One of the most basic pieces of corporate governance for a privately-owned company is a shareholder agreement. Unfortunately, shareholder agreements for many cannabis companies are either non-existent or lack appropriate protections to protect a plant-touching company’s most valuable asset – its marijuana license.
I am regularly engaged as special securities counsel to either assist a cannabis company raise capital in compliance with federal and state securities laws, or to advise venture capital and private investors deploying capital in the cannabis and hemp industries. A necessary step in this process is to review the company’s organizational documents, licenses, cap table and investor list. For a corporation, this generally includes Articles of Incorporation (sometimes called Certificate of Incorporation) and Bylaws. If the Company has been represented by competent corporate counsel, this will generally also include a Shareholder Agreement. For limited liability companies, or LLCs, organizational documents generally include Articles of Organization, (sometimes called Articles of Formation or Certificate of Formation) and an Operating Agreement (sometimes called an LLC Agreement or a Company Agreement). These organizational documents serve the basic purpose of establishing the rules of governance and relative economic rights of the shareholders (called members in an LLC). For simplicity, for the remainder of this article, I will refer to owners of equity as “shareholders” and their equity as “shares” or “stock” without regard to the type of company it is (LLC or corporation).
A basic but often unappreciated dynamic in a private company is that you should have very strict controls over ownership. This is because you want to know who your business partners are. In a typical non-cannabis company, these controls focus on the approval process to bring in new investors, and restrictions on how an existing shareholder may transfer stock to a third party. However, a cannabis company should also address state-imposed ownership requirements and restrictions. Otherwise, your license could be put in jeopardy if stock is issued or transferred to a person that disqualifies the company from holding a marijuana license.
State-imposed restrictions vary from state to state, but generally focus on in-state residency requirements, limitations on number of out-of-state shareholders, limitations on a shareholder’s ownership of other marijuana licenses in the state and prohibitions of shareholders that have certain criminal convictions or have had a professional license revoked. An operator of a cannabis company needs to be familiar with these restrictions and manage them every time the company is raising capital or reviewing a transfer of stock.
My preferred tool to manage shareholder qualifications at the initial investment stage is to include the qualifications and restrictions in the company’s subscription agreement, and make each prospective investor represent and warrant to the company that the prospective investor is not disqualified under state law to become a shareholder in the company. For existing shareholders, I include the concept of a “Disqualifying Event” to the Shareholder Agreement that mirrors the state-imposed restrictions, and create a purchase option in favor of the company to redeem a shareholder that has experienced a Disqualifying Event. For Disqualifying Events that are not the “fault” of the shareholder, the purchase price is generally fair market value, while Disqualifying Events that are caused by some act or omission of the shareholder, the purchase price reflects a significant discount and extended payment terms to compensate the company for the problem caused by the shareholder.
While the best time to include these provisions in your organizational documents is at initial formation, the second best time is now. I find that most shareholders and investors will cooperate in making changes after an explanation as to the value the restrictions provide to the company, and indirectly, their investment.
Edward R. Culhane is an experienced cannabis and hemp attorney focused primarily in the areas of venture capital, private equity, securities and mergers and acquisitions. Mr. Culhane is a cannabis and hemp industry veteran and is licensed to practice law in the states of California, Colorado and Minnesota.