Rescheduling Marijuana FAQs: Cannabis-Related Investments | McGlinchey Stafford

On May 21, 2024, the Drug Enforcement Agency (DEA) filed the Proposed Rule to move marijuana from Schedule I of the Controlled Substances Act (CSA) to Schedule III of the CSA. In light of the rescheduling marijuana news, industry insiders anticipate a significant increase in cannabis-related investments and acquisition activity. While this anticipated increase in activity is exciting, it is no secret that those who have already invested capital into the cannabis industry have learned some hard lessons over the last decade.

Based on those lessons learned, we anticipate capital will be deployed much more selectively going forward. While not every cannabis business will be a prime candidate for investment or acquisition, there are actions prospective investors and owners of marijuana-related businesses can take now to position themselves to take advantage of the predicted influx of capital into the industry, regardless of whether their business goals include expansion or exit.

This two-part post discusses considerations for prospective investors and acquirers and provides advice for how owners of marijuana-related businesses can prepare themselves to maximize the value of their cannabis business to take advantage of the increased opportunities expected to follow marijuana rescheduling.

Part I: Is it the Right Time to Invest in a Cannabis Business?

Will Rescheduling Make Marijuana Businesses More Attractive to Investors?

In short, potentially. It is no secret that cannabis businesses are currently subject to extraordinary effective tax rates, which can be devastating to their bottom lines. Internal Revenue Code section 280E prohibits deductions and credits for the vast majority of business expenses incurred in carrying on the trade or business of trafficking Schedule I and II controlled substances, including, currently, marijuana. Rescheduling would eliminate this tax burden for cannabis businesses.

Businesses subject to 280E can reduce gross receipts by the cost of goods sold (COGS) but cannot deduct other business expenses. Traditional non-COG business expenses, which are deductible by non-marijuana businesses – such as employee wages, advertising expenses, and more – are not deductible by marijuana businesses, drastically increasing a marijuana business’s taxable income and resulting tax liability. In fact, the effective tax rate on cannabis companies can be as high as 80%, as compared with the much lower federal corporate tax rate of 21% in 2023.

Thus, rescheduling marijuana could save marijuana-related businesses millions in dollars of taxes and help spark an influx of capital from prospective investors into the cannabis industry.

Leveling the Playing Field for Marijuana Businesses

Relieving marijuana businesses from the burdens imposed by 280E will help level the playing field for marijuana businesses seeking to attract investors and acquirers. Relief from its direct tax burdens will reduce the cost of doing business and allow the marijuana businesses to reallocate millions more in capital to their own use. Marijuana businesses will also no longer be incentivized to engage in “org splitting” – a common practice by which a single marijuana licensee will split different assets, liabilities, and operations among multiple business entities in an attempt to mitigate the impacts of 280E. These changes may also help make marijuana businesses more attractive to investors.

Navigating State Laws and Cannabis Regulations

Rescheduling does not, however, affect either an investor’s or a cannabis business’s need to comply with the wide variety of state laws and regulations affecting marijuana-related investments. Following rescheduling, important prerequisites and thresholds still exist in state laws and regulations that dictate who can invest in a cannabis business, how much money can be given to or received from a licensed business, how much control or decision-making power an investor is allowed to exercise over the licensed business, and more. Further, the marijuana-related business’s own history of regulatory compliance is, and will always remain, a critical consideration for investors and acquirers of marijuana-related businesses. Failure to comply with these rules can result in enforcement actions, and penalties for violating these rules can include the loss of the marijuana business license and, thus, the entity’s ability to operate or generate any income at all.

Other Considerations for Cannabis Investors

There are also a variety of issues outside of the scope of marijuana-related regulations to consider prior to investing in a cannabis business, which should be discussed in depth with legal counsel with deep and wide experience in cannabis-related matters. Below, we identify and discuss sample categories of risk that are critical to investors. In addition to regulatory compliance (discussed above), these investors and acquirers also consider corporate, securities, labor and employment, and intellectual property-related risks, among others. Additionally, investors and acquirers are well advised to consider the complex interactions marijuana has with other areas of law prior to investing in a marijuana-related business. For example, whether bankruptcy protections will be available to private lenders (including board members in their individual and personal capacities, as well as employees) in the future once funds have been “tainted” by cannabis remains an unsettled and rapidly changing area of law and should be discussed with counsel.

The Takeaway

Rescheduling marijuana could significantly reduce the federal tax burdens under IRC 280E, making marijuana businesses more attractive to investors and acquirers. Despite the ongoing complexities of state regulations and other legal risks, the easing of federal restrictions with respect to marijuana represents a promising shift towards a more equitable playing field for marijuana-related businesses. Cannabis investors and acquirers are encouraged to approach these opportunities with strategic foresight as the industry continues to evolve and expand.

Part II: Is your Cannabis Business Ready for Investors?

How do Investors Evaluate a Cannabis Business?

When investors or acquirers look for target companies to invest in, they generally analyze and price relevant businesses through the lens of risk. The existence and extent of certain categories of risk will often determine whether and how much they are willing to pay for an opportunity. In some instances, the level of risk involved in a cannabis-related investment will close the door to a deal entirely, but in other instances, the level of risk will simply impact the first offer, which in turn sets the table for the rest of the negotiation.

With marijuana rescheduling months away, cannabis business owners should begin addressing these risks now, to stop money from being left off the table in the future. Although most investors and acquirers will use different metrics to assess the loss of value associated with the different categories of risk, as a general matter, they – at a minimum – analyze the following categories as part of their due diligence investigation:

Corporate Risk:

This category examines the nature and quality of a target marijuana company’s internal governing documents. Investors and acquirers will first want to know whether a target has the baseline documents in place; these include legal documents such as operating agreements for a limited liability company and bylaws and shareholders agreements for corporations. Next, investors and acquirers will review these documents to be certain they cover certain basic topics related to considerations such as fiduciary duties, ownership, issuance, and transfer of the company’s equity, and rights to distributions and obligations for capital calls.

Investors and acquirers will also examine how company governance is structured and whether the company has complied with the procedures set forth in its governance documents as well as related state laws. A marijuana business’s failure to have these documents in place or to follow their own procedures creates the risk that an owner (usually a minority owner) may make a claim against the business or the company’s other owners for a breach of a fiduciary duty or other obligation set forth in the company’s governing documents.

Securities Risk:

This category examines the way in which a business has previously raised capital and issued its equity. As a general rule, the equity in a company is considered a “security” under federal and state securities laws. This means that the sale and issuance of ownership equity in a company is subject to the myriad of federal and state laws and regulations that govern how and to whom it may be sold. While the issuance and sale of the initial ownership in a new business is generally subject to exemption from securities registration requirements under federal and state securities laws, some states have in place reporting and notification requirements that apply to these transactions. Perhaps more importantly, even if a transaction is exempt from such registration requirements, the transaction is still subject to the general anti-fraud provisions of both state and federal securities laws, which means that company founders may not make false or misleading statements in connection with raising money for the business.

Investors and acquirers will ensure all of the equity of a business (including options and promises of future equity) is both accounted for in its capitalization table and appropriately documented. They will also check to confirm that the company has strictly complied with any reporting or notification requirements associated with the issuance of its equity. It is likely that investors and acquirers will also want to see all written materials prepared or presented in connection with all previous sales and issuances of the company’s equity, including business plans and financial projections. A cannabis company’s failure to strictly comply with securities laws or properly document all securities transactions creates the risk of government enforcement and private lawsuits by those who previously purchased ownership in the business or those who may have been “promised” ownership interest in the future.

Regulatory Compliance Risk:

This category examines the target’s history of compliance with state (and sometimes federal) regulations. The cannabis industry is heavily regulated. Historically, state cannabis regulators have required strict compliance with all regulations and have been quick to impose significant penalties, including revocation of licenses, for what may appear to many as inconsequential violations. Investors and acquirers will review any and all formal or informal violations, notices, investigations, and other compliance issues that may have been raised by state regulators and what, if any, action was taken in response.

Investors and acquirers will also likely request to visit all company facilities to ensure that there are no compliance issues that could create enforcement risks in the future. Regulatory compliance risk is always one of the key factors in a decision to invest in or acquire a business because a regulatory enforcement action, even one that does not result in the loss of a license, is costly and time-consuming and takes focus away from the primary operations of the business.

Labor and Employment Risk:

This category examines the target’s compliance with state and federal employment laws, including the marijuana company’s categorization and handling of independent contractors. Labor and employment laws are rapidly evolving at both the state and federal levels. In addition, many labor and employment requirements begin to apply anew or increase as a company grows and hires more employees. Investors and acquirers will want to review all relevant documentation – such as employment contracts, payroll policies, employee handbooks, compensation schedules, and independent contractor arrangements – to ensure that all of the marijuana-related company’s documents, policies, and procedures are in compliance with recent legal changes and the increased obligations that are triggered as a result of the company’s growth.

A cannabis company’s failure to comply with labor and employment laws or failure to have well-documented internal records and policies creates the risk that an employee or former employee may file suit against the company. This risk is further heightened because, in many states, employees (and former employees) who prevail in a lawsuit against an employer are entitled to increased monetary damages as compared with other civil actions, and a successful outcome will also oftentimes result in the company being required to pay the employee’s substantial attorney’s fees.

Intellectual Property Risk:

This category examines how well the target has protected its valuable intellectual property from infringement or unauthorized use. Brand identity and recognition are crucial to success in the hyper-competitive marijuana marketplace. In addition, unique formulations, processes, and other valuable trade secrets give businesses a competitive advantage that often contributes to making them an attractive target to potential investors and acquirers.

Unfortunately, with success, businesses often see copycat and other infringement strategies used by other businesses and competitors. Cannabis businesses must object to the infringing conduct of third parties or risk losing their intellectual property protections through “abandonment.” Marijuana-related businesses should also enter into enforceable licensing agreements (and, where relevant, confidentiality or intellectual property assignment, or other agreements) with key business partners who are authorized to utilize the company’s intellectual property.

Investors and acquirers will review a company’s intellectual property portfolio to ensure that it is adequately protected from infringement under federal and state law, including that its trademarks are registered or protected at common law to the greatest extent possible. They will also review a marijuana-related business’s other agreements, such as co-packing agreements and manufacturing agreements, to assess the risk and enforceability considerations related to those agreements. Failure to adequately acquire and invoke intellectual property protections creates the risk that the business could lose its competitive advantage or, worse, could be sued for infringing on another’s intellectual property, and can significantly decrease the perceived value of a company.

The Bottom Line

While the information provided here is not an exhaustive list of considerations for investors, acquirers, and marijuana-related businesses alike, and there are certainly other categories of risk that an investor or acquirer will explore during due diligence (e.g., contract risk, tax risk, etc.), these categories of risk are the ones we find are critical to investors but are often overlooked by cannabis business owners.

Importantly, these are categories which include risks that are relatively easy for a marijuana-related business to fix on a prospective basis in order to make themselves more attractive to investors. With rescheduling around the corner, the time to start addressing these issues is now and put your business in the best position to attract high-value investments.

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