Commercial real estate took a dive last year as companies began to work from home, but changing regulatory environments have opened doors to a new industry in need of property: cannabis. Growing rapidly at both the medical and adult use levels, cannabis businesses have been eager to move into vacant buildings, quickly buying up space as more states adjust their laws regarding cannabis.
Cannabis businesses cannot go at it blindly, however. Legal cannabis firms of all sizes – from the smallest startup to the biggest enterprise – will face regulatory challenges, traceability requirements, process control standards and, ultimately, the right technology to keep them moving forward in this promising industry.
Use data to keep track of plants, patients and regulations
As a highly regulated industry, cannabis companies could be investigated at any time. Regulatory authorities may, at the very least, request proof that they are compliant with state restrictions. Cannabis enterprises will only be able to quickly and easily provide that proof if they have immediate access to accurate historical data. With that information, they can generate the necessary reports at a moment’s notice and maintain a reliable audit trail.
Historical data is also useful for both growers looking to evaluate why certain plants are more successful than others and for sellers looking to improve their customer experience. By tracking everything from mother plants to clones, growers can build a strong genetics profile and gain a powerful competitive edge. Historical data also aids sellers, who can use it to enhance their digital storefronts and keep track of customer information, shopping history and other details that could improve the e-commerce experience.
In addition to customer details, sellers must also keep track of patient information when selling in a medical-only environment. Prescriptions need to be carefully managed to ensure that patients only receive products that they have been approved to purchase and use.
Utilize process control to foster scalable and repeatable processes
Process control is another vital component that every cannabis grower, manufacturer, processor and distributor must possess. They need scalable and repeatable processes to prevent steps from being bypassed, ensuring that every finished product matches the same high-quality standards. If there are no stopgaps in place, steps could be missed if employees are rushing to meet a deadline or simply think that a particular test or check isn’t needed. Those kinds of mistakes can be hugely detrimental to any cannabis company and may waste product, diminish profits and turn off customers.
Similarly, visibility and control over inventory is a top priority for any business, but it reigns supreme in the cannabis space. Managers should always, at all times, know where the product is as it moves throughout the warehouse, or risk costs and waste. By directly tying scanners and barcodes to the right technology, organizations can ensure that all product is accounted for and easily located using real-time data.
Build a foundation for scalability
Cannabis businesses don’t have the time to manually keep track of these aspects, and it wouldn’t even be possible as they grow and expand their operations. As they evolve, so too will the list of software requirements that are needed to operate smoothly, reliably and efficiently.
Cannabis processors have traditionally invested in seed-to-sale technology, relying on barcodes to track products throughout their lifecycle. While it is critical for cannabis enterprises to keep a strong level of control over lot tracking, this type of software is very limited. Cannabis firms would therefore be better served by an ERP solution with a single data source that provides centralized, real-time access to vital business information.
ERP technology can also help cannabis businesses better manage their production schedule, material requirements planning, accounting, purchasing, inventory management and document generation. The key, however, is to choose the right technology, avoiding ERP solutions that rely on customizations and bolt-ons, which will impede an organization’s ability to scale. Cannabis businesses should instead use technology that makes all of its features, enhancements and extensibility available to all customers, ensuring that every user has access to the same benefits.
This piece is intended to provide some considerations that current and potential license holders should think about as they work with advisors to make entity selection decisions or consider potential tax elections. Please note that this article is a high-level overview and is not intended to declare the best type of entity structure for a license holding entity. Although there are numerous tax variables that should be contemplated, tax issues are not the only concerns relevant to determining entity type. In addition, some states may tax entities differently than how the entity is taxed for federal purposes.
First, let’s look at the legal entity types that may be set up to hold a license, operate a business and what that may mean for how an entity is taxed. Often, entities are set up as either limited liability companies or corporations.
If a limited liability company is organized and the entity is owned by only one owner, a single member LLC, the default tax treatment would be that the entity is disregarded for tax purposes. In other words, it would not file a separate federal income tax return, except in some states including CA, TX, TN and RI. All the tax consequences of the activities within the legal entity are reported on the tax return of the owner of the entity.
If a limited liability company is set up and the entity is owned by more than one owner, a multiple member LLC, the default tax treatment would be that the entity is taxed as a partnership. An entity taxed as a partnership reflects the tax consequences of the activities within the legal entity on a partnership return. The partnership generally does not pay tax on the activity, but rather the taxable income and loss are passed through to the owners of the LLC. The owners of the LLC reflect the taxable income or loss on their tax return and are responsible for paying any resulting tax. In the rare instance of an entity being audited, there is a possibility that the entity may have to pay tax on the partners behalf, depending on the ownership structure. Either a single member LLC or a multiple member LLC may elect to treat the LLC as a C-corporation or an S-corporation for tax purposes.
The Taxation of C-Corporations & S-Corporations
The default treatment for an entity set-up as a corporation is the entity will be taxed as a C-corporation. An entity taxed as a C-corporation, including an LLC electing to be taxed as a C-corporation, pays the tax on any taxable income generated by activities within the entity. Additionally, any distributions of earnings from the C-corporation to the owners of the entity are generally considered dividends which are required to be reported as taxable income by the owners when received. In other words, the earnings of an entity taxed as a C-corporation are potentially taxed twice. Once, as they are earned within the entity, and then again upon distribution to the owners of the entity.
An entity set-up as a corporation, a single member LLC or a multiple member LLC may elect to be treated as an S-corporation. Like an entity taxed as a partnership, an S-corporation does not pay tax at the entity level, but rather passes the taxable income and loss through to the owner or owners. Additionally, like a partnership, distributions from an S-corporation are not taxable as dividends to the owner when received.
Since we covered how different entities are taxed based on how they are set-up, and what elections they may or may not make, we will explore some of the issues that should be considered when making an entity selection. We will also address potentially electing to treat an entity one way or another for tax purposes.
Advantages: The advantages of an S-corporation are limited to the avoidance of double taxation associated with C-corporations, as well as some potential benefits of lower Social Security and Medicare taxes.
Disadvantages: The primary disadvantage of an S-corporation for a license holding company is any non-deductible expenses resulting from 280E are passed through to the owner(s), which then reduces the ownership’s tax basis in its investment in the entity. A reduction in tax basis is determinantal to owners of an entity because the basis is used to reduce taxable income when/if the owner liquidates ownership in the entity.
Other disadvantages of S-corporations include but are not limited to restrictions on ownership of the entity, a requirement for reasonable compensation paid to owners and a lack of flexibility in the allocations of earnings among owners.
Advantages: The advantages of a partnership include but are not limited to the avoidance of double taxation associated with C-corporations, flexibility in the allocation of earnings and losses among owners, and flexibility in the type of owners of the entity.
Disadvantages: Like S-corporations, the primary disadvantage of a partnership is any non-deductible expenses resulting from 280E are passed through to the owner(s).
Other disadvantages of partnerships include potential self-employment taxes on earnings allocated to active owners, potential complexity in the allocations of taxable income and losses among partners in entities with many owners or different classes of ownership.
Advantages: In contrast to S-corporations and partnerships, the tax basis resulting from the ownership’s investment in the entity is not subject to reductions from non-deductible expenses being passed through to owners. This protection of tax basis is particularly important to owners of license holding entities.
An additional advantage of C-corporation tax treatment may be a lower tax rate applied to taxable income.
Disadvantages: The most significant disadvantage of C-corporation tax treatment is the potential double taxation of earnings that might be applicable if the entity does have earnings that are distributed.
In addition to the items address above, the advantages and disadvantages of the entity type and related tax elections, additional considerations include:
How much of the 280E nondeductible expenses will the taxpayer be subject to?
How much earnings will the entity be distributing to the owners?
How complex is the entity’s ownership?
The lack of certainty regarding whether or not the qualified business income deduction (QBID) enjoyed by pass-through entity owners is allowable as a deduction by owners receiving pass-through income from an entity subject to 280E.
Are there plans for selling the entity and if so, what is the time horizon for doing so?
At Bridge West, we advise taxpayers to consult with cannabis advisors who have experience in the industry, can help navigate the complexities of tax compliance and Code Section 280E and are experienced with entity structures.
From seed-to-sale, overseeing processing and extraction as well as navigating a dense web of complicated regulations, cannabis businesses have unique inventory management needs.
Unfortunately, there is no magical, one-size-fits-all inventory solution that is perfect for all cannabis companies. That is why cannabis businesses must take time to properly evaluate and identify an inventory system that is effective for their specific needs and requirements.
Inventory management plays a crucial role in maintaining productive and compliant day-to-day operations — and when seeking investment — as it has a direct impact on a business’s bottom line. Because of the regulatory and legal complexities in the industry, using an incomplete, rudimentary or outdated inventory system can lead to serious financial discrepancies guaranteed to cause headaches for accounting professionals and business leaders.
The right system also can give businesses actionable data to respond to changing market conditions, business needs and growth opportunities as they arise quickly. This visibility is a necessary aspect of ensuring your cannabis businesses can achieve long-term, sustainable growth.
Here are some guidelines to keep in mind when shopping for an inventory management system:
Use the Cloud
First, be sure your company is using cloud-based accounting software. This will instantly simplify both your accounting and inventory processes. Cloud-based solutions ensure company financial and inventory records are up to date and accurate.
Do Not Rely on Your Accounting Software
Your accounting software may provide native functionality for inventory tracking — but do not use it. Such native inventory functions are not robust or complex enough to properly maintain the complicated inventories of cannabis businesses. For instance, your business might be cultivating numerous plants across several sites, tracking plant movement and processing, or packaging it internally. You may be selling your products at other dispensaries or supplying other dispensaries’ products at your counter. Simply put: Cannabis businesses need more sophisticated solutions to track sales, monitor supplies, oversee shipments and remain informed on where products originate from and how frequently to re-order. Native functionalities too often do not provide such robust features.
Look for Direct Integration
That said, business owners want to ensure their inventory system directly and seamlessly integrates with their cloud accounting software. You should not have to input or upload information when setting up inventory software manually. In today’s world, the two systems should automatically and easily share information with each other. Each system’s website will often say whether it can integrate with various accounting platforms, but it never hurts to do some additional research. For example, both Fishbowl and Trade Gecko can be directly integrated with Xero. Some systems even offer a demo environment to let business owners experience what the integration will look like.
Explore Invoicing Capabilities
Some inventory management systems include invoicing capabilities, which can simplify the invoicing process – or even automate it. Such functionality reduces the risk of error when transferring data between programs. A consolidated system that automatically links inventory and invoicing allows business leaders to update invoices easily, mark orders as paid or unpaid, filled or unfilled, all while keeping a close eye on inventory. Some inventory solutions even offer dynamic reporting that displays real-time sales reports and fulfillment processes – making it easier than ever to work with vendors, identify and eliminate unnecessary costs and control cash flow.
Do Not Just Sign Up with the First System You Find
Choosing an inventory management system requires plenty of thought, and no two solutions look exactly alike. So, do not rush into a commitment just to get it over with and move on. Instead, spend enough time learning about various systems and their options to guide a confident purchasing decision. Going with the wrong system and having to switch later not only wastes time and money, but it can undo many of the efficiencies you worked to implement.
Consult an Accounting or Business System Expert
Working with accounting and business systems experts will provide insights related to your short- and long-term business goals. Such experts can help business owners understand exactly how their specific inventory ought to be tracked to avoid serious discrepancies or non-compliance. In addition, a strong accounting professional can act as an invaluable resource and partner when it comes to selecting and personalizing an inventory management system and identifying inaccuracies or inefficiencies. A good tax pro also can serve as a point person between the cannabis business and the software developer to address initial customization and setup or any issues that may arise.
Running a cannabis business requires an investment of time and money from the very start. The good news: You do not have to spend an arm and a leg on your inventory management system to find something that works. Some solutions marry affordability with efficiencies — but be sure to explore several options to find the right fit, keeping in mind the guidelines laid out above. Remember: Cost does play an important role, but the system’s capabilities are more vital to positioning your cannabusiness for sustainable, long-term growth and compliance.
The cannabis industry is growing fast as more states implement legislation to legalize cannabis in different ways. If you’re trying to break in or keep your place in this new market, it can be difficult to understand and comply with ever-changing government regulations as you try and scale your business.
Cannabis businesses need to comply with a range of new local, state and federal regulations related to cannabis specifically, in addition to regulations already in place for the pharmaceutical and food industries to ensure their products are safe for public consumption. On top of that, there are the complexities of managing a supply chain, including growing, warehousing, transportation, food safety requirements, product labeling, business plans, marketing, selling and any other necessities that come with running a businesses.
This is a lot of new information when you’re vying for your place in the cannabis industry. That’s why some businesses are turning to consultants to help. Consultancy is a great and time-tested way to grow your businesses and keep a competitive edge. But just like every other industry, when you choose a consultant, there are specific things to look for and avoid.each party will have work to do in order to communicate clearly, define responsibilities and execute on a plan.
Understand the Role of Consultants
The expertise of cannabis consultants can vary widely. Usually there’s no “one stop shop” for everything you need to run your business, meaning consultants often specialize in a specific area. Consultant expertise includes specialties such as cultivation, manufacturing, food safety, dispensary, transportation, legal, accountants, human resources and more, all within different regulatory compliance wrappers.
It’s important to remember that consultants are usually not responsible for setting goals for you, but the right consultant can help you refine, meet and even exceed your goals. However, each party will have work to do in order to communicate clearly, define responsibilities and execute on a plan.
Focus on Your Specific Needs
Identifying your specific needs and understanding what success looks like for you is a critical step to take before contacting any consultant. This prep work helps you identify what kind of consulting you actually need and what you’re willing to spend to get it. Some consultants can help you tackle more than one area, but most will specialize. In fact, choosing several specialized consultants (if you have many needs), may feel like it costs more up front, but it will likely save you frustration, headaches and money in the long run. Additionally, if a consultant claims they can do everything in several areas of expertise, they may be overpromising on what they can actually deliver to you as a customer.
Ask the Right Questions
When vetting a consultant, it’s your job to ask probing questions. Don’t hold back and don’t be put off by vague answers. If a consultancy avoids questions or can’t give clear answers, they may be overpromising or being less than honest about their skillset. Here are some general areas of discussion to help you get started when interviewing consultants:
The consultant’s relevant experience.
Past or current client references.
Detailed discussion of your specific needs as a business.
How much time can the consultant dedicate to you as a client.
Detailed outline of the consultation plan, including a clear timeline.
Responsibilities of each party, deliverables and what success looks like for customer sign off.
Certifications and credentials if relevant to your consultation needs (e.g. legal, accounting, regulatory).
What is and is not included with their quoted fee, and what you may be charged for as an “add on” to your contract.
Any possible conflicts of interest, including how consultants separate work for clients who are competitors.
Avoid Red Flags
As with any burgeoning market, there will be consultants who get into the cannabis space that are more interested in making money than helping you as an individual client as businesses work to legitimize the industry as a whole. Doing your research and asking for referrals helps, but there are also red flags to look for. Some of these red flags may pop up due to inexperience and some may be a sign of bad actors in the consultant market.
Asking for equity as payment.
Refusing to provide references.
Avoiding questions or giving unclear answers.
Unwilling to track time and itemize costs on bills.
Overpromising AKA “this sounds too good to be true.”
Dominating the process instead of treating you like a partner.
Build a Strong Relationship
To get the most out of a consultancy experience, it’s important for both parties to work at building a strong business relationship. You know you’re hitting the sweet spot in business relationships when you have well-oiled communication and feedback loops, including honesty around expectations and frustrations from both parties. A great consultant wants feedback so they can improve their process, therefore they will actively listen to and address your concerns. Additionally, it’s important for you as a client to also be open to feedback and ready to make changes to your process to get the best return on your investment.
Copyright: Protection for Works of Creative Expression
In the course of describing and marketing its products, the cannabis producer will prepare or have prepared any number of articles, instructions, write-ups, photographs, videos, drawings, web site designs, packaging, labeling and the like. Copyright protects all such literary and artistic works from being copied by another.
Copyright arises upon the creation of the work, although one can register the copyright under the Copyright Act for a minimal cost.Canada’s Copyright Act provides that the owner of copyright has the exclusive right to make copies of copyrighted work for the lifetime of its author, and for fifty years thereafter. The Court will enforce this copyright, stopping infringements and ordering infringers to compensate the owner in damages, accountings of profits and delivery up of infringing material for destruction. Intentional copying or renting out of a copyrighted work is also an offence that can attract imprisonment. The owner of a copyright can also request the seizure of infringing articles being imported or exported in Canada.
Copyright arises upon the creation of the work, although one can register the copyright under the Copyright Act for a minimal cost. Registration creates a presumption that copyright subsists in the work and that the registrant is the owner, presumptions that can simplify copyright proceedings. In litigation, the fact of registration also removes the ability of a defendant to argue that it did not have notice of the copyright, a factor relevant to the Court in awarding a remedy.Copyright protects all such literary and artistic works from being copied by another.
There are two aspects of copyright law that tend to cause confusion. The first involves the distinction between the right to use a copyrighted article and the copyright itself. To illustrate, consider the sale of a literary work, such as a book. The purchaser acquires the physical book but not the copyright. The purchaser can use the physical book and can sell that book to another. What the purchaser may not do is make and sell another copy of the book. Making copies is the exclusive right of the copyright holder.
The second involves the ownership of a commissioned work. The first owner of a copyright is either the author of the work or the employer of the author if the author creates the work in the course of his or her employment. Ownership of copyright can only be transferred by written assignment. Further, the author of a work is granted moral rights in the work, meaning the right to be associated with the work and the right to its integrity. These rights can be waived by the author but not assigned.
Ownership of copyright can only be transferred by written assignment.Therefore, if a company hires a third party supplier to prepare copyrightable work, such as brochures, artwork or web sites, and does not secure an assignment of the copyright and wavier of the author’s moral rights as part of the transaction, that supplier will own the copyright in the resulting work and the author of that work will have the right to insist on his or her moral rights. The hiring company will not have the right to make or authorize others to make copies of the work, to amend the work, to derive new works from what was delivered, or to use the work without reference to the name of the author or in a way so as to offend the author’s integrity. The supplier will also be free to sell the same brochures, artwork or web sites to other companies, or to derive other works from it. All of this is so even though the hiring company paid for the work to be done. This result is often surprising and disappointing to hiring companies.
Accordingly, cannabis producers contracting with the third parties for literature, photographs, web sites and the like will need to think about how they want to use the work in the future. It is simplest if the producer contracts to have the owner assign the copyright in the work to the producer upon creation, and deliver the author’s waiver of moral rights. While the third party will likely charge more for an assignment of the copyright and the waiver of moral rights, it may be worth avoiding negotiations over specific uses and how the author is to be credited, as well as avoiding the uncertainty inherent in trying to imagine how the producer will use the material in the future.
In the 6th and final part, Naiberg will summarize the key takeaways from his series that cannabis companies can use to protect their intellectual property in Canada.
KIND Financial, a technology and compliance software solutions provider in the cannabis industry, is launching a new e-commerce and payment processing platform in Canada. According to the press release, they are partnering with a Canadian bank to launch the KIND Seed to Payment platform, which is essentially an e-commerce gateway integrated with their compliance software, KIND’s RegTech platform.
David Dinenberg, founder and CEO of KIND Financial, says this is an approach to help alleviate the cannabis industry’s banking woes. “We’ve been very focused on a global vision and taking a strategic approach towards solving the cannabis industry’s largest problem – banking,” says Dinenberg. “Not only have we built a broad portfolio of finance and compliance solutions with a high-level of technical sophistication, but we’ve made a strong commitment to security and compliance, which is evident through our partnership with Microsoft.” A little over a year ago, they entered a partnership with Microsoft to utilize their cloud-based solutions for government traceability software.
According to the press release, the software has regulatory and security features built in, such as age and identity verification, which can help companies comply with security and chain of custody regulations. “Our mission is to ensure business and technological growth for all constituencies within the cannabis industry while ensuring full compliance with evolving regulations, and that’s why we’re thrilled to make these services available to our great neighbors in the north,” says Dinenberg. “We understand compliance will be a critical issue for some time to come, but with our solution, all providers and their partners can focus on the job at hand while keeping in line with regulatory mandates.”
KIND Financial has not done much work in Canada previously, but this could be a sign of a greater push for international expansion. “We’re excited to be working in a new country to boost the Canadian cannabis industry in a safe and regulated manner, and we look forward to expanding into other markets overseas,” says Dinenberg. The press release says the new platform is designed to work with different languages and foreign currencies, including the euro and Australian dollar, which could help Canadian producers enter emerging markets.
In addition to their announcement of the KIND Seed to Payment platform, the company also announced they will be rolling out a mobile payment system called KIND Pay, a digital payment option for consumers that will accept Visa and MasterCard. They anticipate that KIND Pay will launch before the end of this year.
According to the Marijuana Policy Group, the U.S. cannabis industry is expected to reach more than $13 billion in sales by 2020 and create more jobs than the U.S. manufacturing industry. According to Viridian Capital’s Cannabis Deal Tracker, there were close to 100 M&A transactions in the U.S. cannabis industry in 2016 and approximately $1.2 billion was raised in equity and debt. As the cannabis industry has grown more mature and businesses begin to have more capital available, the M&A activity within the industry is poised to grow significantly over the next years to assist businesses gain necessary scale and take advantage of synergies and diversification.
The Obvious Wrinkle
U.S federal law has prohibited the manufacture and distribution of cannabis since 1935. The U.S. regulates drugs through the Controlled Substances Act, which classifies cannabis as a Schedule I drug (i.e., drugs determined to have a high potential for abuse with no currently accepted medical use and a lack of accepted safety regarding their use). Yet, more than 25 states have by now legalized cannabis for medical and/or recreational purposes and, as a result, there is a clear conflict between such state laws and existing federal law. To possibly help bridge that conflict, the U.S. Attorney General’s office in 2013 issued guidance directing the federal government not to intervene with state cannabis laws except in specific, limited circumstances, but, contrarily, the DEA has shown no desire to re-classify cannabis. To add to the confusion, President Trump and the new U.S. Attorney General have provided mixed statements and signals about their positions.
All of this means that it continues to be risky to acquire cannabis businesses. The requirements to legally grow, distribute, prescribe, and use cannabis for either medical or recreational purposes vary widely by country, state, and local jurisdiction, making it tricky to determine whether such businesses can be legally combined, in particular, across state lines.
Pick the Right Team of Advisors
When preparing to sell or buy a cannabis business, it is important to pick the right team of advisors. Your regular legal counsel, accounting firm or CPA may not be the right advisors for a cannabis M&A transaction. Choose a legal counsel that not only has experience with cannabis laws and regulations, but also has cannabis M&A experience and can offer expert advice on areas like IP, employment, tax matters, etc. Similarly, verify that your accounting firm or CPA has real experience with financial and quality of earnings analysis and due diligence.
Conduct Gating Due Diligence Up Front
In any contemplated M&A transaction, it is wise to prioritize your due diligence investigations. There will always be some more prominent risks and business objectives in a particular industry or with respect to a specific target business. It will be more cost and time effective if those specific risks and business objectives are prioritized early in the due diligence process. These can dictate whether you even want to pursue the target further before you dig into a deeper and broader due diligence investigation. Conducting gating due diligence up front is even more important in an industry like cannabis that contain complex and thorny regulatory hurdles.
So, before you spend money and time on a broader legal, business and financial due diligence investigation, have your legal counsel analyze and confirm that the potential transaction is feasible from a regulatory perspective. This will include whether it is possible to obtain or transfer necessary local and/or state licenses and whether a combination or sale can occur across state lines if necessary. Early on in the process, It is also advisable to request that the target business complete a legal compliance questionnaire or discuss with the target its regulatory compliance program, policies and training. Such up front due diligence will either clear a path to negotiations and broader confirmatory due diligence or flush out “red flags” that may kill a possible deal or require the buyer to investigate further before proceeding.
Important Terms and Pitfalls in the M&A Agreement
Generally, a sale or purchase agreement for a cannabis business does not appear to vary much from a similar agreement in any other industry. However, the complex environment and the premature nature of the industry impacts certain deal terms and processes in different ways from most other developed industries.
Here are few examples to keep in mind when preparing and negotiating a sale or purchase agreement:
Third Party and Governmental Consents: Buyer’s legal due diligence must focus on the consents that may be required from seller’s suppliers, customers, landlords, licensors or other third parties under relevant contracts. Additionally, the due diligence should focus on consents and approvals required by local and state regulators as a result of the sale. The M&A agreement should contain solid seller representations and warranties about all such consents and approvals and any such material consents and approvals should, from a buyer’s perspective, be a condition precedent to closing of the transaction.
Legal Compliance: A buyer should not agree to a boilerplate seller representation about the target’s compliance with laws. Be specific and tailor seller’s legal compliance representation to relevant state and local cannabis laws, regulations and ordinances. From a seller perspective, be careful and thoughtful about any appropriate exceptions (including the federal prohibition) to be disclosed to buyer in the disclosure schedules underlying the sale or purchase agreement.
Financial statements: The cannabis industry is very fragmented and consists of many small businesses. Many of these small businesses do not have financial statements prepared in accordance with GAAP and may consist of only management prepared financials. In that scenario, a buyer should have its financial advisor do an analysis of the financials available and ask seller to provide a representation and warranty about the accuracy and good faith preparation of the provided financials.
Escrow: Typically, a buyer will request some part of the purchase price be placed with an independent financial institution for a period of time post-closing as a source of recovery for losses as a result of breaches by seller of any of the representations and warranties in the definitive sale or purchase agreement. Due to the federal cannabis and banking regulations, many of the larger commercial banks will not provide financial services to cannabis businesses, in particular if the business touches the plant. The parties must therefore consider alternatives, including local financial institutions with more relaxed compliance requirements or perhaps place the escrow in a trust account of a law firm or other independent party.
Working Capital Dispute Procedures: Similar to the escrow, larger accounting firms generally do not provide services to cannabis businesses. Due to the rapid evolution of cannabis related regulations, if the terms of the transaction include provisions for a post-closing working capital/purchase price adjustment and related dispute procedures, it is advisable to not name an arbiter in the agreement. Instead, parties should agree to mutually select the arbiter if and when a dispute should arise.
Indemnification: Because of the tricky legal environment of the cannabis industry, it may be prudent for a buyer to request, at the very least, that certain parts of seller’s legal compliance representation and warranty not be subject to the “regular” caps, deductibles and other indemnification limitations. Also, if a buyer has unearthed a significant issue in its due diligence investigation, it should consider asking seller for a special indemnity for such issue that would be indemnifiable regardless of buyer’s knowledge of the issue and not be subject to the general indemnification limitations.
R&W Insurance: If there’s a lot of competition for the purchase of a target, particularly in a bidding process, it is now common for buyer to offer to purchase a representation and warranty insurance policy (“R&W Insurance”) to possibly gain an advantage by limiting the seller’s post-closing indemnification exposure. The good news is that many of the R&W Insurance carriers do offer such insurance in connection with the sale and purchase of cannabis businesses. However, typically, R&W Insurance cannot be obtained for insured amounts of less than $5 million. Experienced M&A counsel can advise of the advantages and disadvantages of R&W Insurance and assist in the negotiation of the related terms.
The above are just some examples of what to expect in a cannabis M&A transaction. Every M&A transaction will have its unique issues that will need to be appropriately reflected in the sale or purchase agreements and good M&A practices will continue to evolve with the industry. If you are an owner of a successful cannabis business, buckle your seat belt and be prepared for an exciting ride as the industry gets closer to significant consolidation.
California’s tradition of social and political experimentation has made it the national leader in areas ranging from environmentalism and social justice to technology. Now it is poised to make the same far-reaching transformations in the cannabis industry.
As one of the world’s top ten economies and the nation’s most populated state (having a population of 38 million), California could propel the decriminalized recreational cannabis industry to $6.5 billion in 2020, according to a report by ArcView Group and New Frontier.
At the same time, California is in the process of moving from state to local zoning control, as far as issuing the OK to become licensed, effective Jan. 18, 2018. This means collectives and dispensaries have to obtain local approval before they receive a state license. It also puts greater pressure on gray market operations to become licensed.
On the regulatory front, the state is also heading toward a historic vote in November 2016 in the form of Proposition 64. This will open up the customer base to all Californians. It has a similar licensing path as the medical regulations the Governor signed last year, except it allows vertical integration between growers and dispensaries, which is not allowed under the medical regulations, except in very limited circumstances.
“My bet is the demand will outweigh the supply for a while and the legal cannabis businesses that are licensed by the locals and have their supply chain in place will end up profiting,” says Andrew Hay of Frontera Accounting, a cannabis-focused CPA firm based in California under the umbrella of the Frontera business group.
A Huge Market Awaits
If the Adult Use of Marijuana Act passes and is enacted by 2018, the state’s legal cannabis sales are projected to hit $1.6 billion in their first year, the ArcView and New Frontier market report said. Even without the new expanded legislation and working amid a fractured medical cannabis regulatory environment, California now accounts for about half of all the legal cannabis sales nationwide, according to the report.
At the same time, the state is well positioned to capitalize on new technology and financing from Silicon Valley in terms of human talent, money and the applications of new technology in both the medical and recreational sectors. One driving force will come from the Adult Use of Marijuana Act, which mandates that 10 percent of sales tax collected on cannabis sales be re-directed towards medical research and drug abuse programs.
In addition, according to Marijuana Politics, the expected tax windfall is slated to be divided up among a variety of programs: $10 million to public universities, $10 million to business and economic development, $3 million to California Highway Patrol and $2 million for medical cannabis research at UC San Diego. The remainder will be divided between youth drug education and prevention (60%), environmental protection (20%) and law enforcement (20%).
This flow of new funds is expected to propel research into biomedical and applied research, as well as nutraceuticals, or products derived from food sources with extra health benefits in addition to the basic nutritional value found in foods. The driving new ingredients in these products will be derived from cannabis.
Consolidating the Recreational and Medical Markets
Californians will vote in November 2016 to legalize the sale of recreational cannabis. This vote will have serious repercussions since it could mean that the delineation between medical and recreational markets will disappear.
“Should California vote to legalize recreational use this November, we expect implementation of a combined regulated market as soon as 2018,” says Matt Karnes, founder of GreenWave Advisors. Karnes says a merged California market is significant, not only because of its sheer size (it represents about 55% of the U.S. market), but also because it “would mark the first state to implement regulations for a fully legal market without initial oversight of medical use purchases. This could serve as a catalyst for similar action in Nevada, Arizona, Massachusetts and Maine which will also vote to fully legalize cannabis this November.”
In the report, “Mid Year Update: The Metamorphosis of the U.S. Marijuana Market Begins,” the firm said it projects cannabis sales in the U.S. to hit $6.5 billion for 2016. The firm forecasts that by 2021, revenues should reach about $30 billion. This assumes that marijuana will be legal in all 50 states to various degrees. The firm also notes that this year’s election choices can potentially generate $4.2 billion in incremental retail revenues by 2018 and $5.8 billion by 2021.
The Impact on Branding, Music and Culture
As the nation’s culture manufacturing center for films, TV and music, the cannabis business is also expected to shape artistic direction for years to come. Jeff Welsh is a partner at Frontera, a business group that holds a suite of services including the Frontera Law Group, Frontera Advisors, Frontera Accounting and Frontera Entertainment, which is headquartered in Sherman Oaks with a specific focus on the cannabis industry. Welsh says he sees more partnerships between the cannabis industry and mainstream entertainment outlets. Welsh recently signed Chris Sayegh, the herbal chef who uses liquid THC to create elegant restaurant-quality food, in a deal with the United Talent Agency. This marks a cultural breakthrough that links the cannabis and culinary industries.
Because Los Angeles is the largest market, this cultural nexus is expected to contribute more new alliances between celebrity branding and cannabis products.
Luke Stanton, founder and managing partner of Frontera, also said less stringent regulations in the cannabis legal environment could find their way into the regulations and laws of other states that often adopt California laws as templates for their own state. “We have seen this happen in other areas, such as environmental and criminal justice, so it would not be surprising to see our state regulations and policies being enacted in states nationwide, and even in some countries outside of the U.S.,” Stanton says.
California has also been the site of innovative marketing efforts between cannabis patients and growers. The Emerald Exchange held in Malibu, was the first event in cannabis that allowed a direct conversation between Northern California cultivators and the Southern California patient community. According to Michael Katz of Evoxe Laboratories, a California cannabis product manufacturer, “Often the farmers don’t have a chance to really engage with patients, and we wanted everyone to be able to come together, discuss practices, provide information and ultimately support the entire ecosystem of the cannabis community.”
Caveats for Investors
While the California market looks very attractive, it may be the siren’s call for investors until issues related to finding solid companies and taxation are settled.
Since more operations will have to become fully compliant with state regulations, these businesses will face more significant expenses to meet security, taxes, licensing fees, accounting and reporting operations requirements. This could drive smaller operations out of business or force them to become more efficient.
In addition, California’s huge potential and changing regulatory environment is attracting large growers into the state that will compete with smaller, established operations. According to Jonathan Rubin, chief executive officer of Cannabis Benchmarks, these regulations affecting commercial growing vary greatly by municipality. For instance, Mendocino and Humboldt counties have enacted measures to protect local growers, while other counties have not, Rubin says.
In addition, cannabis wholesale prices have been falling due to changes in cultivation methods and variations in supply.
Andrew Hay, a CPA at Frontera Accounting, believes investors should make sure there is a solid plan behind any cannabis company investment. “I’ve seen significant money thrown behind ‘cannabis brands’ with no substance,” Hay says.
“In these cases, the winners are the growers, manufacturers, distributors and dispensaries that are licensed (or are in the process of getting licensed), who pay their taxes and have a successful track record. I wouldn’t invest until you see the underlying operational structure, their tax/regulatory compliance and financials that prove there have been sales,” he says.
Another major problem for investors lies in the IRS accounting regulations. “The biggest hurdle I see facing the California cannabis business is the IRS / IRC 280E, which only allows cost of goods sold deductions. Every cannabis business should be planning their operations around IRC 280E, as there is no way to legitimately survive in the cannabis industry without doing so,” according to Hay.
“IRC 280E is here to stay regardless of California legalization. It is up to the Federal government to fix this issue, which I don’t see happening any time soon. Every cannabis business should hire a CPA and business attorney that work well together to devise a cost accounting strategy to minimize IRC 280E and its impact. Without this, an investor’s profits can go up in smoke to the IRS,” Hay says.
Strictly Necessary Cookies
Strictly Necessary Cookie should be enabled at all times so that we can save your preferences for cookie settings.
We use tracking pixels that set your arrival time at our website, this is used as part of our anti-spam and security measures. Disabling this tracking pixel would disable some of our security measures, and is therefore considered necessary for the safe operation of the website. This tracking pixel is cleared from your system when you delete files in your history.
If you disable this cookie, we will not be able to save your preferences. This means that every time you visit this website you will need to enable or disable cookies again.