We have been working lately with a number of cannabis businesses that are doing well and are ramping up their operations. In an effort to reward their effective employees and to dangle a carrot in front of those employees to extend their good work into the future, some of these employers are offering equity incentives to their employees. These fit into three main paradigms: stock grants, restricted stock grants, and stock options. Because stock options as compensation for employees have fallen out of favor, I will not address those in this post.
Employee equity creates unique issues for marijuana businesses. Given the uncertainty in the industry due to both federal law issues and to the lack of good or long-standing commercial industry data, valuing stock grants can prove tricky. Additionally, the majority of marijuana enterprises are still small and medium-sized businesses whose trading of shares is severely limited. Finally, the majority of marijuana entities are structured as Limited Liability Companies (LLCs), which require significantly more maneuvering than corporations when granting equity to employees.
The easiest of the choices on how to give equity to a marijuana business employee is the simple stock grant. With this form of compensation employees receive some set number of shares or membership units in the company. In a closely held business, the employee also needs to receive a certificate stamped with a “restrictive” legend clarifying that the stock cannot be sold on the open market unless its sale is registered or it falls under an exemption. The SEC clarifies those rules well here. The problem with stock grants though is that they do not give employees much ongoing incentive to perform well for the company. Sure, the value of the shares may go up if the employee is more productive, but that effect is often too indirect to create real incentives for continued employment.
Hence, we have restricted stock grants. Restricted stock grants are equity grants conditioned on some activity by the employee, generally the employee’s continued employment with the company. If a restricted stock grant is made to a marijuana employee today, it could state that if the employee is still employed with the firm in 2020, that restricted stock grant will vest and the company will issue the employee some additional number of shares at that time. If the employee quits or is terminated before vesting, the employee forfeits all rights and never gets the stock. These structures work for employees because even though the grant may be made in 2015, it does not become taxable to the employee until the stock either ceases to be at substantial risk of forfeiture or becomes otherwise transferrable.
Our main focus with our marijuana clients wanting to incentivize their employees has been to rework their LLC operating agreements so that they can offer these types of equity deals to their employees. Because we are doing something that mirrors the use of corporate shares, we typically put “membership units” into the LLC operating agreements. The majority of tax court and civil cases dealing with these types of arrangements are in the context of corporations so it is generally a good idea to try to mimic these corporate arrangements as much as possible.
Bottom Line: Though it can be a good idea for marijuana enterprises to reward and retain their employees by giving them a piece of the pie, to avoid disasters, they need to structure these equity grants correctly, while being mindful of the tax consequences for both employee and employer.