure Data Room. Include everything a potential acquirer wants to see: business and financial records, tax records and all government filings, equity ownership documents including vesting details, key business contracts, contracts with employees, and all agreements with investors. With all this data, did we mention that it must be secure? Look for a provider with encrypted transmission and two-step authorization, and limit those who have access.
  2. Standardize key contracts, and contemplate M&A Scenarios. If your business depends on key contracts with partners, suppliers, distributors, key customers, etc., and those contract all contain a strict “no assignment” clause, then your desirability as an acquisition target will be severely diminished.
  3. Tie Up Loose Ends and Prepare for the Disclosure Schedule. M&A can be a delicate scenario, and a surprising percentage result in disputes – in my experience, 90% of M&A disputes stem from an undisclosed issue of the target company. Hence, the disclosure schedule, which will list every known issue – the company’s key contracts, financing arrangements, and every claim threatened or brought against the company. Therefore, any claims should be resolved prior to the transaction, if at all possible, and all others will need to be disclosed.
  4. Get a Chief Compliance Officer and Document their Work. We’ve written previously about the work of a Chief Compliance Officer, and although it’s a more primary concern for direct operators, even ancillary business should maintain in strict compliance with applicable state laws.

M&A Consultants – Some are Great, Some are Useless, and Some are Downright Dangerous

The cannabis industry, as a whole, is experiencing an explosion of industry-focused consultants, whose levels of competence run the gamut. As an industry still in its infancy, the consulting market hasn’t yet matured, to weed out the bad actors through reputation or elevate the best firms. I regularly hear from clients that past consultants added zero value or (worse yet) badly mismanaged aspects of their business. Also, remember that consultants are not bound by the same ethical rules as attorneys, for example, concerning confidentiality and conflicts of interest.

So for consulting services in 2018, it’s very much buyer beware, and you should assume no level of competence until competence is demonstrated. If you are hiring an M&A consultant – consider that because so few large-scale cannabis M&A deals have been successfully consummated to date, you may be better served to retain a top M&A consultant that services businesses generally, and then rely on your excellent cannabis-focused attorneys (*ahem*) to guide you on all of the cannabis-related aspects.

Finally, if you have your house in order as described above, you may have much less of a need for an M&A consultant and a much smoother time through the M&A process. Ultimately, that’s what it’s all about.

For more on cannabis company acquisitions, see:

Equity incentives can help you motivate the team and grow fast.

It’s a good time to revisit the very basics of cannabis company structuring, particularly in light of two new developments in 2018: tax reform and California state-wide legalization. Thus, this is the second article in our three-part “Reviewing Corporate Law Basics” series. The first post discussed cannabis entity selection. Today’s posts moves past the initial formation phase, and covers equity incentives for startups.

In the startup world, employee equity is as ubiquitous as the logo t-shirt, the bean bag chair, and the ping pong table. The potential upside employees perceive in their equity incentives brings the talent in and keeps them engaged: Employees are both incentivized to increase the value of the company and stay at the company through their equity vesting schedule. In theory, everybody wins.

Cannabis startups, particularly those developing technologies and building capital-intensive businesses to scale, will increasingly find the need to offer employee equity to stay competitive. In making the decision on what types of equity incentives to offer, companies must consider their growth path and the effect on future financing options, their employee base’s preferences, their own capacity to manage an equity incentive plan (or hiring experienced counsel to do so), and, most importantly, the tax consequences for the company and its employees.

This post cannot exhaustively cover each of the below structures, but will provide the key advantages and disadvantages, to inform the business owner (or employee) faced with the choice:

  • Stock Options (ISOs and NSOs)
  • Restricted Stock with an 83(b) Election
  • Restricted Stock Units (RSUs)
  • Something Else – Profit Share, Target Bonus, Performance Incentives

Stock Options

Stock Options come first because this type of equity incentive sits foremost in the public consciousness: Many company founders want a “stock option plan” before they consider what that entails. However, most founders that evaluate all of the potential forms for employee equity incentives eventually choose not to go with stock options. In the end, whether its Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs), the calculus generally boils down to the plans being complicated and unpredictable.

On the company side, the plans are complicated because management must regularly run 409A valuations to determine strike prices, then track all of the exercise dates and received paperwork (and the company’s ever-fluctuating number of shareholders), and then calculate the proper tax withholding for all options exercised based on the delta to the stock’s fair market value set by the 409A valuation.

On the employee side, stock options are complicated because the employee must decide whether or not to exercise the the options, and then pay out-of-pocket if choosing to do so. Options are also unpredictable in that a downtown in the company’s value could result in “underwater options”– employees stuck with tax consequences but with no chance of selling stock to cover the tax bill. While these issues have some solutions to reduce the pain to the company (third-party administrators of option plans are recommended), and while the underwater options issues is rare-but-very real (ask those that lived through the tech bubble bursting in 2000), there’s no escaping that stock option plans inherently complicated and unpredictable, and thus make sense for a small percentage of startups.

Restricted Stock with an 83(b) Election

I use the “…with an 83(b) Election” qualifier when discussing Restricted Stock Plans with clients, because filing an 83(b) election is critical to making Restricted Stock Grant work in an employee’s favor – and it’s an election the company had better inform its employees of, as missing the filing deadline is a mistake that can’t be undone.

So what is a Section 83(b) Election? Simply stated, it’s a “tax election” the employee taxpayer makes with the IRS, under IRC Section 83(b). The election must made within 30 days of the grant of restricted stock (simply by filling out and mailing the IRS a form). The election informs the IRS that the taxpayer elects to realize income as of the grant date, rather than on the grant date. This can be particularly advantageous for very early-stage companies, that can credibly state the value of their shares is minimal. Then, any future gain in value recognized upon selling the stock would be capital gain or loss. Further, if shares are held for more than 12 months, the employee may get long-term capital gain treatment.

Restricted Stock may become more difficult for later-stage companies, because even with an 83(b) election, paying tax on fair market value may be prohibitive for some employees. However, a company that’s later stage and better capitalized may be in a better position to offer an employee a bonus to make up for the tax burden, or can look to switch equity plans now that the company has more resources. But for early-stage companies Restricted Stock with an 83(b) Election is the right choice 90% of the time. The “Restricted” part is to be discussed with your securities counsel – all stock will carry certain securities legends, will initially be subject to a company’s right of repurchase (which lapses over the course of a vesting schedule), as well as other transfer restrictions to prevent sale on public markets and preserve the company’s closely-held status.

Restricted Stock Units (RSUs)

An RSU award is essentially a contract to award stock at a later date, or award an employee cash as value for stock. RSUs are not stock, and because they are not property, an 83(b) Election is inapplicable. They have risen in popularity among later-stage tech companies, primarily at the expense of stock options, because they are significantly more straightforward (particularly from the employee’s perspective). They give the employee what employees want– the ability to receive “stock” without having to pay to exercise or purchase it. Then, upon meeting vesting requirements, the employee either receives their specified shares of common stock, or cash equal to the value of a their common stock.

Many companies had come to disfavor RSUs in recent times, though. Employees with RSUs are not putting in any purchase or exercise price, the 409A valuation requirements are amplified, and the company must pay employees cash upon each vesting milestone (because the 83(b) is not available). Thus, until recently, the RSU only made sense for large, cash-rich “startups” (which at that point, were full-blown companies). However, a new tax election created in the Tax Cuts and Jobs Act (“TCJA”) may make the RSU more feasible for certain companies and employees: The 83(i) election allows an employee that owns 1 percent or less of a company to delay realizing income until there’s an exit (or for up to 5 years), so long as the company has a plan in place that awards some equity to 80 percent or more of the total employees in the company.

Other Incentive Plans

While equity incentives may seem overly complicated, with a well-drafted Employee Equity Incentive Plan and competent counsel, companies can and do manage all of the structures listed above. So maybe you can, too…. but do you need to? Equity incentives work best for startup companies that are building towards an exit: an acquisition, a merger, a public offering. Often these companies want to conserve as much cash as possible, to devote to product development, and offering employee equity allows the company to compete with larger companies for top talent. However, if your company anticipates fewer costs on its runway to profitable liftoff, and is built to operate profitably, then perhaps your business needs another form of employee incentives– a profit share, a target bonus for profit or revenue, or other performance bonuses. Although these aren’t as sexy as the “stock options”–and you may miss out on a few potential employees that have stars in their eyes–crafting an incentive plan that fits your business will ultimately help you attract and retain the right type of talent.

Finally, one thing should be noted: Regardless of the equity incentive plan your cannabis company chooses, you can still get the logo shirts, bean bag chairs, and ping pong table.

california marijuana c-corpIt’s a good time to revisit the very basics of cannabis company structuring, particularly in light of two new developments in 2018: tax reform and California state-wide legalization. Thus, this three part series “Reviewing Corporate Law Basics” will address:

  • Part 1: Cannabis Entity Selection: Corporation, LLC or Something Else?
  • Part 2: Equity Incentives for Your Startup: Restricted Stock, Stock Options, or Something Else?
  • Part 3: Canna Exits in 2018: Sale, Merger, or Something Else?

Cannabis Entity Selection: Corporation, LLC or Something Else?

Prior to California’s Prop 64 taking effect on January 2018, entity selection for “direct operator” marijuana companies was relatively straightforward. State law required companies to operate on a not-for-profit basis, and non-profit mutual benefit corporations became pervasive, with a smattering of other non-profit entity types. In 2018, these not-for-profit entities are converting en masse to for-profit entities.

Transitioning companies, as well as new operators (both direct operators and ancillary companies), are asking the ever-popular early-stage question: should we be a corporation, an LLC, or an *insert creative choice*? Luckily, for most companies the decision becomes clear based on a few key factors. And for the remaining companies, the founders can make a decision based on their assumptions. Changing corporate forms is an option if necessary.

The tax analysis also should be considered, in conjunction with an expert in cannabis company taxation. A detailed analysis of your business’ goals and growth path are needed to do this analysis fully–and you should always consult your trusted corporate attorney–but this article may help you to consider the advantages and disadvantages of your options.

Note that we assume all companies will incorporate in California, which is the default recommendation for businesses in the cannabis space operating in California. However, even for an ancillary company that may choose to incorporate in Delaware, or the newest favorite – Nevada – the state-to-state analysis is not fundamentally different.

C Corporation

General Background.

Are you planning to raise funds through successive equity financings? Are you planning to raise funds from Institutional investors? If the answer to either of these questions is yes, then there’s a 90% chance that a C Corporation is right for you. If both answers are yes, then you’re certainly going to go with a C Corporation.

Simply put, a C Corporation is the overwhelming choice for companies that will raise funds, because of its ability to issue stock to investors, and create classes of preferred stock for equity investment rounds. Further, corporations have better options when it comes to issuing equity incentives to employees. While it’s true that an LLC can mimic a corporation in many respects, and can issue classes of “units” similar to stock – this non-standard structure offers no advantages for financing through equity investments, and it will severely limit the types of investors the business can approach. For a business seeking to get the best terms for an equity financing, immediately cutting out the majority of potentially interested investors makes little sense.

Further, even though an LLC can mimic a corporation in many respects, the differences in tax treatment of a C Corporation versus an LLC must be considered carefully.

Tax Considerations.

Previously we wrote about the tax consequences of entity selection. We also covered the fact that you can make a “tax election” to have your business be taxed as a C Corporation.

Before the Tax Cuts and Jobs Act (“TCJA”) the C corporation was not the first choice of closely-held businesses. The first drawback was that C corporations had a relatively high tax rate of 35%. Under the TCJA, that corporate rate was reduced to a flat 21%.

The second drawback, was the issue of “double taxation”. A corporation is subject to income tax at the entity level. In addition, dividend distributions are taxable to shareholders. Because of the historically high corporate tax rate, this double taxation generally discouraged companies from operating as C corporations.

Under the TCJA, a corporation and its shareholders are still subject to double taxation; however, the corporate tax rate has been lowered such that double taxation may still result in the most favorable tax outcome.

For example, a C corporation that earns $100,000 will pay tax of $21,000 ($100,000 *21%). If that same corporation dividends 100% of its earnings to shareholders, the maximum tax at the individual level is $23,800 ($100,000*23.8%). So the combined amount of tax is $44,800 ($21,000 + $23,800).  In comparison, a partnership (or S corporation) results in less overall tax to the owners $37,000 ($100,000 *37%).

However, a C corporation is the preferred structure if the plan is to limit the amount of dividends paid to shareholders. For example the total tax hit to a C corporation and its shareholders that paid out dividends of $50,000 is: $32,900 [$21,000+ $11,900($50,000 * 23.8%)]. In this case, a C Corporation saves $4,100 of taxes compared to operating as a partnership. The C Corporation has the additional benefit of insulating shareholders/owners from personal liability for federal income tax.

These parameters are why we recommend that our clients use their current business plan and think about how much cash they wish to distribute each year. From there they can use some real data to make a much better decision regarding entity formation,  We have run numbers for other clients to determine what entity structure best fits within their goals.  At the end of the day, a client that manages its cash distributions can operate as a C corporation and usually achieve a better tax result than being structured as a flow-through entity.

LLCs

General Background

If you answered “no” to the questions posed up top, and you can answer “yes” to any of the questions posed below, then an LLC may be right for your business.

Are you planning to keep the number of owners small? Do you anticipate the business will not require significant funding, or do you intend for the principals of the business to self-fund the company’s growth? Will you have a small number of capital partners, that you know are already comfortable with an LLC?

If so, an LLC could suit your business. The primary LLC advantages are:

  • Ease of establishment and maintenance
  • Ease of amendment
  • Highly customizable

LLCs are set up by and managed through an Operating Agreement, which is essentially a contract between the LLC Members governing the management and structure of the business. As such, the Operating Agreement can be modified a myriad of ways, allowing the business to have fewer moving parts that require meetings and maintenance (such as shareholders and directors). LLCs are pass-through entities, meaning profits and losses pass through directly to the members. For a business with a few principals, this may keep it simple and straightforward. But for outside investors, the LLC may generate “unrelated business taxable income.”

Tax Considerations

Even if the company’s future fundraising plans are not determinative, sending you down the C Corporation path, founders should also undertake a detailed tax analysis before making their choice. Our firm has developed a model for determining whether a cannabis LLC should be treated as a partnership/flow-through entity or as a C Corporation for federal income tax purposes. Generally, taxation as a partnership/flow-through entity will be more favorable under the following circumstances:

  • The individual tax brackets of the LLC members are below 37%;
  • The individual member/partners qualify for the favorable 20% deduction for flow-through income under IRC section 199A;
  • The business plan emphasizes distributing cash to investors over reinvesting cash into the business (growth).

Anecdotally, roughly ninety percent of our clients that go through the exercise of comparing LLCs and C Corps, end up choosing a C Corp. That said, a fair number are more comfortable with LLCs through their experience in real estate investing, private equity, or other business experience, and go with the LLC without much additional thought. By and large, these are businesses where the principals anticipate contributing their own capital to fund the company’s growth, or possibly reaching out to a small pool of capital partners or other financing.

Something Else

Cannabis investors and operators should also consider whether a hybrid structure would be advantageous. Real estate investors, for example, should consider the application of the Real Estate Investment Trust (“REIT”). The REIT is a legal entity not subject to federal income tax. Instead, a REIT may deduct dividends it distributes to investors, essentially acting as a conduit. REITs must have at least 100 shareholders and are suitable only for large scale investments.

Likewise, certain corporations may be treated as cooperatives under federal income tax law. Cooperatives may or may not be taxable entities under the federal income tax law. An organization that is considered a cooperative under state law does not mean that the organization is a cooperative (or tax-exempt) under federal income tax law. One possible advantage to operating as a federal cooperative is that certain patronage dividends are deductible by the co-op and taxable to the recipient. Cooperatives may avoid double taxation; however, the operating requirements are highly technical and strictly enforced.

There are a few other “hybrid” corporate forms that we regularly see proposed—the California Benefit Corporation and the Social Purpose Corporation. In essence, these entities require that corporate leadership consider factors in all business decisions: a Benefit Corporation must advance “general public benefit” and consider not only profit, but also how its business decisions affect its community, society, and the environment.

While these are commendable goals, B-corps can be problematic: any shareholder can bring a derivative lawsuit against the corporation alleging that its leadership, in any business decision, did not consider all of the required factors. Growth stage startups need to be able to make decisions quickly and confidently—and not under the constant threat of a suit. Also, from an investor point of view, B-Corps and Social Purpose Corporations often carry too many unknowns. Therefore, founders moving from a C-Corp to B-Corp may find their investors moving from a “Y” to “N.”

Stay tuned for parts 2 and 3 of this series, on equity incentives and company exits.

marijuana securities fundraising
Don’t let myths get in the way of solid financing.

With new startup companies that plan to raise funds, I’ll often have a sit-down meeting to discuss the fundraising process, the company’s growth path, and address any concerns of the startup founders regarding financing. At these meetings I’ve heard company founders say each of the following:

  • We’re all going to get diluted!
  • We’re going to lose control of the business!
  • We’re too busy to raise funds, so it makes sense to pay someone a “finder’s fee” to procure the investors.
  • Everyone loves our idea, so we’ll have the investors’ checks in hand next week.
  • Let’s just focus on the business, getting angel investment, and we’ll deal with all the corporate legal mumbo-jumbo later.

Trading stories with our corporate cannabis attorneys up and down the west coast, it seems like all of us have heard similar things. However, none of the above is based on reality or adviseable, and some of it is downright dangerous. So, let’s bust some myths around financing your cannabis startup.

  1. We’re all going to get diluted!

“Dilution” is super-scary word that rarely has the perceived affect, particularly in the context of equity financing. By-and-large equity financings are done in successive rounds, when the value of the company is increasing. Companies very rarely do a down-round (raising funds at a decreased valuation from the previous round) unless they are truly backed into a corner and in need of cash. Outside of these rare occurrences, a round of equity financing that significantly increases the valuation of the business may result in the “dilution” of owning a bit less of pie that has now become much bigger. Consider: would you rather own 10% of a $10 million dollar pie ($1 million), or 8% of a $25 Million pie ($2 million)? The answer is why a company would want to go from a $10 million Series A to a $25 million Series B. Ultimately, the focus should be on growth and total value of the expanding pie, not on the percentage assigned to one’s slice.

  1. We’re going to lose control of the business!

If the dilution concern bogeyman had a slightly more dramatic cousin, it would be the “investors are going to take over our company” concern. The popular conception of this phenomenon is likely owing to Aaron Sorkin’s creative genius in the film “The Social Network” – the glass conference room scene in which Eduardo Saverin, played by Andrew Garfield, was both diluted (your stocks are worth pennies now!) and unceremoniously kicked out of The Facebook through some sneaky lawyer tricks that not even his spidey-sense could detect. In reality, not only is Saverin a billionaire, but investors will only have the ability to “take over the company” if they are given that ability. That type of term is rarely hidden in a footnote or a tiny font. No company with sound counsel “suddenly” loses control of a business. If the company does five rounds of equity financing and investors come to cumulatively hold a majority of the equity, then yes, they could wrest control of the board and therefore the company. But this happens over the course of many years, and many decisions made by the company in many conference rooms. Not in a single, dramatic scene.

  1. We’re too busy to raise funds, so it makes sense to pay someone a “finder’s fee” to procure the investors.

Raising funds is not easy, and anyone claiming to be able to do it for you, particularly for a fee, should be viewed with extreme skepticism followed by an extreme review of their certifications to confirm that they are a “Registered Broker-Dealer” under the Exchange Act and with FINRA. See the SEC’s guidance here. The payment of a “finder’s fee” (even if you call it “consulting”) or any transaction-based fee to an unregistered broker-dealer may lead to severe penalties, and enough issues on the securities side that the company will be dead in the water.

  1. Everyone loves our idea, so we’ll have checks in hand next week.

Did we mention raising funds is not easy, particularly for companies in the cannabis space? Based on my anecdotal experience, the “conversion rate” from “we met an angel that’s interested, sounds like they want to write us a check right now” to the check’s actual arrival is well shy of 50%. Angel investors (good ones) don’t write checks on a whim, and responsible companies shouldn’t accept checks on a whim. Any investor who wants to write a check without seeing any documentation or doing other diligence on the company should be viewed with skepticism. Further, all investors need to be vetted and need to provide the company with information as to their accredited investor status. Angel rounds can be done fairly quickly and with minimal expense, but there is some process and the checks aren’t written after a single, informal chat.

  1. Let’s focus on the business, we’ll deal with the corporate legal mumbo-jumbo later.

Some elements of your corporate set-up can be delayed, and a competent business attorney should be able to identify those elements. But the critical “mumbo-jumbo” includes:

  1. Incorporating your company and adopting Bylaws
  2. Issuing your equity and making tax elections
  3. Protecting your intellectual property (IP)
  4. Securities compliance

Incorporating is quite obviously crucial (look out for my next post on entity selection for cannabis startups in California, in light of state-wide legalization and federal tax reform). But issuing the company’s initial equity is a single important task that accomplishes many smaller important tasks: not only does it force the founders to have necessary discussions regarding their roles, ownership stakes, equity vesting, and whether and how to reserve equity for employees. But it also achieves the necessary task of assigning all the IP of the founders to the company, and forces the company to act by board action (either at a meeting or by written consent). A discussion with your attorney regarding equity should also cover 83(b) tax elections, and address the company’s growth path and cover securities compliance for any future inbound investments, as well.

At that point, you’re done with the legal mumbo-jumbo (for now), and you can get back to making the company a smashing success— even if that means being “diluted” just a bit.

A growing number of startups in the cannabis space are engaging brokers and online platforms to assist in their fundraising. This makes sense: as we’ve written previously, most investors (particularly institutional capital) are staying on the sidelines and taking a wait-and-see approach to the cannabis industry. Thus, cannabis startups will always target a smaller, more dispersed, more specialized investor base, and going through experts is a logical way to reach them. Note that 506(c) is one of the relatively new options for company financing, implemented as part of the JOBS Act of 2012. It allows for companies to engage in a more public “general solicitation”—but with strings attached, as we’ll detail below.

From a securities law perspective, the engagement of a broker-dealer or online platform converts the offering exemption from the ever-popular 506(b) offering to a 506(c) offering – changing this one letter has a number of significant consequences:

1 – You must ensure that the broker-dealer is registered, or else.

Section 3(a)(4)(A) of the Securities Act generally defines a “broker” broadly as “any person engaged in the business of effecting transactions in securities for the account of others.” This broad definition includes any “finder,” “fundraising consultant,” or anyone else receiving any transaction-based bonus or commission in return for introducing or engaging an investor. You should always consult your securities counsel when a third party is assisting the company on fundraising. Once it is established whether broker-dealer registration is required, FINRA provides an online Broker-Dealer Check. The penalties for using an unregistered broker-dealer are extremely harsh, so it’s always wise to err on the side of caution.

2 – You are limited to accredited investors, and you must take additional steps to confirm an investor’s accredited status.

In a 506(b) offering companies have the flexibility to raise from an unlimited number of accredited investors, as well as up to 35 unaccredited investors. Only around 2% of the US population would meet the accredited investor conditions (in short: at least $1 million of assets not including one’s home, or a recurring annual income of at least $200,000 (or $300,000 if married)). The loss of the unaccredited investor option may eliminate some of the classic “friends and family” seed investors, that write smaller—but often critical—checks to keep the company afloat in the early going.

Further, raising under 506(c) puts a higher burden on the company to complete its own diligence to confirm an investor’s accredited status. Under 506(b) you can essentially take the investor’s word for it. The SEC has laid out the types of records one would examine under a “principles-based verification method” and they include the investor’s bank statements, brokerage statements and records of securities holdings, tax returns and tax assessments or appraisal reports prepared by third-parties. Looking at these records may not seem like such a big deal, but the hurdle of developing this method and implementing for each investor can be a significant undertaking for startup company.

3 – You can engage in a general solicitation under 506(c), but with greater visibility comes…greater visibility.

The advantage of expanding your potential investor base beyond those with whom you have a “substantial pre-existing relationship” (which is required under 506(b)) may seem to open a world of possibilities. But putting your company out in the open may have drawbacks: any proprietary info in your investor materials will get passed around, you may pick up shareholders that cause you problems down the line, you may attract attention from the not-in-my-backyard types, and some investors prefer their cannabis investments to keep a lower profile.

Finally, it bears repeating: seek an experienced corporate and securities attorney. With these choices you need principled and consistent counsel, because there is a final consideration: once you’ve engaged a broker-dealer or otherwise engaged in a general solicitation, you are committed for the entirety of your financing round. Any unaccredited “friends and family” are out—they can’t write checks under any circumstances—and you cannot revert to the more relaxed requirements of 506(b).

marijuana investment venture capital
More room for cannabis-specific funds and investors.

Investor interest in the cannabis industry was at an all-time high in 2017 in anticipation of full legalization in California in 2018. The number and dollar figures of deals were up, and packed houses at our investment forums in San Francisco and Los Angeles served as anecdotal evidence of the same. The exponential expansion of available funds was set for 2018, when the institutional capital—venture capital (VC) and private equity funds—were preparing to allow future funds to invest in the cannabis industry. These funds would primarily invest in “ancillary businesses,” but the ripple effect of all that available capital in the industry would have meant more for direct operator cannabis businesses as well.

President Trump’s election did little to slow the enthusiasm throughout 2017, as investors took at face value the words of then-candidate Trump, who claimed to be “in favor of medical marijuana 100%” and to think adult-use “should be up to the states, absolutely.” Further, prior to Senate confirmation, his Attorney General, Jeff Sessions, apparently assured Senator Cory Gardner of Colorado, among others, that he would not interfere with the Cole Memorandum or states implementing their own regulatory systems for adult use cannabis.

The timing of the Sessions Memo—coming immediately after California’s legalization took effect—appears to be a demonstration of federal power to counteract California’s legalization efforts. Just as importantly, it’s an effort to prevent the vast expansion of capital that would flow into the industry. California is, after all, the venture capital capitol of the US, full of smart money willing to take reasonable, calculated risks.

However, so long as cannabis remains federally illegal under the Controlled Substances Act, and the Department of Justice (DOJ) remains ambiguous as to its prosecutorial priorities, institutional capital will stay out of the cannabis industry. Even with immense opportunities available, the possibility that marijuana holdings may threaten a fund’s overall portfolio and make their limited partners nervous means the potential rewards no longer justify the risks. Those analyzing investment trends have already noted that VC interest in cannabis isn’t living up to expectations in 2018. Given the lag in fund formation (because a fund’s limited partners would need to explicitly agree to allow investments in the cannabis industry), 2018 Q2 and Q3 would be the real indication of VC interest. But we in the industry already know the verdict: institutional funds of the Sand Hill Road variety, by and large, are staying out.

What this means for your business, if you’re raising funds in 2018:

  • Cannabis-specific funds (those able to raise funds) could be the big winners: they’ll have their pick of deals and can drive better terms.
  • Individual investors (high-net worth individuals) will continue to be the primary source of funds for direct operators in 2018.
  • A state-wide, comprehensive banking solution is not as close as we believed.
  • Multi-state expansion plans will be problematic—the Sessions Memo could have a detrimental effect on the legal defense in suits alleging Federal RICO violations.
  • Medical continues to be a safer option, for now. The Rohrabacher-Blumenauer Amendment provides a safe haven in California, where courts have ruled that it prohibits prosecution of medical cannabis businesses. Whether or not Rohrabacher-Blumenauer is extended (or expanded) will have a major impact on investment and business strategies in 2018.
  • Pressure for a legislative solutions towards legalization will continue, because: A) it’s popular among the electorate, B) local governments need the tax revenue, and C) these solutions normalize an industry that industry experts say will create more jobs in the US than the manufacturing industry by 2020. These political realities are turning cannabis agnostics into industry advocates – for example Senator Gardner, who has gone from an opponent of legalization five years ago to staking his political future on opposing Sessions’ attack on cannabis.

We are only one month into the new year, so expect plenty of twists and turns along the way. For now, though, it is undeniable that the recent DOJ reversal has impacted VC and private equity interest with respect to marijuana industry investment.

Best not to confuse your local regulators.

Across California local jurisdictions are opening licensing windows and evaluating commercial marijuana license applications. Often the scoring process is conducted by the staffs of city councils, zoning boards and planning commissions, working on a compressed timeframe, and giving scores for various categories using a scoring matrix: “Location,” “Safety & Security,” “Community Benefit,” are common categories, for example. There is typically a “Financial Stability & Capitalization” category, as well, where companies disclose their balance sheet, and their business plan going forward.

The scoring of these categories is unpredictable. Typical requests from the local regulators may be:

  • A budget for construction, operation, maintenance, compensation of employees, equipment costs, utility costs, and other operation costs. The budget must demonstrate sufficient capital in place to pay startup costs and at least three months of operating costs, as well as a description of the sources and uses of funds.
  • Proof of capitalization, in the form of documentation of cash or other liquid assets on hand, Letters of Credit or other equivalent assets.
  • A pro forma for at least three years of operation.

As we’ve previously written, early-stage companies are often raising early capital using convertible notes, as a means of kicking the valuation can down the road into 2018. Although notes are much more akin to equity investments, they show up on a balance sheet as debt. The impact of an applicant having outstanding debt is uncertain, but one can imagine that an applicant that has almost all of their cash on hand through issuing debt may be viewed unfavorably. And that can be a problem.

To a city staffer unfamiliar with a convertible promissory notes, the debt may appear to be nothing more than a short-term loan, and with a balloon payment set at a 12 to 24 month maturity date, the company may look like it needs a moonshot to survive. In reality, though, the company will have no payment obligations, so long as it achieves a priced round equity financing within that timeframe. In that case, investors will convert to equity, the debt is extinguished, and no debt service payments are made. However, in a competitive licensing application environment, explaining the intricacies of a convertible note to a city staffer means you’ve likely already lost the battle.

Rather than carry debt on the balance sheet through the application process, an alternative instrument for early-stage financing can be borrowed from the tech world: the SAFE (Simple Agreement for Future Equity). This instrument was developed for early company financing by startup accelerator Y Combinator. It serves the same function of a convertible note, and will often convert to equity on nearly identical terms. But is explicitly NOT a debt instrument. It’s a more company-favorable means of raising capital, as compared to the convertible note: the investor loses the security of holding a debt instrument, and the leverage of having a maturity date.

To the local regulator – likely unfamiliar with either instrument – the SAFE would appear to be much more like a letter of intent to issue equity in the future. And the SAFE investment received by the company appears on the balance sheet as cash on hand and unencumbered, making the company appear much better capitalized than a company whose capital all comes with a corresponding debt obligation.

SAFEs are not for everyone, and an investor familiar only with convertible notes but not SAFEs will almost always prefer to hold the convertible debt. However, for companies that can raise funds with a SAFE, there are a few potential advantages: 1) these companies may find their applications get a critical boost in their “Capitalization” score; and 2) they are easy to put together, as a SAFE is just a standard agreement with few negotiable terms – the Cap, the Discount, the Most Favored Nation Clause. If the terms are right, companies planning to navigating multiple local cannabis application processes would be wise to consider taking the SAFE route.

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!