Over the years in my practice, including several instances in the past six months, I have advised cannabis business owners when a former partner has come back to haunt the business operations, usually looking for some type of payout based on a prior conversation or an agreement originally inked upon a lost napkin or envelope.
If You Haven’t Completed Your Partnership Agreement, You’re Not Unusual
In a perfect world, business partners would agree to all of their business terms, form an entity, sign an operating agreement, give copies of everything to their attorneys, and unswervingly abide by their original agreement. I do not practice law in a perfect world, and business owners almost never do things in the “right” order from a legal perspective.
Your cannabis business is often developing organically, and no one wants to slow down and spend money to put things on paper that you all agree on. I get it. I have had dozens if not hundreds of conversations with business owners early in the business formation, midstream, or at the end of a business when a final sale is on the horizon or the company is significantly altering its ownership structure.
Ignoring Your Agreements Won’t Make Them Disappear
Often core cannabis business owners award minority equity (like stock) to promising talent at the business’ early stage because: (a) the business has few financial assets to give except equity and (b) equity will potentially appreciate, giving the recipient a reason to stay with the company and work hard for the long-term.
Business disputes happen at all stages of a company’s business, so it is not uncommon for some of these minority owners to have disputes with the core owners and leave, often without dealing with the equity that has been granted. The departing minority owner thinks the cannabis company’s equity is not worth much, so they do not feel like they are leaving anything on the table when they quit. The majority owners often continue running the business and ignore that there is someone missing from the company’s cap table, which information does not always get passed onto the accountant for year-end tax reporting or the attorney for recordkeeping updates.
You Issued Securities. Now What?
When you offer someone debt, equity, or quasi-equity (like options or convertible debt) in your business in exchange for something of value (funds, IP, other assets, or sweat), you issue securities. All state attorneys general and divisions of securities take this seriously, and the federal Securities and Exchange Commission does, too (even if it’s cannabis). If you offered and the recipient accepted and performed their obligations to earn the minority interest, that constituted a securities offering.
Even though employee equity grants are treated differently than an outside investor putting money into a cannabis business, the pitfalls are similar. The most common ways these types of deals go bad is when an investor claims they were defrauded because the company received something of value from the investor and the investor did not get what they were promised.
The state attorney general sometimes gets involved to add a breach of securities laws investigation on top of the investor’s fraud claim. State departments of labor may get involved where the equity grant was issued as part of a compensation package.
There are often regulatory filings (or at least a legal analysis or two) that need to happen when a cannabis company issues securities. This is true in every state, but there are very often filing exemptions that eliminate these filing obligations – hence the need for the analysis at the outset.
With securities filings, the rule of thumb is that it is better to file late than not at all, even if it is several years later. Your legal counsel can help you analyze your compliance steps and risks.
Our Company Structure is Really Different From Five Years Ago. It’s Not Fair!
Companies may expand to include parents, subsidiaries, and related entities as they add licenses, assets, and other business partners. Often a long-lost business partner will resurface when they hear that the company or the owners are about to engage in a significant transaction that could result in a healthy return on their investment.
You can expect that your prodigal business partner will push for the highest valuation possible for their ownership interest (of the entire business enterprise), even if you feel like they are not entitled to a large payout because they left the company years earlier. As unfair as that windfall seems, you need to deal with the business partner, and the sooner you can reach a negotiated buyout price, the better.
A negotiated settlement is almost always much cheaper than a fight in court or even hiring one or more valuation firms to agree upon the value of the minority partner’s ownership interest. Also keep in mind that any prospective purchaser for the entire company will require you to disclose any ownership-related disputes during your prospective sale process, and they will not be willing to proceed if you have not settled your internal ownership affairs.
In the next post I’ll discuss how to deal with valuation considerations when trying to decide how to buy out a long-lost (and undesired) minority partner who recently resurfaced.