The Pitfalls of the Sweat Equity Model in Small Marijuana Companies

We see this scenario all the time: a newly licensed marijuana producer wants its owners to enter into an operating agreement or shareholders’ agreement after the company has been formed. One party is putting in 100 percent of the cash, and the other party is putting in work and expertise, and they have agreed to split the company 50/50. Sounds easy, right? In reality, ownership arrangements like this are complicated on both ends. And in our experience, they are the structures that most often go sour.

The problems stem from the same issues that face many closely held businesses: startup is the honeymoon phase, it’s difficult to foresee the ownership spats down the line, and parties’ expectations may not be aligned. The financier probably sees his money investment being paid off before distributions go to both parties. Otherwise, if the business falters in the short term, the working partner could go away with a decent chunk of change, while the investing partner could end up losing more than he or she gained in the process. Unless it is made clear to the working partner that the investor wants to see priority payback on the invested amount, this disagreement will eventually arise. Even if the partners do come to an informal agreement, terms like timing of payments or a time limitation on return of capital are impossible to set without having a fully negotiated agreement in writing.

Another common dispute occurs when the investing partner is surprised that they gave up 5o percent equity in the company for a sweat-equity partner that is not putting in enough sweat worthy of the equity. Without an agreement in place for vesting of equity over time, the non-investing partner could end up with a 50 percent stake in the business for doing almost nothing at all. This is where employment agreements, incentive agreements, and time-based vesting of ownership are all useful, if the parties are willing to enter into them.

From the opposite perspective, the sweat equity partner may be frustrated by his perception that he is “doing all the work” while the investing partner is just letting her money work for her. The working partner might also have bargained for more than he can handle and realize shortly after opening the business’s doors that there is more work to be done than he realized, and he’s not getting paid enough.

Bottom line: any number of things can go wrong in this sort of equity arrangement. When partnerships (using the word in the non-legal sense) like this work, they are often set up as lending and employment deals, rather than as profit-distribution deals. The investor receives regular payments until his original investment and some interest have been paid off. The sweat-equity partner receives a controlled salary with vesting of equity over time, and the partners both end up receiving a fair deal during the first few years of business operations.

Deals do not have to mirror these terms exactly, but is is important for all parties to at least think through these issues and to put their agreements in writing. Otherwise, a successful operation can turn south very quickly. Do not play armchair business lawyer on these deals or you may find yourself on the wrong side of the line with no buy-out and no recourse.

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