Many marijuana businesses include one or more people in their ownership group that contributed “sweat equity” to their business, rather than cash or other valuable assets. Because of the level of state regulations, even small cannabis businesses typically require a lot of capital to start. Many experienced entrepreneurs have had to team up with investors to get their cannabis businesses off the ground. Many other people looking to start cannabis businesses have had to entice experienced growers to help set up their facilities by offering equity in lieu of or in addition to salary.
But working relationships don’t always last. Whether it be for poor performance or for more serious issues (violating state regulations, stealing from the company, etc.), cannabis companies often find themselves wanting to part ways with senior employees that also have an ownership interest in the company.
For large publicly traded companies, this is no big deal because they can easily terminate employees that have received stock — even a large amount of stock. All the company must do is finalize the termination, stop paying salary, and determine whether there are any stock options or grants subject to a vesting schedule that need to be finalized. Then, the company and the employee simply go their separate ways. There is no reason for a large publicly traded company to worry about the stock already issued, as it is likely only a minute fraction of the company’s overall capitalization.
For small, closely held companies, however, stock grants and LLC membership interests held by employees can be far more complicated. The employment relationship and the ownership relationship tend to intermingle, especially if the owner/employee was also one of the company’s founders. Depending on the size of the ownership group, even a 10% share of the voting ownership interest can be significant and can handcuff owners trying to bring on more capital in the future while also trying to retain a voting majority.
First, it is important to decouple the ownership interest from the employment relationship. For businesses that are taxed as corporations (subchapter C or S), owner/employees likely receive a significant part of their compensation as standard W-2 employees. For businesses taxed as partnerships (how most multi-member LLCs are taxed), the employment portion of income is likely categorized as a guaranteed payment. Regardless, this is the issue that should be dealt with first. Company owners with work obligations should be treated like employees for purposes of those obligations. The company should set expectations for employment, and best practice is to have a written employment agreement specifically drafted for the owner/employee scenario. That employment agreement, or the LLC operating agreement or shareholder’s agreement, should determine who can decide to terminate an owner/employee. The decision will need to be made by a majority of either the company’s managers, members, directors, or stockholders. There is no cookie-cutter answer on how to do this as every situation is different.
Once the employment situation is handled, the next issue is what to do with the lingering ownership interest in the cannabis business. Inexperienced business owners that gave away equity as compensation too often treat it as something more temporary than it is. There are mechanisms to provide a worker with profit-sharing so long as that person is working, only for that profit-share to disappear when the person is no longer working for the company. But that is something different than standard ownership of stock or membership interests, which we see far more often. There is a property right in the stock or the LLC membership interest, and it isn’t just going to disappear.
One option is to let the departed employee keep the stock or membership interest. If there is no pressing need, there is nothing inherently wrong with having a former employee continue to have an ownership interest in your cannabis company. They are still entitled to their vote and to their distribution of profits, but that does not mean they need to play a day to day role in company business.
But for cannabis companies looking for a clean break, their easiest option is to have an agreement, either in the LLC operating agreement or in the corporation’s shareholders agreement, providing the company with a buyout option for owners that no longer work for the company. Making it optional helps the company if it does not want to be forced to make a significant cash payment, but the employee would likely want the buyout to be mandatory. The value can either be set by a mathematical formula or the agreement can refer to a third party appraiser. The payment terms are set, and the company is able to buy out the owner/employee.
The important thing is that this is something that needs to be laid out ahead of time. If there is no buyout mechanism in an LLC operating agreement, there is no automatic right under most states’ LLC laws to remove individual LLC members. It is to both the company’s and the owner/employee’s benefit to figure this out up front when negotiating the original hiring. Once termination has started, it can be really hard for the cannabis company and the owner/employee being terminated to cooperate. If you set up from the outset what a break-up will look like both parties will have an easier time dealing with the change and moving on.