Cannabis Business LawyerI recently worked on a relatively typical, relatively straight-forward LLC member buyout of a cannabis business. Member A wants to stay with the company, but Member B is ready to exit. Member A will be the sole Member of the company after the purchase. The parties have agreed on a price and on payment terms, but major questions emerged: What is the mechanism of purchase? Is Member A buying directly from Member B, or is the company itself buying the interest back? Does it even matter?

Setting aside this example for a moment, minority buy-ins and buy-outs in closely held cannabis companies are coming up more and more often in states with more mature cannabis marketplaces. The mechanism of these transactions depends on several factors, the most important being entity form. Corporations work in very different ways than LLCs do in this regard. Corporations are primarily creatures of statute, with the inherent rights stock ownership grants to stockholders largely determined by state law. LLCs, on the other hand, are creatures of contract. The precise meaning of “membership interest,” “membership unit,” and other oft-used terms vary widely between entities, as all of these terms are defined predominantly in LLC operating agreements.

Looking at buyouts from a corporation perspective, the main question is who is doing the buying? There are four main choices here:

  1. The corporation itself
  2. Corporate officers and directors
  3. Other shareholders
  4. Third parties

When a corporation repurchases stock directly, it may be doing a favor to a shareholder looking for liquidity, or it may be signaling that current shareholders and management think the stock is worth more than the repurchase price. In all circumstances, there are some short terms pros and cons for the remaining investors. On one hand, the total number of outstanding shares of the company has just decreased, meaning that each investor owns a proportionally higher stake of the company. On the other hand, the company has likely used cash it could have used for company investment or even shareholder dividends to pay off a few selling shareholders. Otherwise, the remaining shareholders don’t see much change.

When individuals are involved in the buyout, there are a few other concerns. In general, directors and officers of a corporation cannot take opportunities for themselves that they don’t grant to shareholders at large companies. Separate agreements that corporate shareholders often enter into, including voting agreements, management rights agreements, and right of first refusal agreements, can alter these rules somewhat. When members of management are doing the purchasing directly from the owners that are being bought out, the shareholders that aren’t involved in the transaction don’t see their proportional ownership of the company change at all. The shareholders involved in buying out the exiting shareholder will see all of their proportional interests increase, but the source of the repurchase resources are different as well. These resources must come from personal funds, not corporate funds. Remaining shareholders in these circumstances may not be diluted, but the power structure of the company can shift in these circumstances, if a group of shareholders is able to move from a minority ownership in the company to a majority ownership position because of their buyout.

Finally, third party purchasers likely need to be approved by management for any small closely held company. Securities laws restrict the right of resale without registration, and most small companies have not registered their stock for offering on the open market. Before a shareholder takes it on him or herself to sell to a new party, that shareholder needs to be aware of any restrictions on those sales rights.

There are some key differences for LLCs, especially two person LLCs. Looking back at the example from above, the various rights of non-participating shareholders are not a concern, as all of the interest holders in the company are involved. But though the law treats corporate shares as specific discreet pieces of property, its treatment of LLC membership interests is much fuzzier. The idea of an LLC repurchase of its interest doesn’t really make sense unless that process is specifically outlined in the operating agreement. The idea of member exit in general isn’t necessarily common, as most state LLC statutes disallow membership exit from an LLC unless the operating agreement provides for it. For a two-person cannabis company, the issue is one of taxation more than anything else. There are various tax ramifications for different scenarios based on when the transfer of profit allocation rights in the company takes place and what the payment terms are of the transaction. In general, accountants should be included (along with attorneys) in any circumstance involving such a buyout, as it can be incredibly challenging to determine an owner’s outside tax basis in a company before and after these types of transactions.

There are a lot of moving parts in these types of deals, usually including all sorts of cannabis law issues as well. States like Washington want to approve of any ownership change in a company prior to that ownership change taking place, even where the ownership change just involves shifts among current owners. In Oregon, a change that takes one or more investors over a 10% ownership threshold in a business may spark additional state-required disclosures from those individuals. We will continue to see these types of moves, though, as some people choose to exit the industry and others decide it’s time to take a chance on pot.