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 However, Attorney General Jeff Sessions rescinded the Cole Memorandum in January 2018, along with various other policies relating to state-legal cannabis (more on this below).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

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SAFE – A New Financing Tool for Startups

If you follow startups, you’ve probably heard of convertible notes and Series A financings, but the newest item is the SAFE – the Simple Agreement for Future Equity. SAFE is a seed-stage financing tool that provides a lower-cost, speedier alternative to convertible debt financings. SAFE was devised by Y-Combinator partner Carolynn Levy, who is also an attorney. The SAFE documents are designed to be short (about 5 pages, which is short for legal documents), and fairly standardized.

Y Combinator describes SAFE as “essentially convertible debt without the debt.” A convertible note is a loan that converts into equity in a company when certain events occur. When an investor uses SAFE, he is buying the right to obtain preferred stock when an equity-financing round occurs. It’s more like a warrant than debt. And unlike a convertible note, you don’t need to specify a term or an interest rate. When a convertible note reaches its maturity date without another financing round in sight, the startup needs to negotiate with the investor to extend them term. No such problem with SAFE. You also don’t necessarily need a valuation cap with SAFE, which can make the financing faster and less expensive. The SAFE document specifies that when an equity financing round occurs, the holder of the SAFE has the right to get preferred stock, based on his investment and the discount rate. If there is an acquisition or an IPO, the SAFE holder can either get his money back, or convert the SAFE to common stock.

Y Combinator has provided 4 variations of SAFE:

  1. SAFE Cap, No Discount
  2. SAFE Discount, No Cap
  3. SAFE CAP and Discount
  4. SAFE MFN, No Cap, No Discount

Cap refers to the valuation cap, as you probably already figured. Discount refers to the discount rate, which enables the SAFE investor to obtain a more favorable price for equity to compensate for the greater risk of investing early. For example, let’s say there’s a discount rate of 20%. When the next equity financing round occurs, if the new investors are buying in at $1/share, the SAFE investor gets to buy in at $0.80 per share. So the new investor gets 100,000 shares for $100,000, while the SAFE investor gets 125,000 shares for $100,000.

MFN means “most favored nation.” Let’s say a startup issues a SAFE MFN, with no cap or valuation discount, and then later issues a SAFE upon better terms to the later investors (for example, the later SAFE has a discount or a valuation cap). The SAFE MFN will be amended to include the more favorable terms from the later SAFE.

There are two important things to keep in mind with the SAFE. First, they are still securities, and therefore covered by the securities laws. While the documents are relatively straightforward, as legal documents go, it’s still worth talking with your lawyer before doing a SAFE financing. Second, the SAFE does go on your cap table, just like a warrant or option.

AN INTRO TO THE “ACCREDITED INVESTOR”

Startups and other companies seeking investment through private securities offerings will quickly have to master the concept of the “accredited investor.” The underlying idea is that accredited investors have either specialized knowledge or a level of wealth that gives them greater protection in making more speculative investments. By selling only to accredited investors, startups and other companies can make use of the more flexible private placement exemptions, and may be able to avoid some of the more burdensome and expensive disclosure obligations. In addition, accredited investors may be able to provide more value to a startup, through advice, connections, and access to other valuable resources.

On the flip side, anyone that isn’t an accredited investor is an unaccredited investor. These are the widows and orphans, the great unwashed, people like, well, you and me. SEC rules require a much higher level of disclosure when a company seeks investment from an unaccredited investor.

There are three basic categories of accredited investor: one, institutional investors, two, insiders, and three, Very Rich People. The first category, institutional investors, includes:

  • Banks, savings & loans, registered broker-dealers, insurance companies, investment companies registered under the 1940 Investment Company Act, and certain employee benefit plans;
  • Private business development companies as defined in Section 202(a)(22) of the Investment Advisors Act of 1940;
  • Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
  • Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person” as described in the regulations; and
  • Any entity in which all of the equity owners are accredited investors.

Venture capital firms and angel investment firms will typically be included in one of those institutional investor categories. These institutional investors are considered to have the financial resources and expertise to evaluate the prospects and financial condition of companies in which they invest, so that they can evaluate and absorb the risk.

The second category of accredited investors is insiders. These are directors, officers, or general partners of the company that is seeking investment. The idea here is that because they are insiders, they know the financial condition of the company, and are intimately familiar with its business plan and prospects.

The third and final category of accredited investors is Very Rich People. Very Rich People includes:

  • Any person with an individual net worth, or joint net worth with that person’s spouse, of more than $1,000,000. However, when determining someone’s net worth, you do not include that person’s primary residence as an asset. There are additional rules as to what liabilities are counted in determining net worth.
  • Any person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

The notion underlying Very Rich People is that because they are Very Rich, they can afford to lose a lot of money by investing in more risky companies. The problem with the current standard, however, is that it was set more than 30 years ago, in 1982. It’s like the classic scene in Austin Powers when Dr. Evil discovers that $1 million just isn’t that much money anymore:

The SEC is currently exploring an update to the wealth and income levels for individuals that are accredited investors. Adjusted for inflation, the income level would be $500,000/year and the net worth level would be $2.5 million in assets, in 2014 dollars. It’s too soon to tell whether the SEC will update the standards, or perhaps augment them with additional standards regarding education or occupational credentials.

So what are the key takeaways for startups and other companies that may be trying to attract investors? First, make a decision right away as to whether you are only going to talk to accredited investors. This isn’t a decision you can make after you’ve been meeting with potential investors for several weeks or months. In general, restricting your pool of potential investors to accredited investors will be a better strategy — you will have reduced disclosure obligations, and the investors you do attract will be better able to provide benefits to the company that goes beyond mere investment dollars. Second, have a way to confirm that your potential investors are indeed accredited. You may need to have them complete a questionnaire, or you may need to review tax returns or other personal financial statements from individual investors. This may seem awkward, but they are asking to see your company’s financials, too. They are evaluating you, and you are evaluating them. If they aren’t willing to actually share their tax returns or financials with you, ask for a letter from their attorney or accountant, stating that the attorney or accountant has reviewed the relevant materials and determined that the investor meets the standards of an “accredited investor.” Third, and finally, this is a complex area of law, with lots of traps for the unsophisticated. Before beginning to seek outside investments, it is wise to meet with a lawyer to discuss the various requirements, and to lay out a strategy for doing things the right way.

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Ten Common Startup Mistakes – Part 2

In this post, I wrote about the first five out of ten common startup mistakes. Now I will continue with the next five common startup mistakes.
Number 6 – Ignoring Securities Laws

When a startup raises money, it has to comply with the securities laws. The Securities Act of 1933 specifies that a company cannot issue stock without registering that stock with the SEC, unless there is an applicable exemption. There are exemptions for private sales of securities, but these exemptions have various requirements that must be satisfied. When seeking investment from an angel investor or a VC fund, it’s crucial that the startup work with an experienced, knowledgeable lawyer, who can guide the startup through the process. It’s also a good idea to work only with “accredited investors,” who are more likely to understand the kind of investment they are making, and better able to withstand losing their entire investment. Failing to comply with securities laws can give investors the right to get their money back, and can create serious civil and criminal liability on the part of the startup and its executives.
Number 7 – Failing to Protect Against Angel Investors and VCs
Angel investors and venture capital firms are in the business of investing in startups. It is something they do every day, while startups engage in financings only occasionally. Consequently, investors bring a much higher level of experience and sophistication to the process (no insult to startups intended). Startups that fail to understand this imbalance risk getting taken to the cleaners, but there are things startups can do to protect themselves. First, you need to investigate your potential investors, to make sure there is a good fit between the investors and the startup. Second, create a competitive environment, where the investors have to compete with other investors for the opportunity to become part of your startup. You will get more favorable terms that way, although you have to recognize that mishandling the competition could result in all the investors walking away. Third, you have to be willing to walk away, too. If the terms aren’t right, if the investor isn’t a good fit, walk away from the deal. The consequences of a bad deal can be worse than you imagine. Fourth, understand every aspect of the deal. The terms don’t just include the financial terms like pre-money valuation and conversion discount. There are numerous complex legal terms that may seem like boilerplate to you, but they can have a big impact on your company and your equity stake. Which leads to the fifth item, which is get your own lawyer to represent you and explain all these terms to you. Don’t rely on using the investor’s lawyer, or even a lawyer recommended by the investor. That lawyer will have a big conflict of interest, because he or she will not want to alienate the investor and future deal flow from the investor.  You can read more about this subject here and here.

 

Number 8 – Putting Off Developing Proper Management Structure

Many startups have flat organization structures, by design and preference. This may be acceptable at the early stages, but as the business grows and the headcount increases, so does the need for more structure and process. An employee handbook may seem unnecessary for a startup when there are only 3 or 4 employees, but when the hiring rate increases, a handbook is an important tool for communicating the desired culture and for setting expectations. It is also important to develop and communicate policies on harassment and discrimination, including processes for raising complaints. Clear policies in this area will help foster a productive work environment, and will help protect the company from liability. Another consideration in the HR area is creating a bring-your-own-device policy. If employees are doing company work on their own laptops, tablets, and smartphones, does the startup have procedures and policies in place to ensure data security and protection of its intellectual property? I work out of a co-work space where there are lots of startups, and I would guess that every one of them has employees and founders that use personally-owned devices. I would also guess that none of them have policies or technology in place to manage these devices (hint hint). You can read more about BYOD here.

Number 9 – Issuing Stock Options Without a Formal Stock Option Plan

Stock options can be an important compensation and recruitment tool for cash-poor startups. Stock options are securities, however, and failure to observe the formalities when issuing stock options can violate the securities laws. A company will need to reserve an option pool and create a formal stock option plan. Options will need a Section 409A valuation. Shareholder and board of director approval will be needed for all of this. There are legal and tax complexities, and a startup should consult an attorney before moving forward with stock options.

Number 10 – Failing to Consider Privacy Issues

Privacy issues are increasingly important not just for startups, but for any company. If Target can get in trouble with data breaches, so can your business. If your company is collecting information about visitors to your website, you need to disclose that in your website privacy policy. You need to disclose the kinds of information you collect, how you use it, and how visitors can opt out of information collection. There are additional requirements if you collect information about children who are 13 years old or younger. Once you have collected information about customers and visitors, you need to secure that information. Almost every state (46 at last count) requires some kind of public notice when there has been a data breach. Failing to properly consider privacy issues can cost your company millions of dollars, and could result in a devastating loss of trust between you and your customers.

Thank you for reading, and I hope you found it informative. If you are running a startup (or thinking about it), I hope this post gives you food for thought.

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Anatomy of a Term Sheet – Reps & Warranties

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. 

The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We’ve already gone through the charter terms. Those are the terms that involve changes to the startup’s certificate of incorporation, and included items like redemption rights, anti-dilution, pay-to-play, and liquidation preference. All very important, and if you are just joining the series now and if this topic interests you, I hope you will make time to review those earlier posts (there are 10 of them!!).

Today we are going to start tackling the “Stock Purchase Agreement” section of the model Term Sheet. In a Series A investment, the startup is issuing preferred stock to the investors. As part of the transaction, the startup and the investors sign a contract called a stock purchase agreement, which contains a variety of terms applicable to the transaction.

This part of the model term sheet has three components:

  1. Representations and warranties
  2. Conditions to closing
  3. Counsel and expenses

Today we will cover the reps and warranties. While these can be fairly extensive and detailed, we will just cover a few to give you a flavor. You can see a broader, more representative list of reps and warranties in the NVCA model stock purchase agreement.

Representations and Warranties

Typically, each side will make various representations and warranties to the other side. Most of these are pretty straightforward. For example, the startup will represent that it is duly incorporated, in good standing, authorized to carry on its business, and qualified to transact business in every relevant jurisdiction. This seems pretty basic, but if the company hasn’t paid attention to these corporate formalities, it can delay the closing. If the company is incorporated in Delaware (as it should be), but its main office is in Cincinnati, the company needs to qualify to transact business in Ohio as a “foreign corporation.” This is often overlooked by startup companies.

The investors will want reps and warranties as to the company’s capitalization, so that there are no surprises as to the number and classes of authorized shares. Sometimes the company’s stock ownership records can be a mess. Keeping good records of how many shares have been issued and to whom will save everyone a lot of trouble (and legal fees) later. The investors will want to know about any pending or threatened litigation. Investors also will want reps and warranties that the company owns the rights to any IP. This can be a problem if the company failed to get founders to assign all their relevant IP to the company, or if there aren’t adequate provisions governing IP ownership in employment and consulting agreements.

Another provision that might cause problems is the representation that the company holds all necessary licenses and permits for the conduct of its business. It would be very interesting to see how Lyft and Uber dealt with that particular term, given the controversy over whether they should be licensed in the states and cities in which they are operating. Finally, the company will be asked to make reps and warranties regarding its data privacy practices, so it is a good idea for startups to address data privacy issues as early as possible.

The investors will make reps and warranties, as well. The investors will typically represent that they have the authority to invest in the company, that they are purchasing for their own account, and that they have had an opportunity to discuss the company’s business plan, management, and financial condition. It is advisable to have the investor represent that it is an accredited investor, within the meaning of Regulation D. Many of the investor reps and warranties are designed to address compliance with securities laws, including qualification for a private placement exemption.

Next time we will talk about the various conditions to closing. Thanks for reading!

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