Investing in State Law Compliant Cannabis Businesses: Part 2 - Diving Deeper
In Part 1 of this two-part series, we addressed the high-level concerns that a new investor should consider in making an investment in a state legal cannabis company. In this follow up, we address some of the more nuanced issues that investors should consider before deciding to invest in a specific cannabis company.
Regulatory compliance (past and present) is difficult to confirm. The cultivation, manufacturing, distribution, and sale of cannabis products is regulated by state and local law, yet the rules and regulations governing those activities can vary significantly depending on the jurisdiction and in many cases remain works in process. Investors should confirm that the appropriate legal entity is holding the type of license that is required, and investors should seek also to understand as much as possible about the operational history, whether licensed or unlicensed, of both the specific licensed entity as well as the founders and operators of that business and the direct or indirect ultimate equity owners of that licensed entity. This is important both to verify compliance with applicable license requirements and to identify any risks that could result in the revocation or non-renewal of the license.
Pay attention to taxes and 280E! Section 280E of the Internal Revenue Code prohibits cannabis businesses from taking any ordinary business deductions in preparing federal income tax returns. This is extremely important to understand, because 280E in many cases 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.
280E is designed to apply to all deductions from gross income, but not from gross receipts. This is important because, while cannabis businesses are not permitted to take ordinary business deductions, they are allowed to deduct (or adjust gross receipts to account for) the costs of goods sold. Many cannabis companies try to maximize their costs of goods sold to deduct those amounts as permitted by 280E while incurring ordinary business expenses in a different entity that may not be subject to 280E’s restrictions. Good cannabis investors will analyze the company’s accounting and the company’s treatment of certain expenses as non-deductible ordinary business expenses versus costs of goods sold to try to evaluate the risk of unanticipated tax liabilities resulting from a 280E audit.
Pay particular attention to the company’s real estate portfolio. Cannabis licenses are often tied to a parcel of owned or leased real estate, so investors are well advised to understand the licensed entity’s rights as to the specific parcel of real estate. While some holders of cannabis licenses own their real estate free and clear of liens, many licensed parcels are encumbered by a mortgage or deed of trust. Many other license holders only lease or sublease the specific parcel of real estate that is subject to their license. In many cases, losing the right to possess real estate, whether through a foreclosure on a mortgage or deed of trust or termination of a leasehold interest, can seriously impact the value of the business if not wipe it out entirely. Debt service payments and lease payments must also be evaluated, as cannabis lenders and cannabis landlords charge much higher rates to cannabis operators than lenders and landlord would charge to comparable borrowers or tenants in other industries.
Related party transactions must be evaluated with care. Most cannabis operations involve not just a single entity but multiple related parties or affiliate entities. Why those entities exist and how those entities interact is important for all investors to understand. Often there are legitimate reasons relating to licensing, financing, geography (multiple state operations), and 280E compliance driving the complexity of the corporate structure, so complexity alone should not be considered a red flag. That said, a good investor will fully appreciate the reasoning behind the corporate organization before deciding to make an investment, for failing to understand the structure could leave an investor holding debt or equity claims against an entity that does not own or control the most valuable assets or could leave an investor structurally subordinated to claims against one or more of the other entities.
Understand the target company’s intellectual property. Most businesses derive at least some value, and very often significant value, from their intellectual property. Cannabis businesses are no different, but their strategy for protecting their IP may differ in comparison to other businesses because marijuana remains illegal under federal law. Cannabis businesses find it difficult if not impossible 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. Using a mark in connection with a cannabis business violates that lawful use requirement, so the PTO declines to register cannabis related trademarks. Accordingly, a cannabis business that relies on customer brand identification will need an IP strategy that does not involve federal trademark protection, such as state level protection as well as common law protections.
Note also that brand name companies outside the cannabis industry have become increasingly aggressive in going after cannabis operators for infringing on their intellectual property rights. Mars Wrigley, the owner of Skittles, is currently suing the owners of Zkittlez for infringing on their intellectual property rights. If successful, it is possible that other cases will follow.
To conclude, as more jurisdictions legalize cannabis and as the regulatory frameworks within the legal jurisdictions mature, it is likely that cannabis investment opportunities will continue to increase. For investors contemplating cannabis investments, developing an understanding of both the cannabis industry on a macro (state) level as well as the applicable cannabis business on a micro level will be important. Although not by any means an exhaustive list, the issues described above should give financial investors the perspective on key issues to begin to speak with confidence to the promoters of specific cannabis investment opportunities.
This article is for information purposes only and should not be construed as legal advice, business advice, investment advice or tax advice.
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