Many of our clients that are raising money ask us to draft or review private placement memorandums (“PPMs“) for private securities offerings in their cannabis companies and/or ancillary cannabis companies. The goal of a PPM is to describe the company raising the money, its management, how much money is being raised, how the money received will be used, and the risks involved in the investment. All of these things are important, but the description of the risk factors is the most important section for protection under federal and state securities laws. This is when our clients often cringe because we always encourage full disclosure of all risk factors associated with the marijuana-related business seeking investment. As much as our clients may want to soften the blow for potential investors regarding the cannabis company’s potential volatility, they need to be as up-front and honest as possible about the criminal and business realities of cannabis investments. Should they fail to do so, they will face the consequences from state and federal regulators.
This post focuses on the very specific risk factors inherent in pretty much every marijuana-related PPM, regardless of the complexity of the offering or the sophistication of the targeted investors, and the risk factors investors should be reviewing when contemplating a cannabis investment. Though investor fraud investigations are (thankfully) beginning to pick up in various states, investors still need to be wary of cannabis PPMs as far too many are more unsubstantiated marketing pitches than legally viable securities disclosures.
Here are the marijuana risk factors that should be present in every PPM to avoid anti-fraud issues:
- Marijuana is federally illegal. This is a no-brainer. Though you can mention the various enforcement memoranda the Feds have issued on the subject, none of those memos have any real legal meaning or effect and — most importantly — they are not going to protect a cannabis company or any of its investors from criminal prosecution or asset forfeiture under the federal Controlled Substances Act (and, of course, a new U.S. President could change the DOJ’s current enforcement priorities). Even ancillary companies should discuss marijuana’s illegality in their PPMs since these companies and their financial backers could be subject to charges of aiding and abetting or conspiring to violate the Controlled Substances Act for providing goods and services to cannabis businesses.
- Investors risk criminal liability and the cannabis business’s assets are subject to forfeiture. See point one above. Because marijuana is federally illegal, investing in cannabis businesses could be found to violate the federal Controlled Substances Act. Not only can investors and company directors or management be indicted under federal law, all of the assets they contribute to a cannabis business (and even to an ancillary cannabis business), including real property, cash, equipment and other goods, could be subject to asset forfeiture because marijuana is still federally illegal.
- Marijuana businesses may still not be able to secure bank accounts. Though more banks are providing services to marijuana businesses, most banks and financial institutions will not because they worry about criminal liability under the federal Controlled Substances Act and under the Bank Secrecy Act for money laundering. Though FinCEN issued guidelines in 2014 that allow financial institutions to provide bank accounts to marijuana businesses, few banks have taken advantage of those guidelines and many marijuana businesses still operate on an all-cash basis. This makes it tough for cannabis businesses to manage their businesses, pay their employees and taxes, and having so much cash on hand also creates significant public safety issues. Many ancillary businesses that service cannabis businesses have to deal with the unpredictability of their clients or customers not having a bank account.
- IRC 280E. Some securities attorneys omit IRC 280E from the list of cannabis industry risk factors, presumably because they don’t see taxation as a business risk. But it is. IRC 280E prohibits marijuana businesses from deducting their ordinary and necessary business expenses, forcing them to contend with higher effective federal tax rates than similar companies in other industries. The effective tax rate on a marijuana business depends on how large its ratio of nondeductible expenses is to its total revenues, but it can be as high as 90%. When trying to determine the future profitability of a marijuana business, a failure to mention 280E should be viewed as a red flag. This holds true even for an ancillary business PPM because having such an onerous tax burden significantly impacts the profitability of their of cannabis clients.
- State marijuana laws and rules are not uniform from state to state and they can and do change constantly. The PPM should clarify how investors can legally participate in the cannabis company and make clear that state (and local) marijuana laws and regulations can change so as to significantly diminish the cannabis company’s prospects. For ancillary businesses, the PPM should note how regulatory changes can negatively impact their cannabis clientele. Marijuana laws and regulations vary on investment and financing vary among the states where cannabis is legal. For example, until recently, Washington State required lenders to cannabis businesses to have been a Washington State resident for at least six months before lending funds to a cannabis business. Lenders are now exempt from this residency requirement, but it still applies to owning any portion of a cannabis business. Oregon freely allows out of state investors, but Alaska does not.
A well-thought out listing of your cannabis company’s risk factors tells your potential investors what they should consider before investing in your cannabis company and it conveys that you know the industry and are cognizant of its inherent risks. Equally important, it can shift the investment risk from your company to your investors. If you say high taxes puts your cannabis company at risk and high taxes eventually render it difficult or impossible for your cannabis company to operate profitably, you have made it more difficult for an investor to sue for your cannabis company having failed to achieve profitability.
If you want to know more about the various legal and business issues involved with cannabis investing, check out the following:
- Marijuana Business Investing: The Basics on Investment Rounds
- Five Tips for Securing Investment Funds for Your Cannabis Business
- Marijuana Business Investments: Not Simple
- Marijuana Fundraising: Top 5 Tips on Approaching Investors
- Seven Reasons to Invest in Cannabis Stocks Now–And Many More Reasons to Exercise Extreme Caution
- The Future of Cannabis Funding