Disclosing Risks to Investors In Your Cannabis Business

February 28, 2018

Medical marijuana is now legal in Ohio, and both adult-use and medical marijuana are now legal in California. Many companies that have received or are seeking licenses for cultivation, processing, and retailing of cannabis products, are also trying to raise funding from various sources. Because cannabis is still a Schedule I substance under the federal Controlled Substances Act (the “CSA”), it is highly unlikely that banks will lend money to finance these operations. SBA loans are certainly off the table. In addition, a public offering of stock, which would have to go through the SEC, is off the table. That leaves entrepreneurs in the cannabis arena to seek out private funding. There is already a fairly large group of angel and venture capital investors that focus specifically on the cannabis industry, and that have developed expertise through investments in Colorado, California, Washington, and other states.

Whether you are dealing with experienced cannabis-industry investors or first-timers, it is crucial to clearly disclose the unique risk factors that apply to the cannabis industry. By making such disclosures, companies can protect themselves against potential liability to investors when trouble strikes. The following is an overview of some major risk factors that should be disclosed to potential investors in a cannabis company.

Cannabis Is Still Illegal Under Federal Law. Under the CSA, cannabis is considered a Schedule I substance, and therefore the cultivation, manufacture, processing, possession, and distribution of cannabis products is illegal under federal law. Regardless of how obvious this point may be, any company investment documents must disclose this fact. Company officers, directors, and investors are still potentially exposed to criminal liability under federal law, regardless of whether medical and/or adult-use cannabis is legal under state law. This criminal liability includes the CSA, money laundering statutes, as well as RICO — the Racketeer-Influenced and Corrupt Organizations Act.

Prior to this year, the Justice Department, following the “Cole Memorandum” guidance, took a hands-off approach so long as cannabis companies were in compliance with state laws. However, Attorney General Jeff Sessions rescinded the Cole Memorandum in January 2018, along with various other policies relating to state-legal cannabis (more on this below). As a result, the individual US Attorneys across the country are free to enforce or not enforce the CSA against cannabis companies, as they see fit. Given that there are 94 US Attorneys in various districts, there is a vast potential for widely different treatments.

Difficulty Obtaining Banking Services. Cannabis companies in states where medical and/or adult-use cannabis is legal have had great difficulty in finding banking and credit card services. A company will open a bank account, only to have that account shut down shortly afterward when the bank realizes the money being deposited is from a cannabis company. Some companies aren’t making it easy for themselves, by having cute but obvious names. Even for more discreet companies, deposits of cash have the distinctive reek of marijuana. Cannabis companies also have great difficulty obtaining credit-card processing services, forcing them to rely on cash transactions. Because of this, cannabis companies must take cash payments from customers, and must pay their suppliers and employees in cash. The security risks are enormous, as well as the compliance risks associated with having to properly account for so much cash. There are a handful of banks that are attempting to do business with cannabis companies, but when Attorney General Sessions rescinded the Cole Memorandum, he put in jeopardy the “FinCEN” guidance that gave these banks some cover. While the FinCEN guidance is still in place, the landscape has become even more uncertain than before.

Customary Business Expenses Are Not Deductible. Another risk factor that must be disclosed is the effect of Section 280E of the Internal Revenue Code. This provision disallows most normal business expenses incurred by cannabis companies when calculating income tax liability. Cost of goods sold is deductible, but most other expenses, such as employee wages, are not. Consequently, cannabis companies will be at an extreme disadvantage when it comes to profitability, compared to conventional companies.

These are just a few of the risk factors that a cannabis company must disclose to potential investors when raising capital. There are a host of other risks, as well, relating to intellectual property protection, availability of bankruptcy, local regulations, enforceability of contracts, etc. It’s important for companies operating in the legal cannabis industry to work with attorneys that understand the unique risks, and have not just relevant corporate law experience, but also cannabis industry experience.

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2 commnets on “Disclosing Risks to Investors In Your Cannabis Business

  1. Reid Johnson says:

    Is it possible to obtain your more in depth list of risks?
    We have a PPM for a small ($1.5m) raise and want to be sure I have the risks disclosed to the point of overdoing it
    Thank you

    • Paul H. Spitz says:

      That’s something you should be asking your attorney for, or more to the point, your attorney should have the necessary experience in securities offerings and the cannabis industry to be able to provide it. I certainly hope you aren’t trying to do a securities offering without an attorney.

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