We’ve recently been seeing an increase in client requests to draft contribution and investment agreements for cannabis business entities. We have represented both investors and cannabis businesses on these deals and we’ve been fairly surprised by some of the expectations on both sides of the table, at least as compared to those of our non-cannabis clients.
Investment is never a simple thing. There are all kinds of issues over which the parties should be concerned: profit sharing, business failure, and administrative control, to name just a few. Investing in marijuana businesses is even more of a challenge because there are no reliable standards for marijuana business valuation, and it is difficult to predict business operating budgets when consumer demand is unknown. Despite this, both parties should be aware of the following when negotiating an investment in a marijuana business:
1. These contracts will not take 48 hours to put together; mind your timeline. Typical of the marijuana industry (which is maturing and moving at light speed), there is an expectation that these deals can and should close in two days or less. We are here to tell you that any well thought out and negotiated investment contract is going to take at least a couple of weeks to put together. And if one side is pushing back against presented terms and conditions, it could take even longer.
Timelines matter in a regulated industry like marijuana. Just by way of an example, Washington State requires that all marijuana investments and investors be disclosed to the State Liquor Control Board during an applicant’s initial phone interview, or stiff time and/or administrative penalties will result. If your initial I-502 interview with the Liquor Control Board is in three days, do not expect a solid investment contract to be put together beforehand.
2. Investment means ownership. Some cannabis businesses wrongly believe that investment is somehow separate from ownership in a marijuana company. If you take on a “financier,” he or she will be considered an owner of your cannabis business. In turn, all of your ownership documents (like the LLC operating agreement or articles of incorporation) will need to be amended to account for that investor/owner. These ownership agreements are separate from the actual investment, and modifying them requires negotiating and agreeing to a different set of rights, duties, and obligations.
3. Businesses can’t just say anything to investors. Businesses can be held liable for providing potential investors with untrue, inaccurate, or fraudulent information. For example, if your profit projections fail to take into account a 280E analysis, your numbers will be wrong and you may be opening yourself up to a lawsuit. Businesses also need to protect their trade secrets, intellectual property, and other business assets from potential investors. You do not want to tell your potential investors “everything,” only to have them choose to compete with you rather than invest in your company. You should have a well-crafted and signed non-disclosure/non-compete/non-circumvention agreement (NNN Agreement) in place before you reveal much of anything to anyone.
4. (Oftentimes) investors must meet state regulations. State-licensed marijuana businesses in some states are prohibited from taking funds from just anyone. In most states with legalized marijuana (medical or recreational), all investors and their spouses must have resided in the state for a certain amount of time prior to the date of the business’s original application to the state, and they (typically) must also pass all financial and criminal background checks.
5. Due diligence on both sides is paramount. Given the strict regulations under which marijuana businesses must operate, both sides of the investment deal should perform due diligence on each other. The last thing an investor wants is to put large sums of money into a marijuana business applicant who has an excluded felony charge that will nuke the application altogether. The cannabis business for its part should want to know if its potential investor has a strong financial background, and also the specific source of the investment funds.
6. Controls over funds. Savvy investors rarely provide funding without some sort of controls to ensure that “their” money is used to advance the business. Some might require the business in which they invest to secure their approval to spend any amount of the investor’s money. Some might provide a lump sum for a certain project and will only provide more if the business hits a certain profitability mark. Most investors refuse to allow for profit distributions unless and until their original investment is repaid. Though there are many different ways to structure an investment deal, cannabis businesses should expect most of them to involve the investor maintaining at least some controls over funds.
7. Administrative control over the business. Investors usually seek a percentage of ownership in the company relative to their financial contribution, and that ownership oftentimes comes with at least some type of say on company decisions. You need to be prepared to negotiate just how much say each party will have.
8. Beware of parties with no legal counsel. Structuring complicated investment relationships (made even more complicated due to cannabis’s overwhelming regulatory framework from state to state) requires written, enforceable contracts drafted by experienced legal counsel. Beware of any party expecting to do a cannabis investment transaction without their own legal counsel. Lawyers help keep the investment process transparent and aid in both communications and in keeping the transaction moving along. When one party does not have its own legal counsel the odds of the deal falling through go way up.
These are just several of the many issues that should be analyzed before you undertake a cannabis investment deal. Though there are many investment opportunities in the marijuana industry, there are certain things you really should do before money changes hands. Failing to do these things can mean lost money, a failed business, and, in some cases, revocation of a marijuana license.