Private Investments in Legal Cannabis Businesses

Is it finally safe to invest in cannabis?

If you haven’t been living under a rock for the last several years, chances are you’ve been presented with one or more opportunities to invest in a cannabis business. As more jurisdictions legalize some form of cannabis use, it is hard to think of any other industry (with the arguable exception of bitcoin and crypto tokens) that has recently generated as much excitement and attention. Yet while projections may look good on paper, many investors don’t know where to start when evaluating a specific potential cannabis investment. The following is a list of considerations that every budding cannabis investor should understand before deciding to make a private equity or debt investment in a cannabis venture.

Cannabis investing remains high risk. Given the legal and tax uncertainties, the speed at which the regulatory landscape is evolving, the significant capital that will likely be required, the highly competitive nature of the industry, and the challenges involved in rapidly scaling operations, private investments in cannabis businesses should be considered as high risk as any other investment with the potential for a high reward. Just as angel and venture capital investors understand they risk significant if not total loss of their investments in their search for the next technology “unicorn,” cannabis investors should appreciate the downside risks inherent in each specific cannabis venture notwithstanding the overall growth projected for the industry as a whole.

[To read more of Sander C. Zagzebski’s thought leadership click here]

Marijuana is still illegal under U.S. federal law. The importance of this issue cannot be overstated. Marijuana remains a Schedule I drug under the federal Controlled Substances Act of 1970. Its cultivation, manufacturing, distribution, sale, possession, and use is a violation of federal criminal law. Until recently, cannabis investors took limited comfort in a series of published memoranda from the Department of Justice, including an August 29, 2013 memorandum from James M. Cole, then Deputy Attorney General, addressed to federal prosecutors, which set forth explicit federal enforcement priorities and urged prosecutors to defer to state law and state enforcement—hence allowing, if only indirectly, state legalization—in cases that didn’t implicate those specific federal enforcement priorities.

On January 4, 2018, the U.S. Justice Department announced that Attorney General Jeff Sessions had determined that the previous published guidance, including the above-mentioned “Cole Memo,” was unnecessary and was “rescinded, effective immediately.” So, although President Trump was recently quoted as supporting an end to the federal ban on marijuana and federal prosecutors do not appear to have significantly changed their attitudes toward legal cannabis ventures since, cannabis investors no longer have clear legal guidance at the federal level to give them comfort that making an investment in a cannabis venture that is compliant with applicable state law will not result in a federal penalty or prosecution.  

Confirming regulatory compliance (past and present) is both important and challenging. The cultivation, manufacturing, distribution, and sale of cannabis products is regulated by state and local law, yet the rules and regulations governing those activities varies significantly depending on the jurisdiction and in some cases remains a work in process.  Investors are well advised to understand the licensing and other regulatory requirements of the cannabis business into which they are seeking to invest. Investors should confirm the appropriate legal entity is holding the type of license that is applicable to that entity’s business, and investors should seek also to thoroughly understand the operational history of the business.

Understand the ramifications of Internal Revenue Code Section 280E and the company’s approach to 280E. Section 280E of the Internal Revenue Code prohibits cannabis businesses from taking ordinary business deductions in preparing their federal income tax returns. This is extremely important to understand, because 280E can result in an extremely high effective federal tax rate on the actual net profits of the business. It also creates additional audit risk for cannabis businesses that may have taken an aggressive approach to managing their 280E exposure.

While cannabis businesses are not permitted to take ordinary business deductions, they are allowed to deduct (or adjust for) the costs of goods sold. So, a 280E analysis from an investor’s perspective involves analyzing the company’s treatment of certain expenses as non-deductible ordinary business expenses versus costs of goods sold, and investors should make sure that the company’s management is seeking advice from qualified tax professionals in connection with 280E compliance.

Cannabis businesses are often complex webs of related party entities and transactions. For a variety of legitimate reasons relating to licensing, financing, geography (multiple state operations), 280E compliance and the like, the corporate structures of most cannabis ventures are rather complex. It is not unusual in connection with a cannabis investment to be presented with an organizational chart showing a number of subsidiary entities or affiliated entities, some of which hold cannabis licenses and others of which are unlicensed and intended to operate unregulated aspects of the business. It is important in any cannabis investment to understand what business operations each entity on the organization chart is handling, how that entity is owned and controlled, what contracts and other deals that entity has or will have with the other entities on the org chart, what other obligations or liabilities each entity will have both to other entities on the org chart as well as to third parties, and generally how money and product will flow through the various entities on the org chart.

Knowing and trusting the founders and key management is particularly important in a cannabis business. The background, relationships, and skill sets of founders and key management personnel are of significant importance to all growth businesses, because so much depends on the industry know-how, connections, and experience of those companies’ key people. In cannabis businesses, the founders and key management are arguably even more important because those individuals are often listed as responsible parties under the cannabis company’s licenses. Accordingly, a cannabis investor should get to know all of the cannabis company’s founders, major investors, key managers, and operators.

Pay attention to the real estate. Cannabis licenses are typically tied to leased or owned real estate, so investors should understand the licensed entity’s real estate rights. Many licensed parcels are encumbered by a mortgage or deed of trust. Other license holders only lease or sublease the specific parcel of real estate that is subject to their license. Accordingly, there is often some risk that a cannabis company may lose its license and its right to operate as a result of a foreclosure on a lien or the termination of a lease or sublease.  

Understand the target company’s IP strategy, including the details of any celebrity endorsement or branding deals. Many cannabis businesses drive significant value from their intellectual property, but their strategy for protecting IP must take into account that marijuana remains illegal under federal law. Cannabis businesses generally are unable to secure federal trademark protection from the U.S. Patent and Trademark Office for their brands and related marks because federal trademark protection is contingent upon the lawful use of the applicable trademark in commerce. Accordingly, a cannabis business that relies on customer brand identification will need an IP strategy that doesn’t involve federal trademark protection, such as state level protection as well as common law protections.

In addition, many cannabis companies have sought to leverage celebrity endorsements and related celebrity branding to set themselves out from the cannabis product crowd. A potential investor should review all agreements relating to that celebrity’s endorsement or branding relationship, particularly if the continued participation and marketing of its products is a key assumption in the company’s projections.

[For more on Greenspoon Marder LLP’s approach to Mergers & Acquisitions click here]

Cannabis businesses continue to have significant difficulty with banking. Banking institutions are generally licensed and regulated at the federal level, and federally regulated financial institutions fear fines and other regulatory action if they provide banking services to cannabis businesses. Accordingly, most banking institutions shy away from doing business with cannabis companies. Lack of access to the banking system remains a significant operational challenge for many cannabis companies.

Although not an exhaustive list, the issues described above should give financial cannabis investors a perspective on key issues to begin to speak with confidence to the promoters of specific cannabis investment opportunities. Indeed, cannabis investing is not much different than investing in any other high growth industry or sector. Financial investors should develop both an understanding of the cannabis industry on a macro (state) level as well as an understanding of the applicable target cannabis company’s business on a micro level to make a fully informed investment decision.