foreign investment california cannabis
Coming soon to California cannabis?

In addition to our California cannabis business attorneys’ work on corporate, finance, and transactional issues with marijuana-related businesses, we also work with our firm’s foreign direct investment group. As California has implemented MAUCRSA since January 1 of this year, we have been getting tons of interest and questions in and about foreign investment into California’s booming cannabis industry. As would be expected, much of this interest is from Israel, Canada, Spain, Turkey, South America, the Netherlands, the UK and Germany. These investors are interested in California because of the size of the market, but also because California has no residency or citizenship requirement to invest in cannabis businesses.

In general, foreign direct investment (FDI) refers to any type of cross-border transaction where a company or investor from Country A invests money in a company located in Country B. It generally doesn’t refer to dumping money broadly into stocks and bonds — it is specifically about a concentrated, single-enterprise investment.

FDI exists in several forms. Foreign investors can start a new company and can finance and build it from the ground up. They can participate in a joint venture with U.S. partners. They can wholly or partially acquire a U.S. business. They can also take a lighter touch, where they provide primarily branding and process support while having U.S. parties take on the bulk of the financial risk — the basic franchise model.

In the marijuana industry, we have already seen large FDI projects in cannabis ancillary services (i.e., the companies that provide the goods and services that support the actual marijuana traffickers). Foreign investors have opened up domestic companies for the manufacture and import of cultivation equipment like grow lights and hydroponic equipment, processing equipment like automated trimmers and extraction machines, and associated inputs including soil, fertilizer, vapor pen batteries and cartridges, and more. We have also seen large amounts of foreign money come in for cannabis real estate projects, especially in the Coachella Valley and certain desert cities. In addition to buying the real estate, the foreign investors put money into greenhouses, grow lights, storage facilities, and more to offer turnkey cultivation and processing facilities for lease to local businesses. These companies are largely unregulated at the state level, and their foreign investment issues are similar to non-cannabis businesses, dealing with things like registering as U.S. taxpayers for partnership taxed businesses, complying with FIRPTA, and dealing with immigration issues.

For firms directly involved in the buying and selling of cannabis, state-specific restrictions become more of a concern. States like Washington do not allow anyone who is not a state resident (much less not a U.S. resident) from having any profit interest in a marijuana business. California, similar to Oregon, is extremely liberal with its cannabis regulations regarding owners and “financial interest holders.” As mentioned above, there is no residency or even citizenship requirement to participate. Still, on the whole, state regulations and state laws are typically written with U.S. residents in mind. In turn, things like criminal and financial background checks on foreigners remain a bit of a gray area (though California’s Department of Public Health, which oversees manufacturers, has accommodated the situation somewhat with an “out of state owner” background check). Ultimately though, neither state officials nor the FBI are likely to have any real information on foreign nationals who haven’t had prior contact with the United States. How the Feds will react to foreign ownership in terms of the Department of Justice (rather than via immigration through the Department of Homeland Security) still remains to be seen, though nothing’s been publicly reported that’s a red flag against foreign marijuana business ownership in California.  

As far as federal laws go, the Controlled Substances Act doesn’t differentiate between activities that are international, interstate, or fully intrastate in nature. Possessing, manufacturing, and distributing marijuana are illegal federally regardless of where the company’s owners live. Still, there are a couple of criminal statutes that add fuel to the fire when interstate and international commerce are involved. 18 U.S.C. § 1952, for example, criminalizes traveling or using the mail in interstate or foreign commerce with intent to distribute the proceeds of marijuana sales.

More questions arise when considering foreign ownership in the context of the Department of Justice marijuana enforcement memoranda that cannabis-legal states are working under. The main takeaway from the August 2013 Cole Memorandum (which has been rescinded by U.S. Attorney General Jeff Sessions) was that if the states want to keep federal law enforcement away, they need to make sure their regulations prevent state licensees from violating the various federal enforcement priorities. One of those priorities was that state regulations need to prevent “revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels.” If the state and federal criminal background check databases don’t have extensive coverage on foreign crimes, how can a state, including California, have faith that the foreign investors don’t fall into one of those categories?

For now, with no broad pronouncements apparent, it appears that the federal government is taking a wait-and-see approach to foreign ownership of state cannabis businesses. That means it is up to state cannabis business participants and the states themselves to ensure that foreign owners do not violate federal enforcement priorities — starting with California.

marijuana cannabis loan
This industry is different, you know.

Many cannabis businesses are funded with debt. Sometimes, the debt is owed to one of the business’s owners, who pursued a debt structure for tax reasons. Other times, the debt is owed to a third party. That party could be a friend or family member, an investor keen on the industry, or even a professional hard money lender. Our marijuana business lawyers have papered a large number of loans in the industry, on behalf of both businesses and lenders. This blog post identifies some considerations for lenders making plays in the industry.

Do Your Diligence.

Before making a loan of any type to a cannabis business, do your diligence. Like so many things related to cannabis businesses, this exercise is different than with standard businesses. There are several reasons for this: 1) cannabis businesses often have short or non-existent operating histories; 2) by extension, cannabis businesses often have limited financial information at hand (tax returns, P&Ls, etc.); 3) the financial projections for cannabis businesses are more speculative than for other businesses, due to market dynamism; and 4) regarding operations, cannabis businesses may be “license pending” and thus offer little to vet.

Altogether, these factors make it supremely important to vet the actual owners of the business, as well as whatever you can get on the enterprise. This means having a look at personal financials and assets, credit reports, asking for personal references and calling around, etc. And when it comes to diligence on the business, make sure you do more than simply run a UCC search and review financials. Ask for company agreements. After all, a business may have an oppressive lease or licensing agreement which makes it less likely to succeed, or it may have similar documents with contingent or springing security interests that diminish your repayment prospects.

Prepare to Be Vetted.

The cannabis business will look into you, of course. But the real vetting is likely to happen by the licensing authority. 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, but it’s very likely that as a lender, you will need to be disclosed and vetted by the licensing authority. This may entail submission of information on your business, if you have one, and/or its owners and spouses. It also usually means fingerprints, background checks, and having your name on file as a part of the public record.

Demand Security.

Arms-length loans are almost never unsecured, so this one is a no-brainer, and if a marijuana business pushes back, it should be a dealbreaker. The best type of collateral is something tangible, like real property (land) that is unencumbered by senior interests, or where foreclosure by a senior noteholder would not wipe out all available equity. But there are other types of collateral, too, like personal property (including intellectual property); and there is always the option for a convertible note. Finally, lenders often get creative with deposit control agreements and other collection levers.

In the personal property category, the noteworthy asset when lending to plant-touching businesses is the cannabis itself. Most states have procedures for secured creditors to take control of a cannabis business under provisional licensing authority, for liquidation purposes. But, before you sign up for this, ask yourself: Could I really see myself chopping down cannabis plants one day? Or paying a receiver to do that? If not, and if the business has no other valuable assets, this loan may not be right for you.

Demand Personal Guarantees.

This ties into the diligence and security categories. A personal guaranty is just an extension on whatever security you can otherwise acquire as a part of the loan. Make sure these guarantees are uniformly integrated into the loan documents, and that each guaranty is more than a cursory sentence appended to a promissory note. The personal guaranty should cover various contingencies, e.g.: What happens if the guarantor dies? Are there any allowances for its termination, aside from repayment of the loan? Etc. Also, consider whether your borrower resides in a community property state like Washington or California, where the guaranty may not attach to marital property.

Do Market (and Legal!) Research.

Lenders to the cannabis industry are getting better rates than almost anyone else. They are taking on more risk, and feeding an insatiable capital market. We have seen loans with interest rates up to 50%(!) for relatively quick turns, but we have also seen loans that do not conform with licensing rules, or with state lending and usury laws. The exercise here is to ascertain market norms, look at your prospective borrower’s situation, and consider these factors in the greater context of lending statutes and marijuana licensing program rules. Finally, balance what you think you can get against the decreasing odds of collection that inevitably come with higher interest rates and compact repayment schedules.

cannabis marijuana term sheet

When I receive a summary of a cannabis business deal–the first emails, calls, LOIs, and term sheet in any form–with 90% accuracy I can say whether the transaction will be a difficult one or not. Note that “difficult” does not correlate with complex: Often the more complex deals, with multiple entities and asset transfers, end up being much easier, whereas a simple secured loan can be more difficult. And in the context of a transaction, “difficult” = “time consuming” = unnecessary expense. Everyone would like to avoid that.

The number one differentiating and determinative factor in assessing the difficulty of a marijuana business deal is the term sheet. If a deal is a building, think of the term sheet as both the architect’s blueprint and the physical foundation on which the deal is built. Deals that are smooth are built with a clear plan and on a solid base; these come in on time and under budget. Deals that are built based on a vague understanding of the final goal but with no firm, documented plan, will be typified by stops and starts, walls built, torn down and rebuilt, and a final product that stands but doesn’t resemble what either parties had in mind (“in mind” being a key phrase here, as often what was in the parties’ mind was never exchanged in an agreement). Oh, and the dreaded cost overruns.

Engage your attorney before you sign a term sheet. 

Having a final term sheet is necessary for a smooth transaction, but agreeing that a half-baked term sheet is “final” may prove worse than having no term sheet at all. Do not make the mistake of thinking you cannot engage your attorney until you have a term sheet signed: In fact, an hour with your attorney before you finalize the terms, could save you many hours down the line. Your experienced business attorney will know how the terms will fit in the documents, and in turn what terms you may not have addressed fully, or at all.

Do not have your attorney draft the transaction documents until after you sign a comprehensive and binding term sheet. 

Speed in transactions is defined by certainty. Term sheets that say “market standard” terms for X is likely a proxy for “we didn’t take the time to discuss X.” This can work if the parties have a common reference point or an external reference. For example, in the context of an equity financing, “standard NVCA language on Registration Rights” is OK. “Standard anti-dilution” is not OK: There are at least three flavors and they are wildly different, so the drafting attorney with that term sheet is guessing–or likely talking only to his side–on the issue. The stops, starts, and re-drafts is what eats up time.

Continuing with the building analogy: Every couple building their dream home wants the house built quickly and correctly, and on budget. But they had better get all the critical details decided and in the plans before the first brick is laid. In other words, if you don’t agree on the location and number of bathrooms, you wouldn’t tell a contractor to “start building now and we’ll decide on the bathrooms later.” The decisions won’t get easier if you put them off, and having a full plan in place from the beginning will make the process more enjoyable for all.

Definitely say “NO” to unregistered broker dealers.

Startups in the cannabis space have few options when looking to raise funds– almost all banks, venture capital (VC) firms, and other institutional funds are off limits. Suitable private investors are few and far between. This situation is unfortunately leading to a proliferation of unscrupulous individuals that offer their “services” or “connections” to help companies meet investors and bring in dollars, for a fee. We’ve referenced on a few occasions (see here and here) that these investment “finders”, as well as any type of commission on dollars raised or other transaction-based fee, is 100% illegal (unless they hold a FINRA license to serve as a securities broker, and as I’m seeing, nearly all do not). Engaging an “unlicensed broker-dealer” can have serious consequences for the company. Even a dollar raised in this way puts all other company funds and assets at risk.

The frequency with which these issues are raised by clients and others makes me believe that 1) some companies are engaging unlicensed brokers without thinking to run this by their attorney, and 2) some of these unlicensed brokers are aware they are breaking securities laws, while others are simply ignorant and trying to capitalize on their “connections”, not knowing their business model is illegal.

So clearly this topic deserves its own post and its own bolded and underlined warning: Don’t sign any engagement with an advisor / consultant / snake oil salesperson that offers to raise funds for your company, in exchange for a fee. If anyone approaches you, run it by your business attorney right away, and keep them involved throughout the process.

The Law:

Section 3(a)(4)(A) of the Securities Exchange Act of 1934 generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Pursuant to that law the SEC has laid put extensive regulations and guidance to further define “broker activities” and prohibited fee structures.

Assuming the individual is not a registered broker-dealer (which you can confirm on the FINRA site here) then here’s what you certainly cannot do:

  • Engage an advisor, agent, or anyone describe their role or duties in terms that touch broker activities. At the most basic level, you should avoid any engagement that calls out “introducing” or “finding” or “bringing in” investors. If an engagement calls out “fundraising advice” or “investor relations” as a euphemism for broker activities, you’re walking a fine line. Best to reword your engagement and make no references to broker activities.
  • Tie any compensation to funds raised. This includes the obvious “transaction-based” fee of a percentage of funds raised, or fees scaled to milestones. This includes “fees” paid as equity grants. It also includes any fee contingent on a fundraising round – such as a retainer charged when funds arrive.

As a startup you often feel stretched thin, and in need of any help you can get. But in this case, this is not the help you want. Accepting any funds raised through an unregistered broker-dealer, or another performing broker activities for a fee, is worse than not having funds at all. The risk is then to the entire company, and in turn all the investors and employees current and future. Don’t do it!

cannabis capitalization license
Prepare to describe how the sausage was made.

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.

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.

california marijuana cannabis invest own

Passage of California’s Medicinal and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA“) has opened the doors to institutional investing in California cannabis companies. California’s lack of a residency requirement for investors and its relatively limited investor disclosure and background requirements have made it popular for institutional investors looking to invest in cannabis. In that sense, California is building out its program to mirror wide-open states like Oregon, and not protective states like Washington.

There are two main types of California cannabis applicants: owners and financial interest holders. To be legally considered an “owner” under California’s cannabis regulations, one does not actually need equity in the applicant’s cannabis business. “Owner” means any of the following:

  1. A person with an aggregate ownership interest of 20 percent or more in the person applying for a license or a licensee, unless the interest is solely a security, lien, encumbrance;
  2. the chief executive officer of a nonprofit or other entity;
  3. a member of the board of directors of a nonprofit; and
  4. and any individual who will be participating in the direction, control, or management of the person applying for a license.

An individual who directs, controls, or manages the business includes any of the following: a partner of a commercial cannabis business that is organized as a partnership; a member of a limited liability company of a commercial cannabis business that is organized as a limited liability company; and an officer or director of a commercial cannabis business that is organized as a corporation. These are all fairly standard definitions, as far as cannabis regulation goes.

Even if someone is not an “owner,” however, that person or company may still be deemed a financial interest holder (“FIH”). “Financial interest” is broadly defined to mean “an investment into a commercial cannabis business, a loan provided to a commercial cannabis business, or any other ‘equity interest’ in a commercial cannabis business.” California cannabis regulators consider the term “equity interest” to include less than a 20% ownership in the cannabis applicant and pretty much any profit-sharing arrangement or entitlement to profits from cannabis licensee, including IP licensing royalties and percentage rent arrangements. The following are not considered FIHs: banks and financial institutions; diversified mutual funds, blind trusts or similar instruments; holders of security interests, liens, or encumbrances on property that will be used by the commercial cannabis business; and individuals holding less than 5 percent of the total shares in a publicly traded company.

California requires FIHs be disclosed to and vetted by the state upon application for annual cannabis licenses. The license applicant must provide a complete list of all financing it receives. Specifically, the license application mandates that applicants include the name, birthdate, and government-issued identification type and number (i.e., driver’s license) for any individual with a financial interest in a commercial cannabis business. FIHs are not required to submit to criminal background checks but they will still undergo some vetting by state regulators.

Even with these new rules, most institutional investment in the cannabis space is still concentrated in “ancillary services“, i.e. services that support cannabis businesses but do not “touch the plant.” Examples include turnkey real estateequipment and materials leasing and salesintellectual property licensing, consulting services, and tech platforms. Many institutional investors still want to stay one or two steps removed from touch-the-plant cannabis businesses and do not like the idea of being listed in a state database as being an owner or FIH. However, given California’s wide-reaching definition of owner and FIH, even these companies and their investors can be deemed by the state to have a direct cannabis business interest. To avoid being considered owners or FIHs in California, ancillary service providers will need to avoid directly providing financing, using profit-sharing or similar performance-based payment schemes with cannabis businesses. They will also need to avoid managing, directing, or controlling the licensed entity.

Editor’s Note: A version of this post originally appeared in an Above the Law column, also by Hilary Bricken.

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.

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.

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.