Challenges of Cannabis Deals

Avoiding Risk At the Onset

Cannabis investing is a hot topic these days. Many investors are now comfortable with the federal illegality of cannabis and are pouring money into state-legal cannabis businesses. It seems that every week a new high-profile investment is made into a direct or ancillary cannabis company. Like any trendy area of investment, a new pool of potential investors has arrived, greeted by countless entrepreneurs eager to take their money. And deals are now being cut at breakneck pace. But both investors and companies need to be aware of the risks and structuring issues inherent to cannabis deals.

The headline question investors should be asking when determining how to structure a transaction is whether the target company holds a cannabis license. It should not be taken for granted that it will be easy, or even possible to change the ownership of a licensed cannabis company. The relevant rules and regulations need to be carefully reviewed to determine if the potential acquirors or investors are eligible to be owners of such a license and that a transfer of ownership is permitted. In fact, two of the major cannabis markets, Washington and Colorado, impose significant residency restrictions on cannabis license owners and prohibit direct license ownership by public companies. Once it is clear that the investors or acquirors are eligible for licensure, deal makers need to determine if it is possible to change ownership and consider the timeline involved. This is not just a matter of state law. Many localities have their own rules when it comes to a change of ownership of a local license or permit. These are questions that need to be asked at the beginning of a cannabis deal; not after large amounts of time and money have already been invested.

Investors must also understand the potential of being subject to intrusive background checks by regulators, which can serve as a prerequisite to licensure or ownership. When raising money, many companies promise investors that they will not reveal their identity to regulators. Investors are often concerned that their cannabis investments, if made public, will have negative repercussions on their careers or reputations. It is absurd to think that making an investment into cannabis, a plant that has yet to provide a case of fatal poisoning in human medical literature, could harm an investor’s reputation, especially when no one seems to worry about the reputational consequences of making investments in alcohol a product that causes approximately 88,000 deaths per year in the US. But there are real consequences associated with being a known cannabis investor; for example, certain Canadian investors have been subject to lifetime bans from entering the US as a result of their industry involvement. While it is easy to promise investors that they will never have to provide their names to a regulator, it is far harder to ensure that regulators will never ask. And it is even harder to do so in a way that is compliant with state and local law (after all, it is not hard to simply fail to provide required information to a regulator – a practice that is far too common in the cannabis industry). The bottom line is that regulators have wide authority to conduct background checks and anyone involved in a cannabis deal, even an ancillary cannabis deal, needs to evaluate this risk and the risk of potential required disclosure.

It is not just ownership restrictions and background check requirements that vary between states. While many states have similar legal systems, there are important differences to be aware of as a company raising capital or as an investor. One of the most important differences to consider is state and local restrictions on concentration of ownership. For example, in Maryland, no one may own an interest in more than one of any given type of license. That means an investor cannot own an interest in two processing licenses. Violating these rules, or seemingly violating these rules, can subject a company and its investors to regulatory scrutiny, censure or both.

Investors should also bear in mind that these unique rules and regulations are typically enforced by newly created regulatory agencies. Often the person or agency interpreting a rule matters as much, if not more, than the rule being interpreted. In some cases, such as in Colorado, these regulators are drawn from the ranks of law enforcement, which strongly influences the interpretation of otherwise ambiguous rules and regulations. This is why it is critical to consult with someone who deals frequently with the state and local regulators of the target jurisdiction. Merely reading the rules may not provide a complete picture – direct regulatory experience is often needed to provide context.

Finally, no article on cannabis deal making would be complete without addressing 280E (the provision of the Federal Tax Code prohibiting ordinary course business deductions for companies trafficking a Schedule I or II controlled substance). Deal makers need to be aware of the tax implications of acquiring or investing in an entity that is subject to 280E. An example here is the choice between a corporation and a limited liability company. In addition to the typical pros and cons of each entity choice, there are unique cannabis considerations—members of a limited liability company taxed as a partnership can be personally exposed to 280E audit risk. It is also important to perform diligence on any existing 280E tax liabilities. Avoiding tax liens is one reason asset deals are so popular in the cannabis industry. But don’t be fooled into thinking asset deals are a panacea. One must always assess the risk of successor tax liability in a sale of assets.

Given the unique risks and structuring issues involved in cannabis transactions, it is important to work with qualified professionals in structuring and closing cannabis deals. That means you need to have a team comprised of individuals familiar with the laws, rules and regulators in each state and local jurisdiction touched in any given deal.

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