Best Practices: Shareholder Agreements for Cannabis and Hemp Companies

Best Practices: Sharehold…

Raising capital through the sale of stock can be challenging for new business ventures. Like many other companies, cannabis and hemp business owners often invite shareholders to invest in the early stages of their venture. But all too often, the cannabis business structure lacks a vital document: a comprehensive, written shareholder agreement.

While written shareholder agreements are critical in all industries, in the cannabis sector, an improperly drafted shareholder agreement can jeopardize your most vital asset—your cannabis business license. If your company has more than one shareholder and has or is seeking a cannabis or hemp license, this post is for you!

Cannabis Business Shareholder Agreement: The Basics

We’ve written about the different types of cannabis business structures before, and you can read about this topic here. For simplicity, in this post, we will refer to operating agreements, LLC agreements, buy-sell agreements, and partnership agreements as "shareholder agreements."

Regardless of which structure you choose, one of the essential elements of corporate governance for a privately-owned company is often the most overlooked: the principals should maintain strict controls over ownership. You want to know and control who you are in business with. In the cannabis and hemp sectors, this basic tenet takes on significant importance. Why? Cannabis business owners must establish expectations about how new investors will be brought in and how existing shareholders may transfer stock. In addition, state-imposed ownership requirements and restrictions must be addressed. If you're not a cannabis lawyer, these can be difficult to analyze, but they're vital to understand. For example, if stock is issued or transferred to a person who disqualifies the company from holding a cannabis or hemp license, your license could be in jeopardy.

Given the nature of the cannabis industry, these requirements vary from state to state, but they generally focus on a few critical areas:

  • In-state residency requirements
  • Limitations on the number of out-of-state shareholders
  • Limitations on any shareholder’s ownership of other in-state cannabis licenses
  • Prohibitions on shareholders who either have certain criminal convictions or have had a professional license revoked

For hemp licensees, these state requirements outright prohibit or severely limit the involvement of persons who have had certain drug-related convictions in the past ten years.

Additionally, securities laws effectively disqualify a company from raising capital if the company is associated with so-called “Bad Actors” who have previously engaged in securities fraud or mail fraud. Companies are required to conduct reasonable inquiry to ensure their promoters, directors, officers, and 20% or more shareholders are not "Bad Actors." You can read more about that here.

If you're currently in the process of establishing your cannabis business structure, now's the time to protect yourself from future risks. A best practice is to include specific representations and warranties in your subscription agreement that track the shareholder disqualification language and relevant language to your state’s cannabis or hemp statute. This causes investors to affirmatively state their ownership of stock will not disqualify the company from obtaining or keeping a cannabis or hemp license.

In addition, your shareholder agreement should include an affirmative obligation on the part of shareholders to provide any information requested by regulators in connection with obtaining or maintaining the cannabis or hemp license, including submitting to fingerprinting. It should also authorize the company to disclose this information to the cannabis and hemp regulators.

Finally, your shareholder agreement should include "Disqualifying Events" that mirror the state-imposed restrictions. The company should have a purchase option to redeem a shareholder who is found to have experienced such a disqualifying event. The purchase price is generally fair market value for events that are not the "fault" of the shareholder (i.e., the company changes its business plans and seeks to acquire a new type of license or expand to a new jurisdiction). While in the case of events caused by the shareholder's act or omission, the purchase price typically reflects a significant discount and extended payment terms to enable a cash-strapped company to exercise the option without bankrupting the company.

Cannabis Business Structure: Get Expertise on Your Side

Writing a solid shareholder agreement should be a top priority if you're interested in attracting investment capital in your cannabis or hemp venture. When you engage a business lawyer to draw up the document, we suggest going one step further and retain a cannabis law expert to draft the document. Your license depends on it.

Culhane Law welcomes an opportunity to bring our extensive corporate, business, and cannabis law experience to work for you. If you're ready to ensure that your cannabis or hemp business is built on a firm foundation, reach out.

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 licensed to practice law in California, Colorado, Minnesota, and Wisconsin.