Over the past few years, we have had many cannabis clients call us during the license application process and ask some version of the following: “The state is asking me to disclose the capitalization of the company. What should I write?” From a lawyer’s perspective, the answer to this question is usually something very simple, such as: “The capitalization of the company should be disclosed as the amount and type of capital you used to start the company.” Makes sense, right? But there is often more to this question than meets the eye.
In most cases, cannabis businesses are built differently than other businesses, as far as funding sources and mechanics. Therefore, we get the capitalization question from business neophytes, seasoned entrepreneurs, and everyone in between. When we dig a little deeper, there may be any of several reasons the question surfaces during the licensing process, some better than others. I’ll run through each of them below.
The owners had to start this business without access to financial services, and therefore do not have bank records of capitalization.
It’s true that most cannabis companies start off unbanked, whether the business starts “from scratch” or is transitioning out of medical or grey market operations. This creates a documentary hurdle in many cases: Unlike with a new generic venture, the cannabis business owners are unable to fund a bank account (creating a record of capitalization) and begin writing checks for business expenses. Therefore, most cannabis businesses have to be extra diligent in tracking business funding and expenses through internal recordkeeping. These records should be immediately producible in the event of a state inquiry, IRS audit, member dispute, potential investor inquiry, or for any number of reasons.
The owners were in a rush to apply for the license, and don’t really care about business formalities.
If you want to make your lawyer nervous, tell her that you only need a company name because it’s a cannabis licensee requirement. If the lawyer is worth your time, the first thing she will tell you is that you should always run your marijuana company like a real business. That means writing things down and using appropriate forms to do so. Failure to follow basic business formalities can land owners in a world of hurt if anything goes sideways; and in such a case, a company shell will be no defense at all to personal liability.
The owners are nervous to disclose funding and funding sources on the public record.
This is a legitimate concern. Every state has public records laws, and depending on how those laws intersect with cannabis program rules (and administrative policies), public disclosure of funding and funding sources may be unavoidable in response to nosy, third-party requests. If someone makes a public records request related to a licensee file in Oregon, for example, records of funding sources and amounts will be made available (other sensitive information, like security plans, will be redacted). There may be no ideal workaround here, other than describing the source of funds in a general sense, and hoping that further information is not required.
The owners are not sure how much capital will be required to get through the license application process.
This is also a legitimate question. Regardless of business projections, the simplest course is usually to list all financing the business has received to date, and to update the licensing authority if and when new or existing parties with financial ties to the business provide or pledge funds.
The owners are not sure if a funding source or a promised source of funds constitutes capitalization under relevant administrative rules.
This is an area where it is critical to know the rules and how they are interpreted by the governing agency. The question of who and what constitutes a “financial interest” holder in a business is often unclear and varies from state to state. In Washington, for example, the two groups that must report to the Liquor Control Board are “true parties of interest” and “financiers.” In California, it’s “owners and financial interest holders.” And in Oregon, it’s anyone with a “financial interest.” Each of these terms is defined in each state’s ever-evolving administrative rules (for example, Oregon only recently required disclosure of lenders). It’s important to get guidance on these issues because the penalties for nondisclosure can be severe — often including denial or loss of licensure.
The owners are not sure whether a licensing authority prefers to see a certain kind of capitalization (e.g. cash, sweat equity, debt, convertible debt) or if some ratio of the foregoing may be ideal.
In our experience to date, licensing authorities in Oregon, Washington and California do not really care how you have funded your business, as long as the source of funds is legitimate. That said, state reporting should be consistent with company records and tax filings, because the IRS definitely cares how the sausage was made and how you report that information. For example, the IRS may consider a company that is capitalized predominantly with straight debt to be “thinly capitalized.” In determining this, the Service looks at other businesses in the same industry for their debt-to-equity ratios. An old rule of thumb is also that any company with a debt to equity ratio greater than 3:1, or 4:1, is too thinly capitalized. How this analysis might be applied to cannabis businesses is an open question.
When it comes to capitalizing a cannabis company, primary goals should be: 1) structuring and running a legitimate business, and 2) accurate state and income tax reporting. Unfortunately, the former is more challenging in marijuana than in other industries, and the latter takes some knowledge of administrative rules and policy. But it can be done with a little planning and study, and it can be done correctly. At the end of the day, the license will follow.