The cannabis litigation lawyers at my firm have litigated many partnership lawsuits involving cannabis businesses where better planning could have avoided the dispute. Business owners will always disagree with one another, but good partnership agreements, LLC operating agreements, and shareholder agreements figure out ways to get past disputes without going to trial. Litigation is expensive and stressful and doesn’t leave either side feeling great. In a business ownership dispute we are working on now, in addition to legal fees, both sides are hiring their own forensic accountants to come up with a company valuation more favorable to their side, and this is before a complaint has even been filed. Costs add up fast. Partnership disputes have a lot in common with divorces disputes, where logic and reason often give way to emotion, and the parties seek to punish each other more than they try to come to a reasonable settlement. The best time to plan for disputes is before your company has any revenue, any investment, any debt, or any obligations. In this post and subsequent posts in this series, I’ll discuss negotiable provisions in partnership agreements that business owners should make sure to address as early in their business’s life cycle as they can.
Today’s post will talk about individuals getting ownership for services and what happens when a company needs to raise more capital.
Ownership Interest in Exchange for Service
This is a common arrangement, but companies often get themselves into hot water by not thinking through the implications. If an individual is going to receive a significant percentage of equity in a company without putting in a proportional value of cash or property, company owners need to think long and hard about the implications. The question that all too often goes unasked is what happens if the partner receiving the equity in exchange for services stops working for the company or fails to perform those services well? If the partnership group doesn’t put thought into how it structures the grant of ownership in exchange for services, it can find itself having signed away a large chunk of equity in their cannabis business without any recourse if the service-for-equity owner stops working.
There are a couple of solutions to this. One common fix is for the equity interest to vest over time. Every month or quarter or year in which a partner contributes services corresponds to a partial grant of the equity interest. With a vesting schedule of three to five years, the company knows it will either be getting good value for the services or it will be able to terminate the services and cut off any further vesting. But another problem shows up even if the services are terminated — you have a voting owner of the company who likely holds some ill will against the other partners. This is where another clause in the operating agreement can help – company buyout right triggered by termination of the partner’s services. The company will still have to pay out for the equity vested to date by the services provider, but it has a clean way of removing that person from the company, likely avoiding additional clashes.
Additional Financial Contributions
It’s hard to estimate how much capital a company is going to need. Many of our cannabis producer clients found out mid-stream that they were having a tough time selling their dried marijuana flower, so they pivoted and moved into the oil extraction business. But the capital equipment needed for that and the construction costs to set up the lab can be expensive, and when those expenses are not planned for additional capital is needed.
One of the main differences between LLCs and corporations is that default corporate law makes it easier to bring in new capital in exchange for equity than default LLC law does. In corporate law, the board of directors generally has the authority to issue new shares in exchange for capital. And if the current shareholders don’t have a negotiated right of first refusal, the directors are free to look to whomever they want, whether that person is a current shareholder or not. Compare to LLCs, where the default law tends to say that unless the operating agreement says otherwise, the members of the company must unanimously approve of any new members. LLC agreements, then, should have clear clauses on what happens when the company needs more money. If only one member is willing to put that money in, do they get additional interest that dilutes the other members? If the company doesn’t want a dilutive issuance but wants a member to loan money to the company, does that member get priority payback on the loan debt? And if no one in the company is willing to pay money, can they still vote against allowing a new member into the company in exchange for capital? Because if they can refuse to put in more money themselves and can keep the company from raising money from an outsider, they have the power to tank the company. Any negotiated partnership agreement needs to address this issue.