Great news: on March 7, 2019, the “Secure and Fair Enforcement Banking Act of 2019” (or, the “SAFE Banking Act”) was officially introduced in the House of Representatives. Even greater news: championed by Representatives Ed Perlmutter (D-CO) and Denny Heck (D-WA), the SAFE Banking Act reached the House with a bipartisan alliance of 106 co-sponsors – meaning a quarter of the House recognizes that state-legal, marijuana-related businesses need to be able to engage with banks and other financial institutions, and vice versa.

As discussed in this earlier blog post, the SAFE Banking Act aims to prohibit federal regulators from punishing banks and other financial institutions that provide banking services to state-legal marijuana businesses, marijuana-related businesses, and their owners and employees. This includes preventing federal banking regulators from limiting a depository institution’s access to the Deposit Insurance Fund and taking action on loans made to marijuana businesses.

At the time of its introduction, Representative Perlmutter re-emphasized that the legislation was primarily aimed at safety – “The SAFE Banking Act is focused solely on taking cash off the streets and making our communities safer. Only Congress can provide the certainty financial institutions need to start banking legitimate marijuana businesses – just like any other legal business – and reduce risks for employees, businesses and communities across the country.”

Representative Heck went on to elaborate: “We know based on the Treasury guidance that the federal government prioritizes keeping this product out of the hands of children and organized crime. The most effective way to do that is to not only allow, but encourage these businesses to use traditional banking methods to track their sales, deposits, expenses, tax payments, and other business transactions. If Congress fails to act, we are discouraging responsible, regulated markets and allowing a serious public safety threat to go unaddressed.”

In case you need a refresher, the SAFE Banking Act needs to pass the House by a simple majority (218 of 435) to reach the Senate. While it’s a long way off from becoming law, the SAFE Banking Act is certainly off to a much better start than all its predecessors. Stay tuned.

SAFE banking cannabis

Six years after it was initially introduced, the House Financial Services Committee released the latest draft legislation that would create a “safe harbor” for banks to serve the rapidly expanding cannabis industry on February 7, 2019. Entitled the “Secure and Fair Enforcement Banking Act of 2019” (or, the “SAFE Banking Act of 2019”), the bill aims to prohibit federal regulators from penalizing banks and other financial institutions that provide banking services to marijuana businesses, marijuana-related businesses, and their owners and employees.

As a reminder, thirty-three states and the District of Columbia have legalized the sale and use of medical marijuana, while ten states and the District of Columbia have approved marijuana for adult or recreational use. With the fast-growing acceptance of cannabis evident as ever, the bill’s supporters claim that it would provide sorely needed legal clarity at a time when the cannabis industry faces serious financial and security risks. Accompanying the draft legislation was a memorandum prepared by the Financial Services Committee, which explains the reasoning behind this renewed push for legislation:

An increasing number of financial institutions have expressed interest in providing banking services to state authorized cannabis-related businesses as nearly all states have authorized various degrees of cannabis use, such as for medical use … However, many financial institutions are refraining from offering banking services to these businesses based on several legal and compliance risks. … As such, cannabis-related businesses have been described as a “soft target” for being robbed and assaulted, having their stores broken into, and their plants stolen” (citations omitted).

Generally, this iteration of the SAFE Banking Act pushes for even greater protections than those included in prior versions by including some new provisions, including:

1. Identifies (for the first time) and adds protections for ancillary businesses providing products or services to cannabis-related legitimate businesses (this is huge because even banks that would choose not to provide services to cannabis businesses may get caught under the present scheme);

2. Adds protections for marijuana-related “retirement plans or exchange traded funds” and “the sale or lease of real or any property [and] legal or other licensed services … relating to cannabis”;

3. Adds protections for the “distributing or deriving any proceeds, directly or indirectly, from cannabis or cannabis products”;

4. Specifies how businesses on tribal land could qualify; and

5. Requires that the Federal Financial Institution Examination Council develop guidance to help financial institutions lawfully serve cannabis-related legitimate businesses.

The general purpose and directive of the Safe Banking Act is arguably summarized by the following catch-all provision:

[P]roceeds from a transaction conducted by a cannabis-related legitimate business shall not be considered as proceeds from an unlawful activity solely because the transaction was conducted by a cannabis-related legitimate business.”

The bill is authored by Reps. Ed Perlmutter (D-CO), Denny Heck (D-WA), Steve Stivers (R-OH), and Warren Davidson (R-OH), who have indicated that they plan to re-introduce the SAFE Banking Act by the end of the month. The House Subcommittee on Consumer Protection and Financial Institutions has already held hearings, which seem to have gone well. Looking ahead, it’s likely that the House Financial Services Committee will also hold a hearing and potentially mark up the bill. Based on the SAFE Banking Act’s reception, and with so many other cannabis-related issues on the table, we might be seeing a much more expansive bill to end federal cannabis prohibition for good in the near future.

We have spilled a lot of ink on this blog related to the 2018 Farm Bill, which legalized hemp at the federal level. It’s huge news. And there are so many ramifications, from food law to trademarks to the financial services environment. This blog post is going to cover financial institutions and hemp at about 10,000 feet. Since late December, we’ve had many clients come to us with frustrations about the ongoing lack of access post-Farm Bill, and questions about how things will play out in 2019.

To frame this issue, it’s important to summarize what the Farm Bill actually is and does. In a recent post, we explained that “the 2018 Farm Bill modified the Controlled Substances Act (the ‘CSA’) to exempt hemp from the definition of marijuana. Not only is hemp now clearly excluded from this definition and thus not a scheduled drug, but states and tribes also cannot prohibit the distribution of hemp.” Seems easy, right?

industrial hemp bank credit unionIf only. Going forward, hemp will be subject to stiff regulation at the state and federal levels. For example, although hemp is no longer a controlled substance under the CSA, the Farm Bill reserves certification rights to the Department of Agriculture over state and tribal industrial hemp production “plans.” Those plans will be nuanced, and what any given state’s plan will look like next year is unknown. That fact alone may be the biggest reason that most financial institutions are still on the sidelines.

Financial institutions are also conservative by nature. We represent a handful of banks (and a larger handful of credit unions), and we give those outfits advice on banking hemp and marijuana. A few of these clients are relatively nimble and bold, but at the end of the day they are still banks. They have directors who worry about individual liability, lawyers and officers who worry about byzantine state and federal laws and policy, and shareholders and members who may see outsized risk and steep learning curves. When banks move into these areas, they tend to offer limited services, which are seldom more than basic merchant accounts.

Financial institutions also understand that when a new piece of federal regulation is enacted, it takes some time for rules to be written in support of the new law (both federally and by states), for programs to be staffed and built, for guidance to issue, etc. Finally, there is often a wave or two of litigation to interpret the administrative environment. All of that happens over the course of years, not months, and all of that will happen with hemp and the Farm Bill. Like the rest of us, financial institutions cannot see around corners and will be watching closely.

So what does all of this mean? Ultimately there will be banking, but banks and credit unions will not come in all at once. When they do come in, early actors will likely provide services for hemp clients that look similar to what is out there today in states like Washington and Oregon for hemp and marijuana businesses. This means limited access to institutional lending, ongoing compliance reporting and audits, and short leashes overall. Everything that happens will be fluid and consistent with best practices for high-risk industries.

Ending prohibition is a lot of fun, but then you get to wake up and go to work. We are optimistic that the hemp industry will have ample banking options. It will take some time, though. In the meantime, we will continue to monitor this issue and other hemp-related matters closely. Stay tuned.

marijuana bank fincen
Slowly but surely, it’s happening for canna businesses.

According to a recent report from the U.S. Treasury Department’s Financial Crime Enforcement Network (“FinCEN”), a growing number of financial institutions are willing to work with cannabis businesses. As of September 30, 375 banks and 111 credit unions were managing marijuana business accounts.

These numbers reveal a steady growth in the number of financial providers willing to engage with the cannabis industry, despite its federal illegality. The report confirms what our cannabis business lawyers have observed over the past few years in Washington and Oregon: namely, most of our licensed cannabis business clients in those states are banked, and it isn’t as hard as it used to be to acquire a basic merchant account. (California is a different story.)

Nationwide, though, most financial services providers have been reluctant to serve the marijuana industry for years, fearing the federal cannabis prohibition would trigger liability under money laundering laws. Earlier this year, many concluded that banks would refuse to associate with cannabis businesses following the decision by then-U.S. Attorney General Jeff Sessions to retract policy protections for licensed marijuana businesses from federal interference. However, the latest FinCEN report reveals that those fears were mostly speculative.

The American Bankers Association, which recently conducted a survey on the issues faced by banks that are serving cannabis businesses, is advocating for greater legal clarity to banks operating in states where recreational and medical cannabis has been legalized. Indeed, the guidelines currently used by the financial services industry are those published in 2014 by the FinCEN and could use an update given the continued ascendance of marijuana reform.

Several key officials of the Trump administration have also expressed the need to clarify cannabis banking issues. For instance, Treasury Secretary Steven Mnuchin stated in congressional testimony that he wants businesses operating in states where marijuana is legal to be able to store their profits in banks.

I assure you that we don’t want bags of cash … We do want to find a solution to make sure that businesses that have large access to cash have a way to get them into a depository institution for it to be safe.”

In June, Federal Deposit Insurance Corporation Chariwoman Jelena McWilliams explained that she instructed her staff to consider ways to address the banking issues, but that the agency’s hands were “somewhat tied” until federal law legalizes cannabis.

Support for clarification and for fixing marijuana banking problems also comes from the states. A few months ago, a coalition of the top financial regulators located in thirteen states asked Congress to take action to protect banks working with the cannabis industry.

In their letter, the regulators wrote:

It is incumbent on Congress to resolve the conflict between state cannabis programs and federal statutes that effectively create unnecessary risk for banks seeking to operate in this space without the looming threat of civil actions, forfeiture of assets, reputational risk, and criminal penalties.”

Finally, back in June, a bipartisan group of twelve governors urged lawmakers to pass the Strengthening the Tenth Amendment Entrusting States (“STATES”) Act, which proposed to amend the Controlled Substance Act to exempt state-legal marijuana activities.

This growing support for permanent protections of banks that serve cannabis businesses is a promising sign that legal reform is on its way. The newly formed Democratic House has expressed a strong desire to move cannabis legislation, including banking issues, in the new year. Only time will tell whether the Republican-controlled Senate will allow it.

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.