Disclosing Risks to Investors In Your Cannabis Business

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 However, Attorney General Jeff Sessions rescinded the Cole Memorandum in January 2018, along with various other policies relating to state-legal cannabis (more on this below).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.

Follow me on Twitter @PaulHSpitz

Startup Financing Is Not A DIY Project

There are projects that are easy enough for a smart startup founder to take on, and then there are projects that are simply too complex, and which require the help of an experienced lawyer. Financings, such as a seed round or convertible note financing, are definitely not DIY projects.

Several years ago, I bought a townhouse in Berkeley. There was no disposal in the kitchen, so I decided to install one. I went to Home Depot, and picked the one that had “Easiest To Install” printed on the box. It was about $65, so the price was right. Well, I learned that “easiest to install” does NOT mean “easy to install.” First, I couldn’t detach the drainpipe from the sink drain, and not being an experienced plumber, I didn’t know how much brute force I could apply without destroying the sink. So I called a plumber, and he took care of that, and installed the disposal under the sink. Then he pointed out that there was no electrical outlet for plugging in the disposal. I called an electrician to install a new outlet, and finally, two professionals and $300 later, my disposal worked. What I thought was an easy DIY project, because of what the box said, turned out to be not so easy or cheap after all. The problem was, I didn’t know what I didn’t know.

When it come to securities and corporate finance, the overwhelming majority of startup founders don’t know what they don’t know. Today I had a discussion with a very smart acquaintance about “friends and family” rounds. I pointed out that there’s no special exemption under securities laws for friends and family, and that when a startup raises money from them, generally the startup is violating the securities laws. Not only might the startup have to return all the investors money, but there could be civil and criminal penalties, as well as problems with later financing rounds. This was all news to him, and I bet it’s news to most startup founders.

Convertible note rounds aren’t simple, either. If you don’t understand all the moving parts, it is really easy to screw up. Do the startup founders read the reps and warranties in the note purchase agreement? Do they know why those reps and warranties are there, or what may happen if a rep turns out to be false? If the convertible note has a valuation cap, do you know about the liquidation preference overhang problem? Do you know how to fix it? Are you willing to pay me a few hundred dollars to save yourself a few hundred thousand dollars? How many startup founders know that they have to file a Form D with the SEC, as well as with the states where the startup and its investors are located, when doing a convertible note round? I imagine very few. There are even some startup lawyers I know of who routinely do not file a Form D after a seed round for their clients.

The bottom line is, when you are facing something where you might incur civil or criminal penalties, and which, if done wrong, can screw up your later attempts to get investment, you should invest in a good lawyer, and let him or her do it the right way. Because some projects, like investment rounds, are simply not DIY.

If I Lie To My Lawyer, Will It Save Me Money?

Not a chance. Even so, I occasionally find a client or prospect holding back important information, presumably because they think it will complicate the project and cost them more money. But that’s exactly why it should cost more money – because it makes things more complicated. Let’s see it in action…

First Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We formed an LLC about a year ago, and now we want to form a Delaware corporation. What will it cost to incorporate with two cofounders?

Lawyer 1: You’ll need to convert the LLC to a corporation. If you are lucky, and you formed the LLC in a state that allows conversion, forming a new corporation and converting the LLC into it will cost $2000, plus about $350 in filing fees. If you formed the LLC in a state that does not allow for conversion, we’ll have to do a merger. That will cost between $2500 and $3000, plus about $500 in filing fees.

Prospective Client: Wow, that’s a lot of money. We’ll have to discuss it and get back to you.

Second Call

Prospective Client: Hi, I’m working on a startup with a cofounder, and we are ready to move forward. We think the idea is viable. We want to form a Delaware corporation. What will it cost to incorporate with two cofounders? [Notice how the client left out that information about the existing LLC?]

Lawyer 2: It will cost you $1500 to incorporate, plus $150 in filing fees.

Prospective Client: Sounds good, let’s do it!

Now let’s flash forward 6 months, when the startup is trying to raise money from investors. They’ve signed a term sheet for an $800,000 investment, and the investors are doing their due diligence check on the company. During the due diligence, the investors discover that a year and a half earlier, the cofounders had formed an LLC, which they neglected to mention to Lawyer B. They also discover that there had originally been three cofounders, and one of them left on bad terms within the first 3 months. Now she’s moving around various hippy beach communities in Thailand, and doesn’t even have a cellphone. Even worse, it isn’t clear whether everyone signed intellectual property assignments, and Gone Girl happened to have developed the most important part of the code that is the startup’s product. Making a bad situation worse, the cofounders used Legalzoom to form their LLC, and even if they got an operating agreement, there isn’t a chance in Hell that it contains vesting provisions that would allow them to recapture Gone Girl’s unvested ownership interest in the LLC.

Here’s what it all adds up to:

  • The corporation doesn’t own most of the software code and other IP that is the core of the business. That belongs, at best, to the LLC, if everyone signed IP assignments.
  • If everyone signed IP assignments, that’s not going to help much, because they still need to convert (or merge) the LLC into the corporation. But they need Gone Girl’s approval to do so, and she was last seen on a beach in Bora Bora, smoking weed with an actor who may or may not have been in Titanic.
  • If there are no IP assignments, then it really doesn’t matter whether they can convert the LLC into the corporation, because Gone Girl owns the core of the business. And when word gets out that the business is worth $1.2 billion, guess who’s going to show up with some very mean lawyers in tow?

Of course, the truth of the matter is, that company will never be worth $1.2 billion, because the cofounders were too cheap to do things right. They thought that if they withheld important information from their lawyer, they could save a few hundred dollars. Instead, that little lie is going to cost them $5000 to $10000, at best, in legal fees to try and sort out the mess. At worst, the lie will cost these guys the $800,000 they were hoping to get from the investors, who are now walking away and looking to invest in a business run by someone with brains.

So the moral of the story is, keeping information from your lawyer will not save you money, it will cost you much much more.

Follow me on Twitter @PaulHSpitz

EQUITY CROWDFUNDING 2.0

On October 30, the SEC took another shot at legalizing equity crowdfunding, by passing final regulations that are much more streamlined and simpler than the original regulations. The new regulations will take effect sometime next spring or summer, at the earliest.

Under the new regulations, a company can raise a maximum aggregate of $1 million through crowdfunding during a 12-month period. The company must use an SEC-registered intermediary – either a broker-dealer or a funding portal. While the company still must file certain information with the SEC and provide it to investors, the new regulations are more relaxed about the required financial statements. If the offering is between $500,000 and $1 million, the financial statements must be “reviewed” by a public accountant, but they need not be audited (unless audited financials are available). This removes a significant cost barrier that had existed in the previous set of regulations. During any 12-month period, the aggregate amount of securities a company can sell to an investor through all crowdfunding offerings cannot exceed $100,000.

On the investor side, the investment limits for individual investors over a 12-month period, across all crowdfunding offerings, are:

  • If either the investor’s annual income or net worth is less than $100,000, he can invest the greater of (a) $2,000 or (b) 5% of the lesser of annual income or net worth
  • If both the investor’s annual income and net worth are equal to or greater than $100,000, she can invest up to 10% of the lesser of her annual income or net worth.

So let’s look at Joe Investor, who earns $75,000 per year and has a net worth of $35,000. Since Joe’s net worth is less than his annual income, he can invest the greater of $2000 or 5% of his net worth, which comes to $1750. So in this scenario, Joe can invest $2000 over a 12-month period.

Now let’s look at Melinda Investor, Joe’s much more successful younger sister. Melinda earns $200,000/year, and has a net worth of $350,000. Since her income is less than her net worth, Melinda can invest up to 10% of her $200,000 income, or $20,000.

Securities purchased through a crowdfunding offering generally cannot be resold for one year after purchase.

While the new regulations greatly simplify the process for doing equity crowdfunding, they don’t really address the main problem that faces any startup that wants to use this. How does the company deal with potentially thousands of new stockholders, many of whom may have invested only a few hundred dollars (if that much)? I call these people the Great Unwashed, because beyond a few handfuls of cash, none of these are value-added investors. None will be bringing their expertise and experience to the company, the way a good angel or venture capital investor does. And yet the startup must prepare an annual report that it has to provide to all these stockholders. It also has to hold an annual meeting, notify all these stockholders of the meeting, hold the meeting at a location where these stockholders can attend (if they want), and allow them to vote on various corporate matters, such as the board of directors. Now the company will need to use some of those new funds to hire an investor relations manager, or use an outside service, and will have to devote time to keeping the Great Unwashed happy.

 

 

Choose Your Investors Wisely

MoneyA recent episode of Shark Tank demonstrates why startup founders have to be careful with who they choose to invest in their companies. I say “recent,” but I don’t watch the show every week, so for all I know, what I saw was the formula for every episode. On this particular episode, a Cincinnati-based startup called Frameri was one of the contestants. Frameri is working on a line of eyeglasses where you can easily pop out the lenses to put them in new frames. If any of my readers wear eyeglasses, you know how much this can save you. The last time I bought a new set of eyeglasses, the cost of the frames and lenses took me past $500 before I could blink.

Pretty much as soon as Frameri’s cofounders explained the product, the “sharks” hit them with abuse and condescension. One of them pointed out that Luxottica (also based in Cincinnati) is a huge player in the market, as if that was an indictment of Frameri’s idea. Apparently the sharkhole has never heard of IBM, which used to dominate the computer industry, or the concept of disruption. Luxottica’s market dominance allows them to inflate prices, creating an opening for innovative players like Frameri and Warby Parker. Pretty obvious, if you ask me.

Another sharkhole didn’t even bother trying to formulate a coherent thought. One of them, I can’t remember which because I don’t care enough about them to try, called the Frameri guys “cockroaches.” I kid you not. My cousin was on Shark Tank earlier this year, and one of the sharkholes called her a cockroach, too. Could have been the same guy, so maybe “cockroach” is his go-to word.

A third sharkhole took offense at the $4.5 million valuation that Frameri’s offer called for. This guy has no business dealing with startups, if a $4.5 million valuation troubles him. Sure, Frameri is pre-revenue, but that’s a pretty reasonable valuation in today’s startup market. Uber has a $40 billion valuation, and it’s only 5 or 6 years old.

At one point in the show, one of the sharkholes asked if they were on the show to get an investor, or if they were using the show for publicity. Well, duh. (that’s an arcane legal term).

About 1 minute into Frameri’s segment on Shark Tank, I was rooting for Frameri to reject all of the sharkholes. Most of them dropped out, leaving one left to make an absurd investment offer. To Frameri’s credit, they turned it down. Just because a rich person dangles money in front of you doesn’t mean you should take it. A bad deal is still a bad deal. And a bad investor is even worse. You want an investor who understands your company, your industry, and your environment. None of the sharkholes seemed to have even a basic understanding. You want your investor to be a source of more than just money. The investor should be able to provide support, guidance, mentoring, and connections. Finally, you want an investor that you can have a good working relationship with over a long period of time. Someone who calls you a cockroach isn’t that kind of guy.

So that’s really the bottom line. Forget about the money. Money is the least part of choosing an investor. Look at the person, and ask yourself if you can work closely with this guy over the long run. Do you want this person to sit on your board of directors? How is he going to respond to business ideas that he doesn’t like? Is he going to call you – the company founder, the CEO – a cockroach in front of your staff? If you wouldn’t want to spend a minute more than absolutely necessary with this guy, then move along and find someone else.

Follow me on Twitter @PaulHSpitz