The destigmatization and legalization of cannabis have been very positive changes for the industry, but it hasn’t only been an increase in consumer sales that has contributed to the industry’s boom. Venture capital investors, as well as businesses that were formerly agnostic (perhaps even opposed to cannabis) are now pouring investment dollars into the industry, fueling massive growth. Aided by the influx of investor opportunities, many cannabis entrepreneurs are eager to use their experience and expertise in the field to create profitable businesses.
With big money entering the scene, the industry certainly has a solid jumping-off point for businesses that partner with investors to increase valuation and profitability. That said, it could also come back to haunt the seasoned cannabis entrepreneur who enters into a partnership without fully understanding the terms of the agreement.
It is imperative for cannabis veterans to have a firm grasp on how they can protect their interests in their business at the beginning of a new partnership and avoid potentially expensive and time-consuming legal battles in the future.
These strategies can be effective in protecting your stake in a developing business, but remember that big money investors often have an “our way or the highway” position. That doesn’t mean an investor has full control in the negotiation just because they put up the money. Without the cannabis professional’s skills, products, processes, or experiences (whatever sets it apart from competitors), the investment opportunity wouldn’t exist in the first place. If you’re critical to the success of the business, you have the leverage to establish terms or walk away if the proposition isn’t beneficial to you.
We’ve set up a helpful roadmap to ensure cannabis entrepreneur is prepared and protected. As always, our business consultants are here to help. Get in touch today.
1. Document everything from the start.
In the beginning stages of building a business, it’s common to get caught up in the euphoria of new possibilities and expected success of a new business venture. When you’re working with your team and investors do develop a shared vision, there usually isn’t much thought to pause the momentum and ask difficult (but important) questions like:
- How will management decisions be made?
- How much of the business does each of the partners own?
- How will we manage disputes between partners?
- How would my interests be protected if:
- ... the venture never reaches great success or goes under?
- ... everything goes as predicted and the business has moderate success?
- ... we strike gold and your founder’s shares are worth millions?
This is why it’s critical to put the terms of your partnership on paper early, so expectations are clear and there aren’t any surprises or misunderstandings down the road. The moment your primary business partners are on board, you should start documenting–even if all investors aren’t on board yet.
2. Hire a lawyer to be your advocate, especially when dealing with potential investors.
Selecting a sharp, business-savvy lawyer to oversee your interests is an imperative step early in the process, especially when dealing with venture capital or outside investors. A qualified attorney will help ensure the correct details are documented from the outset, draft operating agreements (see more on this below), and make certain that your needs are met in negotiations and business proceedings.
3. Utilize an operating agreement to define rights & roles.
Your operating agreement, often referred to as a shareholder or partnership agreement, is an important document defining each members’ rights and creates a framework of operations for events that could render parties in the business unable to continue working together. It could be looked at as a prenup for a business, intended to protect each party should things go wrong or if a member wants to exit the business. It prepares the business for common occurrences such as:
- What happens to a partner’s shares if they want to amicably exit the business?
- The business is booming and a new investor wants to buy in, how will this work?
- What happens when majority partners want to sell the business?
- How do you settle disputes when partners disagree on key management decisions or how to run the business?
As a veteran of the cannabis industry, you more than likely have expertise on the product itself; perhaps in growing it, or selling it, or manufacturing cannabis products like concentrates and edibles. But if you’re engaging with investors looking to inject their money into the business, you’ll want to make sure you are getting the biggest return on your years of work and expertise in the cannabis industry during the difficult years before widespread legalization.
How can minority shareholders protect their interests?
When dealing with angel investors, chances are you’ll find yourself as a minority shareholder; meaning you will own less than 50% of the shares or interest in the company. While you may not own a majority stake in the company as a minority shareholder, don’t be quick to sign an agreement that diminishes your rights. Be sure to take advantage of the leverage you hold as a key player in the business by including provisions in the agreement that will ensure your rights and stake are protected.
With that consideration, you should identify the types of business decisions that will require consent by a supermajority of shareholders in the operating agreement. Supermajority votes are recommended for objectives and plans that will affect the trajectory of the business. These decisions include selling the company, asset liquidation, management changes, spending over a designated amount of money, or taking on a certain amount of debt. For example, if you are one of several minority shareholders who share ownership with an angel investor who owns 60% of the business, identifying decisions that require a supermajority vote ensures the angel investor can't rule over the entire company or make decisions that benefit them over minority shareholders.
Tag-along rights, sometimes known as co-sale rights, are another provision worth considering in the agreement. In this scenario, should a majority shareholder decide to sell off their shares, tag-along rights grant minority shareholders the right to join the transaction and sell their shares along with the majority shareholder at the same price. Tag-along rights ensure the shares of minority partners are just as liquid as those owned by majority partners. Angel investors and venture capitalists may find it easier to sell hundreds of thousands, even millions of dollars’ worth of shares than a less-connected minority shareholder.
Along the same lines, drag-along rights give power to majority shareholders to force minority shareholders to sell their stock if the majority shareholders enter into a sale. Drag-along rights block a minority shareholder from preventing the sale of a business, but also ensure they have the same terms and conditions in the sale as the majority shareholder. Drag-along rights often favor majority shareholders and can be used to eliminate minority shareholders in the event of a sale.
Minority investors can also be protected with buyout provisions by setting valuation equations or naming a neutral valuation expert to determine a fair way for buyout terms to be decided. In this scenario, if a majority shareholder wants to buy out your 15% stake in the business, but you believe your shares will be worth more down the road, a pre-negotiated valuation equation will be used to determine how much your shares might be worth in the future. If you’re being forced to sell as the company is in a growth phase, a valuation equation may give you the means to capitalize on that growth and increase the price per share you’ll receive.
How does vesting work?
In some situations, the operating agreement can dictate that minority shareholders receive their shares in the business on a vesting schedule, meaning the shareholder does not gain full ownership of shares until set conditions are met, such as staying on board with the company for a set period of time. Vesting provisions are common where a business partner is providing “sweat equity” (their time or expertise) as opposed to actual financial investments. These vesting schedules are typically set up to allot a set percentage of shares over months, quarters, or even years, as determined in the agreement. Minority shareholders benefit more from schedules that vest more shares upfront or that vest on a more frequent basis.
“Cliff vesting,” is when a large percentage of shares vest at one time after a set amount of time (typically at a year). This usually mandates that the shareholder continue their role at the company for a period of time before they fully realize their shareholder rights. The usual “cliff vesting” clause is set so that 25% of the allotted shares vest after year one, with remaining shares vesting over the following three years in equal monthly allotments. This arrangement tends to benefit majority shareholders because it gives them the opportunity to push out minority members before a significant portion of their shares have vested.
To protect against this, minority shareholders should ensure a provision dictating that if the minority member is pushed out of their role in the business, his or her shares will continue to vest on schedule so long as they were terminated without cause or separated amicably. Conversely, if the member is terminated for cause or leaves without good reason, they would lose the unvested shares.
“Cause” is usually a defined term in the agreement and will normally include “bad” behavior such as: a felony conviction, a fiduciary breach of duty, misconduct that causes harm to the business, or a willful failure to perform duties. The list of conduct should be tailored to fit the business’ needs and roles.
In the same line, a "good reason" clause sets pre-negotiated situations that are considered acceptable exits from the business that would also trigger vesting or accelerate the schedule. “Good reasons” should be determined in the operating agreement and could include:
- Requiring relocation of more than 50 miles from your home;
- A substantial reduction in compensation;
- A substantial reduction in role, i.e. responsibilities or authority.
Don’t forget, the efficacy of the protective measures laid out here are dependent upon the negotiated terms in your operating agreement. You might not be able to convince each party to agree to all of your desired provisions, but retaining an attorney will help ensure that you understand your rights before any disputes arise and can increase the likelihood that provisions that are protective of minority members are included in the final agreement.