california cannabis marijuana

Welcome back to “California Cannabis: Scams and Schemes of the Week.” We are publishing this series to shed light on the unscrupulousness of certain attorneys, consultants, and operators in the California cannabis industry, with the goal of establishing a more ethical and regulated industry in the state. You can find last week’s post here.

Scam #1: Attorneys Representing Buyer and Seller and Taking Commission

We continue to see attorneys representing cannabis entities on both sides of mergers and acquisitions, and in addition to taking an hourly rate, they’re taking a commission on the deal (from both parties)! We are seeing the same attorneys appoint themselves as counsel for the purchased corporation. We’ve seen some shocking deals that harm both parties and benefit only the attorney. Most often, troubling information about a business or property is concealed for the benefit of the seller and the attorney, to the detriment of the buyer. We often see good, trusting people get taken for a ride by attorneys with unethical motivations. The incentive to close a deal as quickly as possible to get a commission is at odds with the incentive to conduct careful due diligence. Make sure your agents and attorneys have your best interests at heart, and if a lawyer tells you he or she can represent “both sides” in a transaction, run!

Scam # 2: The $10 Million Plot of Empty Desert Land

We’ve seen some outrageous land deals in California. There are a number desert parcels without any improvements or utilities, in the middle of nowhere, being offered for millions of dollars. Due diligence is key in real estate transactions, especially in the speculative cannabis market. Just because cannabis activity is possible in a certain jurisdiction does not mean an empty plot of desert land there is worth $10 million. Supplying that land with water, electricity, and building out the structure is no small feat. Many remote desert areas lack the infrastructure to supply these parcels with necessary utilities, and the installation of such infrastructure takes many years and substantial cost. Beware.

Scam #3: Work for Equity in My Nonprofit! 

In California, no one “owns” a nonprofit. One cannot buy or sell a nonprofit corporation, and no stock can be issued or authorized by a nonprofit. We’ve discussed this before on the blog.

Still, we have people asking us to review equity agreements where their nonprofit employer is offering stock instead of salary. In some cases, the company offering these fake stock deals may not know any better because they’re being advised by incompetent attorneys. In other cases, however, these companies are knowingly taking advantage of employees who are blinded by the excitement of being part of a bourgeoning industry. Walk away.

Scam #4: Buy My License!

Under MAUCRSA, state licenses are non-transferable. According to 16 CCR 5023(c), if one or more of the owners of a state license change, a new license application and fee must be submitted to the BCC within 10 business days of the ownership change.

Most local cannabis permits are similarly non-transferable. And if they are transferable, most jurisdictions require you to obtain written approval from the local government prior to transfer. Keep this in mind if you’re looking to buy or lease a “cannabis approved” property, There is simply no guarantee you will be able to get a license to operate there.

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If you’ve come across a California cannabis industry scam, we would like to hear from you! Leave a comment below, or email us at firm@harrisbricken.com.

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:

marijuana employment litigation
Wage violations are often litigated, even with executive employees.

Are wage and hour claims against cannabis businesses on the rise in Oregon? It appears so. Last week we highlighted a wage claim filed against CNH Labs by a former employee. That post highlighted some of the consequences cannabis employers can face when they fail to pay employees. But what about liability for failure to pay executive employees, including employees who are still employed by the cannabis company? A wage claim filed by Sara Batterby against HFV Enterprises is a great example of the liability a marijuana company can face against its own president and executive employee.

Ms. Batterby is the president and an executive employee of HFV Enterprises, Inc. (“HFV”) an Oregon corporation formerly known as HiFi Farms, a prominent cannabis producer. Ms. Batterby’s position did not stop her from filing a wage claim against HFV  in Multnomah County. She alleges an employment contract required HFV to pay her $2,000 every two weeks beginning in October 2017. According to the complaint, HFV made one $2,000 payment but has since failed to pay her any wages. Ms. Batterby’s claim requests $46,000 in unpaid wages, 9% interest until the wages are paid, and attorney fees and costs. If this lawsuit goes for any length of time, the attorney fees will likely be much higher than the claim itself.

Ms. Batterby’s wage claim is brought under ORS 652.120, which requires employers to establish regular pay days not less than 35 days apart. Violation of ORS 652.120 is a Class A violation punishable by a fine of up to $2,000 for each violation. This means that each payday HFV missed could be punishable by a $2,000 fine.

Ms. Batterby’s claim is unusual not because she is an executive employee, but because of what it does not allege. For whatever reason, the lawsuit fails to request penalty wages under Oregon’s minimum wage statute, and it fails to bring a breach of contract claim. If this case is not settled quickly, it would not surprise us to see an amended complaint by Ms. Batterby, covering these standard claims.

As we discussed in our coverage of the CNH Labs case, employers are required to pay employees minimum wage. Because Ms. Batterby was not paid anything in violation of the minimum wage statute, she likely has a minimum wage claim. Had she requested penalty wages for the company’s failure to pay her minimum wage, she may have been entitled to an additional 30 days wages as a penalty wage. A month’s wages at $10.25 and hour amounts to something like $2,460.

Ms. Batterby also claims she had an employment contract with HFV Enterprises. She likely could have supplemented her wage claim with a breach of contract claim against HFV Enterprises. A breach of contract claim would provide similar relief to Ms. Batterby, including at least 9% interest on the unpaid amount and possibly more if the employment contract included a provision for interest on unpaid wages, as many employment contracts do.

Employees are an essential part of any successful marijuana business. With employees comes exposure to liability. Wage and hour claims can come from any employee at any level and the penalties will depend on the type of violation, as the HFV and CNH cases have shown. The best way to avoid wage and hour claims is to ensure employees are being paid according to state laws. If you aren’t sure, have an outside expert come in and review your practices, from your cannabis-specific employee handbook on down. And if your company does face a wage and hour claim, it’s best to hire an experienced employment attorney to defend the claims and reduce the exposure.

california cannabis scam

I’ve had it with the scams and schemes in the cannabis industry. I’ve never seen so much dangerously ignorant and downright criminal behavior. Since beginning work in the cannabis industry, I have yet to go a day without encountering some sort of scam. The unscrupulousness of some attorneys, consultants, and operators in this industry needs to be called out and eliminated so we can establish an ethical, regulated industry in California. Towards that end, I’ll be posting a weekly list of scams and schemes to help unsuspecting victims avoid getting taken for a ride.

Scam #1: We Turn Your Cash into a Check Through Real Estate Investment!

There is a group pitching a scheme to turn dispensary cash into checks that can be deposited in the bank. The method: fork your cash over to this group. They toss your cash in with other “investors” and buy real estate with it. They flip the property, and send the proceeds to you in a check. Folks, this is textbook money laundering. The pitcher of this scam is exhibiting at industry conferences across the country and handing out “attorney-approved” contracts. Brazen, stupid, and dangerous for all involved.

Scam #2: Cannabis Cryptocurrency

If you want a lesson on what the government thinks about combining anonymous cryptocurrency with a federally prohibited substance, look no further than the life sentence handed down to Ross Ulbricht, creator of the Silk Road. Ulbricht was convicted of money laundering, computer hacking, and conspiracy to traffic narcotics. Those are the exact same charges that could be brought against any cannabis cryptocurrency company. Don’t get me started on the value of cannabis cryptocurrency on the secondary market. It’s complete b.s.

Scam #3: You Must Cultivate Before Obtaining a Permit

Most people laugh out loud when they hear this. Unfortunately, there are a few attorneys who provide their clients with downright criminal advice, trying to convince would-be business partners or landlords to engage in unlawful behavior. The days of collectives and “creative” lawyering to get around the laws are over. We now have a robust regulatory system under MAUCRSA that makes it clear that you cannot engage in any sort of commercial cannabis activity before obtaining all local approvals and a state license.

Scam #4: Your DUI Attorney Can Handle Your Tax Audit

Just say no. You are a legitimate business, and you need to retain a legitimate and experienced lawyer to handle your legal matters See Seven Keys to Choosing Your Cannabis Business Law Firm.

cannabis business marijuana
If only it were so easy.

There is a direct correlation between the complexity of a state marijuana business licensing system and the complexity of financial deals that industry participants undertake. Washington, Oregon and most of all, California, provide fertile grounds for increasingly complex deals. Outside of cannabis, my firm sees similarly complex transactions proposed in our international business practice, especially in our China law practice which is another body of law requiring specialized knowledge. Regardless of circumstance, though, it is vitally important that parties to a deal firmly understand how the deal shifts and manages risk.

Complex transactions can feel like a game of hot potato. Here is a relatively simple example that demonstrates some of the complexity I’m talking about: Sally signs a supply contract with a large processor to provide bulk raw material. Sally realizes that she can’t service this herself, so she asks Henry, who has a background in servicing large orders like this, to use his experience in coordinating and managing production to service the contract. Henry realizes that he needs significant capital to expand capacity and turns to outside investors. Those outside investors want security before they invest, so they ask for, among other things, a pledge from Sally of her contract rights to receive payment from the processor as collateral.

In a perfect world, Henry gets the investment and uses it to provide the raw material. Sally and Henry provide them to the processor and split the contract fees they receive, some of which go to pay back the investors. Everybody wins.

Sometimes deals like this do work for everyone. But there are so many different ways that they can go wrong. None of the parties should enter into the deal without understanding what the consequences would be of various potential failure risks. In the example deal, there are plenty of potential failure points:

  • Can Sally coordinate production to service the contract?
  • Can Henry actually produce?
  • If Sally and Henry can produce, can the processor actually pay?
  • What if state regulations change and disallow contracts like this midway through the production cycle after money has been spent?

All of the parties in the deal need to understand their exposure at each stage of the deal from beginning to end, in order to negotiate the arrangement but also to perform under the contracts. We have seen deals like this look like they are on a good path until, at the last possible moment, the processor decides that they can’t pay for the product.

But that’s the crux of almost any business arrangement. There is a moment where a party spends money with the anticipation of receiving that back with a return. Whether or not the return comes is a function of risk. Businesses that do best are those that can understand and quantify risks and that understand how best to shift risk and hedge against downside. Whether the hedging/shifting mechanism is through security agreements, outside insurance, or reliance on lawsuits, parties need to understand the costs and benefits of each in order to properly manage their risk position.

Risk isn’t necessarily bad. But if a party is taking on a significant portion of the risk in a deal and that risk isn’t properly hedged, that party should receive the lion’s share of the potential upside.

california cannabis labeling
It’s not optional for California packaging and labeling.

California is just starting to get its cannabis packaging and labeling regulations right under MAUCRSA.  As part of this multi-part series on these regulations, I covered transition period product packaging and labeling in a previous post, and I analyzed the packaging and labeling for “New Products” in another post. Today’s post will cover Proposition 65 labeling issues for California’s cannabis businesses. Note that MAUCRSA makes no specific mention of Prop. 65 compliance, so marijuana business owners are on their own in identifying whether or not they must adhere to that law.

The Safe Drinking Water and Toxic Enforcement Act of 1986 (a/k/a Prop. 65), requires theOffice of Environmental Health Hazard Assessment (OEHHA) to publish a list of chemicals known to cause cancer, birth defects or other types of reproductive harm. The list now includes more than 850 chemicals. Given this fact, there is hardly a manufacturing business in California that won’t find itself subject to Prop 65 warning requirements at some point.

Prop. 65 requires businesses to provide their customers with notice of these chemicals when present in the products they purchase, in their homes or workplaces, or that are released into the environment. The ultimate intent is to allow consumers to make informed decisions with respect to chemical exposure (though there have been allegations of abusive lawsuits against businesses by “bounty hunters” almost from the outset of the passage of Prop. 65).

Effective June 19, 2009, marijuana smoke was added to the Prop. 65 list of chemicals known to cause cancer. The Carcinogen Identification Committee of the Office of Environmental Health Hazard Assessment  “determined that marijuana smoke was clearly shown, through scientifically valid testing according to generally accepted principles, to cause cancer.” And back in 2015, a “citizen enforcer” served the first five 60-day notices on medical cannabis dispensaries around the state.

As MAUCRSA licensing and regulation steadily comes online, you can bet that we will see a smattering of Prop. 65 attacks on cannabis business owners who fail to properly label their products. So, what do you need to look out for as a cannabis business? The first thing is to realize that, yes, Prop. 65 likely applies to you where any of the products you’re selling may contain Prop. 65 chemicals above safe harbor levels that warrant the mandated labeling warnings: Prop. 65 applies to everyone in the chain of distribution, not just retailers. Also, just because your products do not contain “marijuana smoke” doesn’t mean you don’t have to adjust your label: If your products contain any of the other ~849 chemicals, you have to disclose accordingly under Prop. 65. For example, any carcinogens or toxins that go into any oil inserted into a vapor pen cartridge are likely going to warrant a Prop. 65 warning.

There have also been updates to Prop. 65, the latest of which passed in 2016 and will be fully effective on August 30, 2018 of this year. These updates to the law affect how you must label your products to secure the safe harbor. The typical warning that’s out there right now in the cannabis community is some iteration of:

WARNING: This product contains a chemical known to the State of California to cause cancer.

With the new laws coming into play on August 30, the foregoing will no longer be good enough. Instead, unless you meet one of the few exceptions (one of which is that your product was manufactured prior to August 30, 2018 and contains the September 2008 safe harbor warnings), you’ll need to follow the new regulations. One of the most important changes with the new regulations is that you now need to actually identify at least one triggering chemical depending on the type of harm caused by that chemical. Specifically, OEHHA mandates that:

If, for example, there are five possible chemical exposures from a given product, and all five chemicals are listed only as carcinogens, then the business would only be required to name one of those five chemicals in the warning. . . If there are exposures to both carcinogens and reproductive toxicants, a business would be required to name one of the chemicals that is a carcinogen and one of the chemicals that is a reproductive toxicant, but the business could choose to identify more chemicals in the warning.

In turn, your new Prop. 65 warning labels will look like one of the following:

For carcinogens: “This product can expose you to chemicals including [name of one or more chemicals], which is [are] known to the State of California to cause cancer. For more information go to www.P65Warnings.ca.gov.”

For  reproductive toxicants: “This product can expose you to chemicals including [name of one or more chemicals], which is [are] known to the State of California to cause birth defects or other reproductive harm. For more information go to www.P65Warnings.ca.gov.”

For exposures to both listed carcinogens and reproductive toxicants: “This product can expose you to chemicals including [name of one or more chemicals], which is [are] known to the State of California to cause cancer, and [name of one or more chemicals], which is [are] known to the State of California to cause birth defects or other reproductive harm. For more information go to www.P65Warnings.ca.gov.”
For exposures to a chemical that is listed as both a carcinogen and a reproductive toxicant: “This product can expose you to chemicals including [name of one or more chemicals], which is [are] known to the State of California to cause cancer and birth defects or other reproductive harm. For more information go to www.P65Warnings.ca.gov.”
If you’re starting to worry, you can also use a short-form label under certain circumstances. Finally, the look of the label has also changed with the new regulations:

“A symbol consisting of a black exclamation point in a yellow equilateral triangle with a bold black outline. Where the sign, label or shelf tag for the product is not printed using the color yellow, the symbol may be printed in black and white. The symbol shall be placed to the left of the text of the warning, in a size no smaller than the height of the word ‘WARNING'”.

You can download the symbol here.

There are a slew of other mandates under Prop. 65, but the bottom line is that if you fail to comply with this law, you’re going to be facing costly legal challenges and/or settlements, none of which will have to do with your MAUCRSA compliance. So double check your labels now to ensure that you’re prepared and in compliance for August 30, 2018.

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 tax
Returns are due next month. Time to hustle.

In California, the first Cannabis Tax Return is due on April 30, 2018 and many of our clients are now working through the issues related to the Cannabis Cultivation and Excise Tax. In addition, many marijuana businesses must file their first 2018 estimated federal tax payment by April 17, 2018. To estimate taxable income, every Cannabis business must understand how to treat the Cannabis Cultivation Tax and the Cannabis Excise Tax on their federal income tax return. Are California Cannabis Taxes an expense of a cannabis business? If so, are cannabis taxes deductible for federal income tax purposes?

We have discussed the mechanics of IRC §280E here and here. IRC §280E disallows deductions for cannabis cultivators, manufactures, distributors and retailers. However, expenses included in cost of goods sold (“COGS”) reduce taxable income and operates outside the reach of IRC §280E. Generally speaking, IRC §280E is less damaging to cultivators than retailers, because cultivators can attribute more business expenses to COGS.

Cultivation Tax
California imposes a cultivation tax on harvested cannabis that enters the commercial market. The tax is:

• $9.25 per dry-weight ounce of cannabis flower;
• $2.75 per dry-weight ounce of cannabis leaves; and
• $1.29 per dry-weight ounce of fresh plant.

The tax is imposed on the Cultivator alone; under state rules, cannabis cannot be sold unless the tax is paid.

IRS regulations (Treas. Reg. §1.471-11) provide Cultivators and Manufactures with a helpful roadmap regarding what costs are appropriate to include in COGS. Taxes can be included in COGS if they are otherwise allowed as a deduction under IRC §164. Under IRC §164, state taxes are deductible if they are “paid or accrued … carrying on a trade or business”. In addition, the state taxes may be included in COGS if they are “attributable to assets incident to and necessary for production or manufacturing operations or processes”. For example, property taxes are included in COGS. Finally, the regulations look to whether a tax is included in COGS in the business’s financial statements.

Cultivation taxes are paid or accrued in carrying on a trade or business. The cannabis plant is an asset of the business (i.e., raw material) that is the core ingredient in all cannabis products grown or processed. Clearly cannabis is the raw material incident and necessary to production; cannabis may not be sold under California law unless the Cultivation Tax is paid. Finally, the tax is imposed based on a characteristic of a business asset (i.e., weight of raw material), like a property tax.  Accordingly, there is a reasonable argument that IRS regulations require that the California Cultivation Tax be included in COGS of a Cultivator.

Excise Tax
California imposes a 15% Cannabis Excise Tax on the purchases of cannabis or cannabis product sold. Generally, the tax is imposed on the average market price. The average market price is the Distributor’s wholesale cost plus a mark-up determined by the CDTFA. Currently the mark-up is 60%. For example, a retailer’s cost of an ounce of cannabis is $75/ounce plus $5 of transportation cost. The mark-up is $48($80 *60%). The average market price is $128 ($80 +$48); the Cannabis Excise tax is $19.20 ($128*15%). The Retailer’s COGS includes the $80 cost. The Retailer will charge the consumer tax of $19.20. Note that for cannabis retailers, COGS is generally limited to the direct purchase cost of cannabis.

So, the big question here is: Should the $19.20 of Cannabis Excise tax be included in the Retailers COGS? By statute, the cannabis excise tax “shall be imposed upon purchases of cannabis”. The Retailer collects the tax from the consumer and pays the tax over to a California Distributor. As the tax is the ultimate liability of the cannabis purchaser, the statutes suggest that the cannabis tax collected is not a cost to the Retailer. Like state sales taxes, the Cannabis Excise Tax is a liability to the Distributor. As such the Cannabis Excise Tax is reflected on the Retailer’s balance sheet and not as an expense on the income statement. The Cannabis Excise Tax probably escapes the reach of IRC §280E.

Although California cannabis taxes do not conflict with IRC §280E, all cannabis businesses should consult with their tax advisors before taking a final approach. For Cultivators and Manufactures, there is a reasonable argument that the Cultivation Tax is included in COGS. For Retailers, there is a reasonable argument that the Cannabis Excise Tax is passed directly to the consumer and, therefore, outside the reach of IRC §280E. At the very least, that may be a good place to start the discussion.

marijuana washington employment
Washington’s new employment legislation hopes to close the pay gap.

More and more states are recognizing there is a pay gap between the genders. Washington is the latest state to address the gap through legislation. The near-final law, HB 1506, is commonly referred to as the Equal Pay Act. It is currently awaiting the Governor’s signature, which we can expect any day now.

Equal pay laws are complicated and understanding your obligation as an employer is critical to avoiding hefty civil penalties and  liability. Washington’s Equal Pay Act specifically notes the difficulties women can face in obtaining equal pay and moving up in companies. The Washington law attempts to address these issues by prohibiting employers from discriminating against similarly situated employees based on gender.

So what constitutes discrimination in this context? Discrimination occurs when an employer pays similarly situated employees different wages because of the employee’s gender, or when the employer fails to promote or advance an employee because of their gender. Employees are “similarly employed” if the performance of their job requires similar skills, efforts, responsibility, and if the jobs are performed under similar working conditions. Job title alone is not determinative.

Employers can pay similarly situated employees different if: 1) the difference is based on a bona-fide job factor that is consistent with business necessity; 2) is not based on a gender based differential, and 3) accounts for the difference. Bona-fide factors include: education, training, or experience; a seniority system; a merit system; a system that measures earning by quantity or quality of production; or a bona-fide regional difference in compensation levels. Employers bear the burden to prove there was a bona-fide factor for the difference in pay, which means that businesses had better get it right. Note that employers may use the same bona fide factors in determining whether to promote or advance employees.

Cannabis companies are not sheltered from the new law. Although cannabis companies boast a higher percentage of female founders and executives than other industries, women still face unique challenges in the industry. Studies suggest that while women have success starting cannabis businesses, they do not retain that success. As the cannabis industry has grown, female ownership and executive percentages has also dropped. Finally, as individual companies grow, they tend to adopt more traditional business structures that results in a high percentage of males in senior roles.

Every Washington cannabis company should have a plan in place to ensure its business practices meet the requirements of the new Equal Pay Act. A good place to start is to have an expert audit your payment practices and assist in drafting a policy identifying the factors that are considered in setting wages and offering promotions. Cannabis companies in other states should also follow suit: Equal pay promotes employee retention, creates positive brand capital, and–most importantly of all–it’s the right thing to do.

Last week I spoke on a panel about compliance at the Cannabis Cultivation Conference hosted by the Cannabis Business Times. If you’ve been following the latest developments in California you’d know that compliance with the myriad of regulations is the biggest obstacle for businesses looking to join the state legal cannabis market. We recently covered the current landscape facing cultivators here.

california cannabis marijuana licensing
Get your compliance checklist ready!

For commercial cannabis purposes California is a dual licensing state (although some would call it a “duel” licensing state, as it can be quite a battle to obtain a cannabis business license). Dual licensing means that in order to operate a commercial cannabis business you have to obtain a cannabis permit from your local jurisdiction before you can receive your license from the state. That means you’ve got to comply with two sets of regulations and in some occasions, many more.

For those that have been operating as collectives, cooperatives, or non-profits under the Compassionate Use Act (1996), Senate Bill 420 (2003) and the California Attorney General Guidelines (2008), compliance requirements were practically non-existent. That all changed when the state passed the Medical Cannabis Regulation and Safety Act in 2015 and California voters approved the Adult Use of Marijuana Act in 2016: Both the MCRSA and the AUMA were merged under the Medical and Adult-Use Cannabis Regulation and Safety Act to form one regulatory regime. In that sense, compliance is more manageable than it may appear at first blush.

Still, for many people who have dedicated themselves to providing medical cannabis to Californians for the last two decades, the thicket of regulations is the equivalent of a meteor-level extinction event. For the last twenty years most cannabis operators have looked at record-keeping as something you’d do if you wanted to go to jail — handshakes, your word, and cash transactions were the non-incriminating way of the land. Due to banking issues, cash transactions are still prevalent, but handshake deals should be sitting on a shelf at Blockbuster now that cannabis businesses are legitimate, licensed entities.

It is also worth noting that record-keeping and compliance does not end once you’ve obtained your local and state cannabis permits. Compliance is not only a prerequisite to obtaining but is also vital in maintaining your cannabis license. If the thought of compliance is overwhelming you and you don’t where to start, don’t worry, we’ve got you covered. This list should not act as a substitute for obtaining competent legal representation but it will give you an idea on what the road to compliance looks like. Without further ado:

  • Prepare a List Of The Regulatory Agencies That You’ll Need To Work With. At the state level, the three main regulatory agencies are the Bureau of Cannabis Control (distributors, laboratories, retailers, delivery-only retailers, microbusinesses, and temporary special events); the Department of Food and Agriculture (cultivators, processors, and nurseries); and the Department of Public Health (manufacturers). Other agencies include the Department of Fish and Wildlife, Regional Water Boards, the California Department of Taxes and Fees Administration, and the California Department of Insurance to name a couple more (there are others out there). On the local side, you’ll likely need the approval of some combination of the following: the City Council or Board of Supervisors, the City Manager, the Planning Department, the Zoning Administrator, and Police, Fire, and Building Departments. Put a list together of all the agencies (and their requirements) that will regulate your cannabis business.
  • Read Your Local Ordinance. Remember, you can’t get your state license until you obtain your local permit. Your local cannabis ordinance will list the criteria you’ll need to meet to get a license. You’ll likely need a security plan, a business plan, an odor mitigation plan, and a community relations plan. Some local ordinances have hours of operation requirements that are stricter than the state’s regulations so make sure your application abides by your local rules. It’s essential that the business, operating, and security plans you submit align with your local ordinance. I also highly recommend that you attend all of the cannabis ordinance public hearings in your local jurisdiction to familiarize yourself with the decision makers and any community concerns.
  • Make Sure Your Location Is Properly Zoned For The Activity. This coincides closely with familiarizing yourself with your local cannabis ordinance. You’ve got to make sure that your business is located in a district zoned for your cannabis activity and satisfies state and local setback requirements. If you’re leasing the property make sure the lease properly lists all of your cannabis operations as a permitted use.
  • Prepare Standard Operating Procedures And Train Your Employees To Follow Them. Prepare SOPs for every part of your operation. If you don’t know where to start, begin with your local and state applications. Every plan or action item that was listed in your applications should have a corresponding SOP.
  • Conduct Financial, Security, And Inventory Audits. Not only is important to have SOPs but you need to make sure your business is following them. Let me be brutally honest here: At some point, something is going to go wrong. If that mistake brings a regulator to your door, you’ll want to show them that mistake was an anomaly and not due to poor business practices. Conducting audits and following SOPs will go a long way in mitigating potential penalties. For more on the importance of audits, see here.
  • Compliance With Securities Regulations. Will you need to raise funds from investors? If so, you’ll need to consult with your attorney to determine whether the investment constitutes a security and if so, whether a securities exemption is applicable or not. For more on securities compliance, see here.
  • Review The Representations, Warranties, And Indemnity Provisions In Your Contracts. When’s the last time you looked over any of your contracts? Make sure the other contracting party has obtained the necessary licenses, represents that they’re in compliance with all regulations, and will indemnify you if they’re negligent or otherwise deviate from their representations and warranties.
  • Have a Compliance Team. Depending on the size of your cannabis business, compliance should not be a one-person operation. Your business will benefit from having a compliance team. Not only is this important for regulatory reasons but having a compliance team will allow you to identify inefficiencies and irregularities in your operation and correct them. Make sure your compliance team or compliance officer meets regularly with your employees as improved communication will also improve profits.

The bottom line is that compliance is necessary for cannabis businesses and should be given the appropriate attention. Compliance isn’t a four-letter word, nor should it be treated like one. A robust compliance protocol will lead to a standardized and reliable cannabis product, and if a purchaser down the supply chain (and ultimately the consumer) can rely on your product to meet the same standard every time, you will differentiate yourself in a competitive marketplace. Life might be like a box of chocolates but you shouldn’t have to guess when it comes to compliance and your product.